After a multi-year run of impressive gains investors have been let down by fast growth stocks in 2022. The US technology-heavy Nasdaq index has fallen more than 20% since the start of the year as investors have suddenly balked at paying high valuations to gain exposure to the potential for significant growth in the future.

The performance of this headline index doesn’t even tell the whole grim story as previous high-fliers like Netflix (NFLX:NASDAQ), down by two thirds year-to-date, and PayPal (PYPL:NASDAQ), 59% lower over the same period, have returned to earth with a bump.

Against this backdrop now is an opportune time to turn to businesses which deliver steady if unspectacular growth year after year, generating lots of cash which they can then return to shareholders. These types of stocks are sometimes known as ‘compounders’.

WHAT IS A COMPOUNDER?

Morgan Stanley says: ‘The key financial characteristic of compounders is that they enjoy sustainable, high return on invested capital, which is generated by a combination of recurring revenues, high gross margins and low-capital intensity. This combination helps support strong free cash flow generation that, crucially, must be either reinvested or distributed to shareholders.’

In simple terms return on invested capital is the amount of money a company makes above and beyond the average cost it pays for its capital, whether that is through debt or shares.

‘Compounders’ might only be delivering growth in the mid-to-high single digits but, crucially, the growth is consistent, it already exists rather than being promised years down the line, and it is backed by lots of cash.

Compounding describes the process where investment returns themselves generate future gains. The value of an investment can increase exponentially because growth is earned on the initial sum of money and the accumulated wealth.

The cash generated by compounders can either be used to supercharge the company’s own growth by being reinvested in the business or it can be returned to shareholders who can use it to generate their own compounded returns, something we will explore with a real-world example later in this article. These effects can be very powerful over time.

VALUATIONS HAVE BECOME MORE ATTRACTIVE

The problem for investors attracted to this type of share is that many compounders had become expensive over the past decade or so. Ever since the financial crisis their attributes had been in high demand thanks to extremely low interest rates, and this had helped drive shares in many of these firms to elevated levels.

However, because of high valuations these companies have also been caught up in this year’s market rotation into value stocks and have seen their share prices fall accordingly. This has created an opportunity to buy compounders at more reasonable prices.

In a recent piece of research Bank of America looked at a group of 33 compounders noting that between 2007 and 2015 they traded, on average, at price to earnings multiples in the range of 15 to 20 times earnings but that from 2015 that went up to a peak of 35 times as of the fourth quarter of 2021.

Subsequently this collection of shares has seen their average earnings multiple decline to 26 times (as of 7 June).

How it works in practice – Ashtead is a king of compounding

We discuss the appeal of tool hire business Ashtead (AHT) in more detail later in this article but as an archetypal compounder which has delivered significant growth in earnings, cash flow and dividends over a long period of time, it offers a useful example of how powerful compounded returns can be.

Let’s assume you bought 1,000 shares in the company at the beginning of 2012 when they traded at 226p, amounting to an initial investment worth £2,260.

Every time you were paid a dividend you used that sum to buy as many shares in the company as you could. Any money left over would (for simplicity’s sake) be held in a zero-interest easy access account and added to the next dividend payment to buy more shares.

Based on our calculations, after reinvesting 10 years’ worth of first-half and full-year dividends, a decade later your stake would be worth £66,767. In addition, you would be holding 1,152 shares compared with the 1,000 originally purchased. This represents a return of 2,854%.

As well as the boost from dividend reinvestment, you will also have benefited from Ashtead’s own smart reinvestment of its cash which has helped support significant gains in earnings and the share price.

Note: In our example, the purchase price for each trade was based on the closing share price on the dividend payment date. It does not include trading costs. 

FOUR COMPOUNDERS TO BUY

Shares has looked for stocks which have the right qualities to offer strong and consistent returns, and which are trading at less than 20 times forecast earnings.

We have identified four names which investors should consider buying with a view to achieving long-term compounded gains.

Two US-listed companies feature on our list. For any account apart from a SIPP (self-invested personal pension), you will need to complete a W-8BEN form to buy US-listed stocks, and any dividends from these investments will be subject to a withholding tax of 15%. US investments inside a SIPP do not require a W-8BEN form and they are automatically exempt from withholding tax.

This article provides more information on buying overseas-listed shares.

Our quartet of stock ideas features water treatment specialist A.O. Smith (AOS:NYSE), tool hire business Ashtead (AHT), meat producer Cranswick (CWK) and semiconductor firm Texas Instruments (TXN:NASDAQ). [TS]

A.O. Smith (AOS:NYSE) $58.06

Investors on the lookout for a US-listed compounder trading at a valuation discount to recent history might consider putting money to work with A.O. Smith (AOS:NYSE), a long-established yet fast-growing global water technology company.

Dividend-paying A.O. Smith has consistently delivered a return on capital employed north of 20% according to Stockopedia and has delivered a trailing 12-month return on invested capital of almost 25%.

Founded in 1874, Milwaukee-headquartered A.O. Smith is one of the world’s leading manufacturers of residential and commercial water heating equipment and boilers, as well as a manufacturer of water treatment products, selling its wares in North America as well as Europe, China and India.

Based on Stockopedia data, a year-to-date share price correction has left A.O. Smith trading on a prospective price to earnings ratio of 16.4, falling to 15.2 for 2023’s estimate. 

This suggests recent weakness presents a buying opportunity for fans of quality merchandise on sale. In the face of component shortages, supply chain issues and Covid surges, A.O. Smith’s first quarter results (28 April 2022) still revealed a 27% year-on-year sales increase to $978 million as the company raised prices to offset higher costs. [JC]

Ashtead (AHT) £35.77

No discussion of long-term growth compounders would be complete without a mention of international plant and equipment hire firm Ashtead (AHT).

Yet due to concerns over global growth and the possibility of a slowdown in the US new-build housing market – which only represents a fraction of Ashtead’s business – the shares are down more than 40% this year.

For this, investors are being asked to pay just 14 times this year’s earnings and 11.7 times next year’s.

Recent full-year results (14 June) revealed record performance with revenue up 18% to $7.96 billion and pre-tax profit up 35% to $1.67 billion. The company was able to invest $2.4 billion in the business and $1.3 billion in bite-sized acquisitions to help lay the groundwork for future growth while also buying back $414 million worth of shares and paying out $269.3 million in dividends. 

According to analysts at Bank of America, even after spending on new equipment to support future rental growth the firm will still generate enough free cash flow to increase dividends by more than 10% and buy back between $600 million and $700 million worth of shares every year. [IC]

Cranswick (CWK) £30.66

A 25% one-year share price reverse at Cranswick (CWK) should have bargain-hunters salivating since this high-quality compounder, which deploys capital at consistently attractive rates of return, is on sale amid stiffening consumer and input cost headwinds.

The fresh pork, poultry and convenience products play, which supplies the retail and food-to-go sectors, has pedigree in passing on rising pig prices to customers and uses its cash generation to support sustained investment in its asset base to cook up organic growth and fund complementary acquisitions.

Cranswick, which has strengthened its non-meat range and entered the fast-growing pet food market through acquisitions, continues to show resilience in the face of labour and supply chain challenges.

Sales topped £2 billion for the first time in the year to March 2022 and Cranswick delivered a 5.6% hike in pre-tax profits to a forecast-beating £136.9 million while achieving a healthy return on capital employed of 16.9%.

For the year to March 2023, Shore Capital forecasts pre-tax profits of £142.6 million for a rise in earnings per share from 204.5p to 213.2p, placing Cranswick on a prospective PE ratio of 14.4, a discount to a 2019 high of 28.9 according to Stockopedia.

Having now delivered 32 years of unbroken dividend growth, Cranswick is forecast to grow the shareholder reward to 79.4p this year ahead of 83.3p in 2024. [JC]

Texas Instruments (TXN:NASDAQ) $165.37

In less than 25 years Texas Instruments (TXN:NASDAQ) has had to deal with an enormous dotcom bubble, a massive worldwide debt crisis and now, a global pandemic and its fallout. In each case, the company has recovered and prospered, and according to Morningstar data, has never once cut the dividend, with an unbroken record of increasing its annual shareholder payout which stretches back over 30 years.

Morningstar calculates that over the past 10 years, shares in the world’s largest manufacturer of analog microchips have delivered average yearly returns close to 21%, beating the Nasdaq’s 16.8% and S&P 500’s 14.4%.

If that doesn’t look like much of an outperformance, let’s look at what it would have meant to you.

In simple terms, the power of compounding would have seen an investor’s £1,000 in Texas Instruments grow nearly twice as much as owning an S&P tracker.

This is not a coincidence. Texas Instruments’ dominance in its field gives it pricing power, demonstrated by gross margins that have averaged 65%, 12 percentage points above the industry average. Operating margins are more than 40% on average.

The company also has a superb record of squeezing value out of what it spends, with a five-year average return on investment of 34.1%, nearly twice that of the industry, while return on equity since 2017 has worked out at 55.7% on average.

These are all marks of a high-quality business capable of quietly building considerable wealth for shareholders over years.

‹ Previous2022-06-16Next ›