Finding tomorrow's big winners: 10 quality software companies

In the short term the outlook for stocks (and pretty much everything else) depends on the evolution of COVID, and how governments, households and businesses respond to it. These are big unknowns.

Activity is down since the beginning of the year and unemployment is up. The timeliest indicators of UK demand have for now stabilised at very low levels. This has caused firms to cut investment, reduce working hours and, in some cases, lay off workers.

It’s a risky backdrop for investors.

There are big opportunities for contrarians with an informational edge, but for many others the best course of action might be to build a robust portfolio of strong, quality companies bought at reasonable prices.

In amongst the uncertainty there are pockets of the economy that are safe and even stand to benefit. Identifying these industry groups and then looking through some of the highest quality candidates with the strongest momentum might lead us to companies that are well placed to continue growing.

Life after lockdown

We can’t get excited about a return to normality anytime soon, but as the saying goes: this too shall pass. In amongst all the grim headlines there are some green shoots.

Risky asset prices have picked up from their lows in mid-March. There are tentative signs of recovery in domestic spending in China. This is likely to be echoed in other countries that have started to relax Covid-related restrictions on economic activity.

The outbreak of Covid-19 began in China, with Wuhan and other cities entering lockdown on 23 January. Now, restrictions are easing and economic activity is resuming. High-frequency indicators such as energy consumption and road traffic suggest that activity is at almost 90% of normal levels. Industrial production had already recovered in March and was only 1% lower than a year earlier.

Retail sales remain weak (around 16% down on the previous year), so perhaps consumer spending is slower to recover. In South Korea, which also experienced the outbreak early, internet searches for restaurants are still well below their level a year ago despite the fact most businesses are open.

Working assumptions

My working assumptions are highly conditional and subject to change. The bulk of my portfolio does not depend upon these assumptions being correct. I am looking for stocks that can survive lockdowns of various length and severity. That said, having some thoughts on how things play out can help.

For now, I’m assuming a very sharp fall in UK GDP in 2020 H1 and a substantial increase in unemployment. Barring a second peak the bulk of this fall should be recoverable towards the end of the year, although certain areas (parts of the Leisure sector, for example) will see a more prolonged period of reduced demand.

Social distancing measures and government support schemes might remain as they are until early June, before being gradually unwound by the end of Q3. It’s not hard to see them lasting longer, though.

There should, at some point, be a rash of insolvencies. These lockdown conditions are exceptional, but as a general rule keeping companies afloat that would otherwise go bust is not good for long run productivity. One company I want to look at in this regard is Begbies Traynor.

It is possible that this lockdown has caused more permanent damage, as well. All of this has probably resulted in a dramatic reduction in investment. In Q2, business investment is expected to be around 40% lower than at the end of 2019, per the Bank of England.

Where to look

At some point soon, I intend to take a more data-backed look at the winners and losers of 2020 so far. For now, here is where I suspect the winners can be found:

• Food retail - supermarket sales in April were slightly higher than a year ago (Tesco, Morrisons, Sainsbury).
• Certain online retailers have reported strong demand for things like electrical goods and home office equipment. Maybe companies like G4M and TUNE. I’ll put BOTB here, too, even though it is not a retailer.
• Some specialty retailers that had closed voluntarily, such as DIY stores and takeaway food outlets, have started to reopen. Other “essential” stores never closed (eg. Halfords)
• Games makers continue uninterrupted (Keywords, Frontier, Sumo, Codemasters, CD Projekt). Other software and IT services companies will also be well placed.
• Consumer defensive companies that manufacture and sell hygiene products are in demand (Reckitts, PZ Cussons)
• Some companies have seen big share price moves as a result of development vaccines etc. from COVID-19. PhilH and co look at this a bit more here.
• Chemicals, pharmaceuticals, and electronic components seem to be largely undisrupted. There are historically good companies here, such as Victrex and Croda.
• A growing number of companies, for example in automotive, heavy industry and construction materials plan to resume production over the coming weeks, albeit at lower volumes initially.
• Demand for insolvency, restructuring and employment advice has increased — particularly for retail, hospitality and construction firms (Begbies).
• Demand for banking and financial services has also increased, as companies seek bridge financing. Larger accountancy firms said demand was holding up.
• Safe utilities companies should also be undisrupted.

A list of quality companies to research

Putting the above thoughts into some kind of actionable insight, I drew up a very simple screen that compiles companies in the Specialty Retailers, Food & Drug Retailing, and Software and IT Services industry groups and excludes Speculative and Highly Speculative shares.

Sorting these by QM Rank, the top 10 are all from the Software and IT Services industry group (out of interest, the closest non-software candidate was specialty retailer Pets At Home). Perhaps that in itself tells us something about where to look.

This screen can probably be refined. It does not touch on valuation or historic growth rates - these might be checks to incorporate later but for now I’m just looking to identify some safe stocks that are outperforming the market - hence the focus on QM and volatility.

I’ve encountered several of these are companies in various other long term quality screens. Moneysupermarket, for example, has exhibited high levels of profitability over many years now and probably warrants a closer look.

Rightmove is one of the highest quality companies out there. Perhaps it is worth seeing through the short term housing disruption to take a position in a company that regularly posts triple digit return on capital figures?

Computacenter’s last update referenced new business being generated by the shift to working from home. Its shares look to have been a steal at less than 1,000p a couple of weeks ago, but perhaps there is still value at 1,466p if it faces a structural growth opportunity.

Periods of heightened volatility can mark a change in market leadership. Looking at high quality companies that are faring well in these tough conditions might be one way of identifying tomorrow’s big winners.