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Three shares for the next decade

We take a closer look at three shares with long-term potential.

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

An investment in shares should be for the long term. The stock market can be volatile, and individual shares even more so. The longer you leave your money invested, the more time it has to ride out any short-term ups and downs.

A long-term strategy doesn’t necessarily mean every individual investment needs to be held for the long term though. If you invest in a business because you think it’s undervalued, it might not make sense to keep holding the shares once they’ve risen to what you think they’re worth. Because the stock market is so volatile, that could happen fairly quickly.

It’s not enough to invest in a company just because it’s good value. If your investment rises to full value within a year, what do you do with the rest of the decade?

We’ve chosen three businesses with attractive competitive positions in their own markets. Each business has the potential to grow and compound wealth over the long term thanks to durable, hard to replicate competitive advantages. However, each business is fairly expensive, so the shares could disappoint if the businesses fail to live up to expectations.

This article isn’t personal advice. If you’re not sure if an investment is right for you, ask for advice. All investments fall as well as rise in value, so you could get back less than you invest. Past performance isn’t a guide to the future.

Investing in individual companies isn’t right for everyone – it’s higher risk as your investment is dependent on the fate of that company. If a company fails, you risk losing your whole investment. You should make sure you understand the companies you’re investing in, their specific risks, and make sure any shares you own are held as part of a diversified portfolio.

Microsoft

Microsoft has been at the epicentre of the technological revolution we’ve been living through for the last few years. Microsoft still makes the Windows operating system, but over the years it’s used that core product to pivot into adjacent spaces. The group reports through three primary segments:

Productivity and Business Processes

This is basically Microsoft Office and associates in various guises, plus LinkedIn and Dynamics. Software used to be something you bought as a one off, but companies have realised that it’s much more profitable to sell you a subscription. That way you end up paying every year. The official jargon for this type of business model is SaaS, or “Software as a Service”. Microsoft’s incredible dominance in office productivity software means revenue has been growing and reliable.

What’s more, the division benefits from exceptional operating leverage. The cost of providing Microsoft Office or LinkedIn is relatively fixed no matter how many people sign up to use it. This means that once these fixed costs have been covered, every extra subscription is almost pure profit. As a result, even though sales rose 16% last year, operating profit rose 30%.

Intelligent Cloud

The cloud business pulls off a similar trick to Office 365 – it turns one-off investments into repeat rentals and a product into a service.

Go back ten years or so, if your business wanted to do anything remotely sophisticated with computers, you needed to invest a lot of money into servers, hard drives and wires etc. But the cloud turns these big, one-off investments into affordable subscriptions.

If a business needs more computing power it can simply rent it, and many of the associated bits of software, from Microsoft’s cloud. This is flexible and needs less capital investment, making it an attractive option for lots of businesses.

Microsoft has a couple of key competitive advantages in the cloud. The first is scale, because larger datacentres are more efficient than smaller ones.

Another is technical expertise, as customers also want sophisticated software to go with raw processing power. Microsoft has been investing a fortune in this fast-growing, high margin business though, and capital expenditure has risen from under $6bn in 2015 to $20.6bn last year.

More Personal Computing

This is everything else, including Windows, gaming, and Bing etc. There are some attractive parts of the business in this segment, like the potential for cloud-based gaming and esports to really go mainstream in the next decade. But there are also some less exciting bits – presumably some people use Bing, but I’ve never heard anyone admit to it.

Microsoft Segment Revenue

Past performance isn’t a guide to future returns. Source: Company accounts. Microsoft’s financial year runs to 30 June.

In December 2012, Microsoft shares traded on a Price to Earnings (PE) ratio of 8.7 and a market cap of $222bn. With the full benefit of hindsight, that was a ludicrously good bargain. The PE ratio is now around 32 and the market cap is just under $2.2 trillion. Remember that past performance is not a guide to the future.

It looks like investors have missed the boat, but we think Microsoft still has something in the tank. Demand for productivity software and cloud computing looks like it will continue to grow as ever more of our lives and incomes are spent online. Microsoft is at the heart of it all, and it charges for access.

See the Microsoft share price, charts and our latest view

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Diageo

Diageo is one of the world’s leading distillers, with a speciality in top and middle shelf liquor.

Premium spirits are an attractive market because brand strength counts for so much. Diageo’s brands include Johnny Walker, Smirnoff, Gordon’s, Captain Morgan’s, Baileys and Guinness. Largely because its brands allow it to charge premium prices, operating margins were above 25% every year in the decade leading up to 2020.

The internet has made it possible to build a competitive brand more easily than in the past, and Fevertree has shown how in mixers. But spirits might be a little harder, in part because creating a new product from scratch can take years as many spirits need to be aged. This means would-be competitors, especially in whisky, often need to pair an existing distillery network with celebrity branding to get going.

We think the strength of Diageo’s brands will be enough to fend off competitors for a while yet though. It will also have learned from Schweppes’ failure to defend itself against Fevertree.

The pandemic wasn’t a great time to be a distiller. Despite a modest home-cocktail boom, sales still slowed without bars and restaurants. However, operating profitability remained relatively strong despite the disruption.

Diageo Operating Profit

Past performance isn’t a guide to future returns. Source: Refinitiv Eikon, 05/08/21. Red bars are consensus estimates.

But the big potential source of growth for Diageo is a growing middle class abroad. As people get richer they want nicer things, and they want to signal to their peers that they can afford nicer things. Premium liquor ticks both boxes, and the trend towards higher shelf booze was well established before the pandemic.

Diageo is well positioned to capitalise on this trend. It already sells its products all over the world, and its portfolio is broad enough to adapt quickly to changing tastes.

Diageo is carrying a little more debt than we’d like, and net debt is currently around 3.0 times cash profits. Management wants to bring that down to 2.5 times – we think it could come down slightly further. Recovering profits will do a lot of the work, but the total level of debt needs to come down a bit too.

Diageo currently trades on a PE ratio of 27.6, which is well above the long-run average. Given the group’s strengths and prevailing interest rates, it doesn’t necessarily look overvalued, but there’s not much room for error.

See the Diageo share price, charts and our latest view

Sign up to Diageo research

VISA

Visa is an electronic payments company. Regardless of who you bank with, your credit or debit card likely uses either Visa or Mastercard to process transactions.

In the case of a credit card, it’s your bank that’s lending you money – Visa just administers the payments. This means Visa isn’t on the hook if you miss a payment or default, it just charges a fee for every transaction.

Historians can debate whether it was the Lydians or someone else who first introduced metal coins. No doubt coins were a fantastically useful and convenient new technology when first invented. But today a pocket full of shrapnel seems almost irritatingly primitive.

It’s little wonder that cash was used for just 17% of all payments in the UK last year, down 35% year-on-year. This is partly because the pandemic made us more conscious about touching things, but the sheer convenience of contactless payments is a long-term winner in our view. And there’s plenty of growth potential left as several markets, including the US, are still relative laggards when it comes to contactless payments.

Visa Revenue

Past performance isn’t a guide to future returns. Source: Refinitiv Eikon, 06/08/21. Red bars are consensus estimates.

In just the last quarter, Visa processed 42.6 billion transactions and generated $6.1bn in revenue. Because costs are relatively low, Visa managed an operating profit margin of 66%, meaning the group made $4.1bn in operating profit.

Margins are so strong because Visa also benefits from significant operating leverage. Once the payments network is set up, each additional transaction costs very little to process. The result is a capital light, highly cash generative business.

The pandemic had crimped lucrative cross border transactions, but these are now well on their way to bouncing back. Once the pandemic recedes, we think these transactions will recover, and probably grow further if everyone decides to get away for a bit.

As is the case with Microsoft and Diageo, this kind of business doesn’t come cheap. Visa shares currently trade on a PE ratio of 34.2, which is well above the long-run average.

See the Visa share price, charts and our latest view

Sign up to Visa research

Unless otherwise stated estimates are a consensus of analyst forecasts provided by Refinitiv. These estimates are not a reliable indicator of future performance. Past performance is not a guide to the future. Investments and income they produce can rise and fall in value so investors could make a loss.

This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however HL has put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing. Please see our full non-independent research disclosure for more information.


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    Important notes

    This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

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