Nicholas Hyett 14 December 2018
High quality companies should always be front of mind when it comes to investing. But when times are tough, quality counts more than ever. A high quality company should be able to weather a downturn, and take advantage of opportunities that allow it to make the most of the recovery.
With Brexit and global trade wars rocking the stock market, we thought it would be helpful to outline what we look for in a quality company.
The first number you see in a company’s financial statements is revenue. It simply tells you the value of goods or services sold.
Companies that can keep revenue healthy even when times are tough should perform relatively well in a downturn. There are several ways they can do that.
The first, and perhaps most obvious, is through long contracts with high quality customers. That could be leases on properties or contracts to build new warships. While new tenants or contracts need to be won from time to time, payment in any given year isn’t overly dependent on the economic cycle.
Consumer goods businesses can benefit from something similar.
Theoretically we could all give up soft drinks and stick to tap-water if wider economic conditions called for a round of belt-tightening. Realistically though a 60p can of Coca-Cola doesn’t dent the bank balance all that much, and things have to get very bad before these kinds of everyday luxuries are out of reach for most people.
That can make branded consumer staples, from soft drinks to shampoo and cigarettes, a pretty attractive place to be when times get tough.
Cash is king
There’s a saying in investing that “Sales are vanity, profits are sanity, but cash is reality”.
Huge sales don’t guarantee huge profits. Carillion’s final set of half year results showed underlying profits of just £50m on revenue of £2.5bn. When margins are that low even a small fall in revenue can wipe out profits altogether. It also suggests there’s not much setting a company apart from its competitors.
A healthy margin provides room for error, but also means customers value the product, and are prepared to pay over the odds for it.
Unilever, which makes branded products from Domestos to Dove, can deliver an operating margin of 18.6%, while McBride, which manufactures own brand cleaning products for supermarkets, managed just 5.5%. Consumers are prepared to pay over the odds for branded products, but not for supermarket own brands.
However, even profits aren’t as reliable as they might seem at first glance. Accounting rules mean it’s possible to recognise a profit before you’ve actually received the money. That’s perfectly sensible in lots of cases, but also creates the potential for accounts to stray from economic reality.
That’s not the case with cash.
Cash is the money actually in the bank, and is much more black and white. Companies that are good at turning profits into cold hard cash, often don’t need to reinvest heavily to generate more profits. And those capital light models mean profits are more likely to reach shareholders.
A good measure here is to compare operating profits with operating cash flow – known as cash conversion. Ideally you’d like a high proportion of operating profits to turn up in operating cash flow (you can find both numbers in half year and full year company statements).
Some tech companies, like Rightmove, that have low capital requirements can post a cash conversion of around 100%.
High margin businesses with good cash conversion have options, as long as that cash isn’t tied up servicing debt.
Debt can be a killer in a downturn.
Even the most reliable revenues will fluctuate from time to time. High margins will sometimes shrink and cash conversion can slip. In short, cash profits are uncertain.
Debt isn’t. Whether the economy is booming or crashing, lenders always want their pound of flesh.
Now, debt’s not all bad. Far from it. It can fund expansion and help turbo charge returns for shareholders by doing so at a lower cost than issuing new shares. But heavily indebted companies can struggle if profits disappear in a downturn.
High interest payments can restrict investment and might mean dividends are cut as management look to get the balance sheet back under control. If debt gets really out of hand companies could be forced to come to shareholders for a bailout.
When the going gets tough
There’s no such thing as a dead cert in investing. But we think a focus on quality will help get the most out of your money even when times are tough.
Companies whose revenues are dependable even in the bad times, have healthy margins and good cash generation should be good investments over the long term. Throw in a balance sheet with little or no debt, and management have the best possible chance of thriving regardless of the conditions.
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