Quality companies are getting stronger, but their stocks are falling

Michael Brush is a columnist for MarketWatch. At the time of publication, he had no position in the stocks mentioned in this column. Brush suggested LNG, Nvidia and Chipotle Mexican Grill, in his stock newsletter, Brush Up on Stocks

If you’re a long-term investor, this year’s liquidation is good news as it offers a great opportunity to acquire quality businesses at a discount. But wait a second. If a company is “high quality”, why would its shares be affected?

“Portfolio managers are selling what they can rather than what they want to sell, and high quality has more liquidity,” says David Sekera, US market strategist at financial services research firm Morningstar Direct.

Now is the time to join the liquidity providers and buy the weakness of the quality names that are getting dunked. You probably won’t catch the exact bottom – and if you do, you’ll be in luck. But quality companies should survive and thrive on the other side of the bear market.

What exactly is meant by “quality”? Here are definitions and examples of four fund managers and strategists.

Solid cash flow and strong balance sheets

This is critical because it prevents a company from being beholden to banks, bond investors or the stock market to continue funding growth, says Chuck Severson, who manages the Baird Mid Cap Growth Fund. “It’s an advantage at times like this,” Severson says.

Financially sound companies don’t have to stop doing research and development. They don’t have to stop opening stores.

“And they come out stronger because their competitors are facing tough challenges,” says Severson. “These companies take part in this environment.”

LILY Investors look to bank earnings season for signs of recession

Here’s another benefit – during recessions, weaker companies cut staff to maintain margins. Thus, the strongest companies have the opportunity to recruit talent.

Severson is worth listening to because his fund has beaten its category and its Morningstar Mid-Cap Growth Index by one to two percentage points, annualized, over the past three to five years, according to Morningstar Direct.

Quality mid-cap companies are currently trading at attractive discounts, Severson says.

Here’s his logic — the group is down about 30%. This corresponds to the typical 30% decline in income in most recessions. But this recession – if we have one – could be milder.

Why? The economy is boosted by the decline of the coronavirus, as well as negative real interest rates and strong employment.

“It would be unlike any recession we’ve ever had,” he says. “We will see earnings estimates drop quite significantly. But I don’t think as broadly as stocks tell you. There are many of our businesses that I’m happy to buy with a one-year time horizon. “

In its portfolio, consider Synopsys and Cadence Design Systems, which offer automation software that engineers use to design and test chips. Their shares are down sharply compared to the rest of the tech sector, but trading performance has held up.

Synopsys reported revenue growth of 25% to $1.28 billion in the first quarter, and operating cash flow rose 29% to $905.7 million. The company expects sales growth of 20% to produce $1.6 billion in operating cash flow this year. Cadence reported first-quarter revenue growth of 22.5% to $901.7 million. Operating cash flow increased by 61.5% to $336.6 million. It expects sales growth of 15% this year to $3.43 billion at the top of forecasts.

Argent Capital Management portfolio manager Kirk McDonald also puts cash flow on his short list of signs of quality in companies. He looks for companies that generate higher cash flow than their peers. He also likes to see above-average profitability, high returns on assets, growth in dividends or share buybacks, and certain changes that could serve as a catalyst, such as a new management team or new products.

Here’s a company that ticks enough boxes to be considered a quality name: Cheniere Energy, which exports liquefied natural gas from the United States.

Cheniere used his huge cash flow to buy back shares and increase dividends. The company will return $2 billion to shareholders this year through buyouts, McDonald said. It also uses cash to pay off debt. Cheniere has increased its return on assets every year since 2016. ROA was 8.2% last year compared to 3.5% in 2017. The big change in the mix here is increased demand for US LNG in Europe as the continent is trying to wean itself off. Russian supplies.

McDonald’s is worth listening to because, since its inception in 2014, Argent Capital Management has posted annualized returns of 12.75%, versus 11% for the Russell Mid Cap Index, through the end of March.

Shops with wide moats

Protective moats help businesses generate excess returns over the long term. Warren Buffett is a huge moat fan, which probably explains his success. These protective barriers are also at the heart of Morningstar’s investment analysis.

Moats are created by assets, such as strong brands, proprietary technology, scale advantages due to size, or network effects (more users render a more valuable service). Companies with moats “generate excess returns over the long term and have the best ability to weather economic disruptions,” says Sekera, US strategist at Morningstar.

In the current sale, you can find an unusually high number of wide-moat companies with four- and five-star ratings (Morningstar’s highest). The list includes several that have “seldom traded at such deep discounts to our intrinsic valuations,” Sekera says.

Choice of three

First, consider chip design firm Nvidia, which creates high-performance graphics processing units used in games, data centers, artificial intelligence, computer-aided design, video editing and vehicles. autonomous. Nvidia benefits from the R&D prowess that powers its GPU technology.

“This is the first time since November 2012 that Nvidia has been four stars,” Sekera said.

Next consider the rating agencies S&P Global and Moody’s. These four-star rated companies have economic moats due to their track record and reputation, as well as the regulatory challenges faced by potential new competitors.

Pricing power

Bill Ackman of Pershing Square says pricing power is a key characteristic that defines “quality” in business. After all, if a business can raise prices without losing customers, that’s a sign that customers really like what it does. This appears to be the case with Chipotle Mexican Grill, Ackman’s second largest position in Pershing Square (at 17% of the portfolio).

Chipotle raised prices 4% in the first quarter. That helped propel a respectable 16% revenue growth to $2 billion, and a beating in profits. Despite the price increases, same restaurant sales were up 9%, telling us that customers weren’t confused by the increases. (The remainder came from new restaurant openings.) Higher prices helped operating margins edge up to 9.4% from 9.3%.

But for real price increases that beat inflation, consider another major Severson holding in the Baird Mid Cap Growth Fund: Pool Corp. which helped push sales up 33% to $1.4 billion.

The company’s operating profit margin increased by 4.5 percentage points to 16.7%. Operating income rose 83% to $235.7 million.

Expect more of the same. The company raised its earnings per share target for the full year to $19.09 from $17.94 at the high end of guidance. The pool is growing through acquisitions, but it is also benefiting from migration to southern states where pools are more common than in the north.

This article was published by MarketWatch, another title of the Dow Jones Group

Comments are closed.