It’s a persistently tricky investment question… to what extent should valuation influence your decision to buy the market’s highest quality stocks?
For some, there’s rarely a bad time to buy shares in good quality firms. After all, if you get your research right, a resilient and highly profitable stock might compound your returns for many years.
But for others, a rich valuation can keep stocks like this almost permanently out of reach. Even when markets plummet, higher quality names can stay relatively expensive.
One company that arguably falls into this category is Machinery, Equipment & Components group, Diploma (LON:DPLM).
Diploma supplies technical products and services into three main sectors worldwide: Life Sciences, Seals, and Controls. It’s due to issue half-year results on Monday (16 May), but a trading statement in April already confirmed that it was seeing encouraging growth across its businesses. That triggered an upgrade to full year earnings guidance.
Over the past five years, shares in Diploma have delivered a return of 130.9% relative to the market. Yet, over that same period, the average price-to-earnings ratio on the stock has been 32.9. By most usual standards, that’s expensive enough to put many investors off. So what are buyers getting?
Hunting for durable quality
Part of the appealing draw for investors is that Diploma has a number of consistently high quality traits. In particular:
- Its Sales and Earnings are stable and growing
- It has strong Operating Margins
- It has an above average Return on Capital Employed
- It has a strong Return on Equity
- It has a stable and growing dividend
These kinds of factors appeal to quality-focused professional money managers like Terry Smith and Nick Train. Train has described his approach as targeting durable, cash generative franchises and then owning those quality-growth companies over the long term.
Part of the reason why these firms are attractive is that their financial strength can protect them from competitive pressures as well as economic turbulence. Here’s how that plays out in the numbers:
With a five-year average Operating Margin of 14.4%, Diploma is way ahead of the industry average. That suggests it has strong pricing power, which is extremely useful in an inflationary environment because it helps to protect it from the impact of rising input prices.
In its recent update, the company noted: “Operating margin performance is very encouraging as we continue to navigate inflation, supply chain…
