Time to buy great businesses at fair prices

Quality investing has been on a roller coaster ride over the last couple of decades. Coming out of the financial crisis in 2008/2009, value stocks performed well as investors realised that a strong recovery was underway and many stocks were cheap. However, by around 2014, quality compounders started to become the talk of the investing community, as well as the idea of "never sell" investments: those that were so good they would just keep generating above-average returns forever. However, as is so often the case in investing, popularity led to overenthusiasm, and investors couldn't distinguish short-term momentum from true long-term fundamental outperformance.

Many quality companies came out of the COVID blip ok and performed well into 2021. However, the inflationary period caused by post-COVID stimulus and the invasion of Ukraine led to a rise in global rates, and many previous stock market darlings struggled. In recent years, these trends have been exacerbated by AI disruption and another inflationary war. Many investors who built long careers of successful returns investing in Quality stocks, such as Terry Smith or Nick Train, were derailed by these shifts.

Perhaps the clearest embodiment of this cycle in the UK was the Buffettology Fund, started by Keith Ashworth-Lord in 2011. The fund built an exceptional track record from 2011 through 2021, roughly tripling investors' money and beating its benchmark by a wide margin, ranking near the top of its sector for most of that decade. However, in 2022, the fund lost 23% against a 9% sector decline, and the performance has been lacklustre ever since. The fund has underperformed the sector on a 1-, 3-, and 5-year basis and its size has fallen from around £1.5bn in 2021 to around a sixth of that today, reflecting both the weak performance and redemptions.

[Chart: Trustnet]

Stockopedia Quality Rank

The recent lack of performance amongst Quality stocks is also visible in the Stockopedia Stock Ranks. This chart shows the two-year returns of the different deciles sorted by Quality Rank:

The first thing that stands out is that all deciles have underperformed the wider market because large caps have outperformed, meaning any equal-weighted portfolio would struggle. However, the most notable point is the clustering of performance within the Quality deciles over the last two years. The Stockopedia Quality Rank simply hasn't given a strong signal recently.

This is in contrast to the clear positive dispersion between the returns to highest Quality and lowest Quality sets of stocks over the last 10 years:

While no one knows for certain when Quality stocks will start to be favoured again, a multi-year period of underperformance suggests we may be closer to that point of reversal than we have been recently.

Quality Jumpers

Another sign that it may be time to focus on Quality is Ed's recent finding that the best-performing Super Stocks in his Stock Rank jumpers data were those that saw a significant short-term improvement in their Quality Ranks:

Investors who spot companies with improving quality metrics, in an environment where quality is increasingly valued, may generate great returns.

A Quality Framework

When considering Quality Stocks, my thinking is influenced not just by some of the well-known UK fund managers already mentioned, but by the GOATs, Warren Buffett and Charlie Munger. (I'm sure I'm not alone in this!!) Plus, Christopher Mayer's writings in the excellent 100-baggers book stand out among the published literature.

The fundamentals of this strategy boil down to the fact that trading businesses that generate very high long-term returns to equity holders tend to have the following characteristics:

• Moat: Not every company benefits from having a great idea or product. Too often, competitors enter, and the returns get shared among many. Great companies need a way to keep competitors out, known as a sustainable competitive advantage. This can take many forms: a secret recipe, technical know-how, patent protection, brands or network effects. The result is often known as a "moat" in investing circles – a protective barrier that competitors struggle to breach.
• Runway: In the studies of high-return stocks, almost all get there by generating high sales growth. They have products or services that are in increasing demand. However, you can have some great companies, but if their market is already saturated, they have little room to grow. Their moat gives them little advantage.
• Operating Leverage: High sales growth is good, but returns really improve when the bottom line grows faster than the top line. This typically happens when the cost base is relatively fixed, so increasing sales drop mainly into profits.
• Cheap: Finally, if investors can identify these types of stocks early enough that they aren't already paying a very high multiple, they benefit further as the market starts to spot and price in the growth potential and the multiple re-rates.

I think of the moat, operational leverage and cheapness factors as levers. The best returns come from being able to pull most or all of these simultaneously. Runway is harder to define, but thinking about it helps you avoid a stock with great metrics that can't take advantage of them by growing its sales.

Screening for potential high-return stocks

The good news is that we can screen for three of these MROC factors:

• Moat: Consistently high returns on invested capital or equity tend to mark out companies with a strong competitive advantage. Because these figures tend to be mean-reverting and depend heavily on profit, investors should look beyond a single good year and find companies that show consistently high returns on capital, or, better yet, high and increasing returns on capital. Invetsors need to be wary of certain types of businesses when using these metrics. People businesses can often have high returns on capital, but the real assets are the people, and they aren't on the balance sheet! Similarly, extractive industries tend to be cyclical, so a high return on capital is more likely to indicate a commodity boom than a sustainable competitive advantage.
• Operating Leverage: One of the most controversial findings of the 100-baggers book is that investors should look for high-gross-margin stocks with low net margins. The idea is that the profit potential of such a business may be obscured to many investors by the low current net margin. However, if sales growth materialises, the high gross margin on a relatively fixed cost base would drive a rapid improvement in profits.
• Cheap: The valuation multiples investors are willing to pay may be higher than a pure value strategy. We are after great businesses at a fair price, after all. However, we should still have some limit so that we have the potential for multiple expansion to drive higher returns than profit growth alone.

Sadly, I haven't found a way to screen for Runway, so this needs to be more of a manual sense check post-screen.

Screen Criteria

Here is how I have attempted to screen for these types of stocks:

Moat:

I've not specifically screened out people businesses, as that is hard to do without false positives, but this should be a manual check.

Operating Leverage:

Cheap:

Size:

We tend to restrict ourselves to writing about stocks above £10m market cap on Stockopedia for liquidity reasons. I also think it makes sense to exclude mega-caps, as their growth potential is clearly constrained. A cut-off of about £2bn market cap is arbitrary but feels about right.

Screen Results

The screen currently generates 12 results:

Interestingly, the screen highlights three companies that are currently attractive to acquirers. Ramsdens Holdings (LON:RFX) has an agreed takeover, so we can ignore it. Gamma Communications (LON:GAMA) is also in takeover discussions but has no firm offer, so it's still worth considering. System1 (LON:SYS1) has an offer in place from major holder Brave Bison, but the board has rejected it.

The list

Here's a quick introduction to the stocks:

System1 (LON:SYS1)

This company, which assesses the effectiveness of marketing campaigns, grew very rapidly for a while. However, the costs of developing new products, combined with marketing industry weakness, led to a couple of severe profit warnings and the share price collapsing:

Since then, the founder swapped his shares for a holding in Brave Bison, which has since made an offer in shares and cash for the rest. The board has rejected this, so it is likely to remain independent.

Brokers are now forecasting a big recovery in 2027, and given the bid defence, the board will be under pressure to deliver:

The rather patchy delivery makes EPS much more volatile than shareholders would ideally like to see. However, the high gross margin means it wouldn't take much sales growth for this to look very cheap again from the current levels.

Colefax (LON:CFX)

This company has performed remarkably well in current market conditions for a designer and distributor of furnishing fabrics and wallpapers. The returns on capital suggest that its designs provide a moat:

However, growth has been steady but rather lacklustre:

It has a rather quirky capital allocation policy, paying minimal dividends and then occasionally doing low-premium tender offers. There are not great signs that they can deploy additional capital to accelerate earnings growth.

One could argue that this remains undervalued, but I'm not convinced this is the type of high-return company we are looking for.

Cake Box Holdings (LON:CBOX)

While it may have declined in recent years, the ROCE on this celebration cake producer remains above its cost of capital:

My instinct says that their market may lack Runway. After all, how many cakes can a nation increasingly taking weight-loss jabs consume?! However, at 22%, the revenue CAGR is strong and shows little sign of slowing down if brokers' forecasts are to be believed:

So far, there is a lack of operational gearing, meaning the EPS CAGR is a much less impressive 9%. So the case for being a high return stock probably hinges as much on the ability to keep costs under control as on the overall runway potential.

Aoti (LON:AOTI)

This is a relatively new float I haven't come across before. The revenue CAGR looks strong at over 30%, but I'm just not convinced by the forecast figures from this wound-care technology provider:

Looking at the note from their broker, Panmure Liberum, I see they have $2.7m PBT pencilled in for FY26E, versus $3.1m for FY25A. This confirms my suspicions. They are not cheap.

Somero Enterprises (LON:SOM)

Having followed this company for many years, I find its ROCE hugely impressive. While this was lower last year, it was largely a function of a weak year and will bounce with stronger future profitability:

However, my on-the-ground research leads me to believe the moat is largely brand, rather than any technical advantage. Indeed, I think they may now be too far behind the curve in Europe on factors such as battery power and metric sizing for this to be a key market again.

Their various innovations over the years have failed to gain any significant traction compared to their core North American Boom screed sales, which means revenue has been flat to declining:

While there may well be some sales recovery yet to come at this point in the cycle, I just don't see this growing sales or being able to deploy additional capital at historically high rates in order to be anything other than a recovery trade.

dotDigital (LON:DOTD)

Of this list, this is the one I hold personally, having picked up a position after it appeared on a screen I created looking for cheap growing companies. I subsequently wrote a Stock Pitch on the company to check what I may be missing.

The ROCE is following a worrying trend:

However, this is largely due to acquistion accounting, where goodwill is sitting on the balance sheet, and the earnings from the fast-growing companies they are acquiring, with stated cross-selling opportunities, are yet to be seen in the numbers.

Revenue growth is reasonable at 12% CAGR. However, acquisitions have played their part in that:

I don't think there is any lack of Runway for their direct marketing tools; the bigger concern is how big their moat is versus competitors' products.

A lack of operational gearing is also a concern, but one that will probably be assuaged if they can deliver on current broker forecasts:

M&C Saatchi (LON:SAA)

While the ROCE is reasonable in the good years, there is significant inconsistency between years:

Overall the numbers aren't great, especially as this has some aspects of a people business. And neither revenue nor EPS shows any real growth over the medium term.

The forward multiple is relatively modest, but perhaps not stand out for the sector:

This may make it a good recovery play, and I know it has fans among some well-regarded value investors. However, on the surface this doesn't look like the kind of quality compunder we are looking for.

Liontrust Asset Management (LON:LIO)

This is exactly the sort of quasi-people business where ROCE doesn't really measure moat. They undoubtedly have a well-known brand, but this hasn't stopped them from facing large redemptions like the rest of the UK fund management industry. This may yet prove to be a great recovery play, but it isn't the sort of quality compounder we are looking for.

PayPoint (LON:PAY)

In most years, Paypoint has a high ROCE:

However, EPS has been somewhat variable:

EPS is forecast to grow strongly going forward, which puts the company on a modest forward P/E.

This is a recent Stock Rank jumper:

And driven by a jump in the Quality Rank, which Ed showed to be the strongest historical signal:

Today:

June 7^th:

In the past, I'd say this company struggles with the Runway available to it. After all, payment terminals in corner shops are likely to be a saturated market. However, the company has successfully diversified into wider EPOS systems, as well as parcels and open banking. This last area has strong growth potential.

However, I am also cautious about the company's short-term outlook. In their recent Q1 results announcement, they said they were " on track to meet market expectations for FY27". The problem is that the numbers show Open Banking remains a small, low-growth part of the business, while everything else declined significantly. These figures may presage a profits warning to come:

Gamma Communications (LON:GAMA)

Gama has shown decent revenue growth in the past, although aided by acquisitions:

And some modest operational gearing:

Their ROCE is consistently above their cost of capital too:

The challenge is that revenue growth is forecast to be quite lacklustre in the next couple of years. If this is a blip caused by market conditions, this could be a great time to buy this sort of business for the long term. The biggest risk may be that if there is enough evidence of a recovery, the private equity bidder will benefit from that return to form, not shareholders.

Dunelm (LON:DNLM)

Dunelm's returns on capital are simply great:

Historically, they have managed to generate some decent revenue growth:

And with some modest operational gearing.

However, all that growth was from 2020-2023:

EPS has gone nowhere since, and it's not forecast to improve anytime soon. There are some very genuine reasons to think this is temporary, though. Homeware sales are linked to housing transactions, and the UK housing market has been particularly weak over the last few years.

Retail is a competitive market, and gains will only come at the expense of others. However, this doesn't mean there isn't scope to grow. It may just be a long wait for housing market sentiment to help.

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Screening is, of course, a blunt tool. Let me know in the comments which of these you think may be quality compounders and why.

Similarly, if you think you have a company that meets the Moat, Runway, Operational Leverage, and Cheap criteria that I've missed then let me know.

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[Disclosure: Mark owns shares in dotDigital (LON:DOTD)]