Quality companies are getting stronger, but their stocks are falling

Michael Brush is a MarketWatch columnist. At the time of publication, I had no position in any of the securities mentioned in this column. Brush has suggested LNG, Nvidia and Chipotle Mexican Grill in his stock newsletter, Brush Up on Stocks

If you’re a long-term investor, this year’s sale is good news because it offers a great opportunity to pick up quality companies at a discount. But wait a second. If a company is “high quality”, why would its stock be affected?

“Portfolio managers have been selling what they can rather than what they want to sell, and high quality has more liquidity,” said David Sekera, US market strategist at financial services research firm Morningstar Direct.

Now is the time to join the liquidity providers and buy the weakness of sinking quality names. You probably won’t catch the exact bottom, and if you do, it will be pure luck. But quality companies should survive and thrive on the other side of the bear market.

What exactly does “quality” mean? Here are definitions and examples of four money managers and strategists.

Solid cash flow and solid balance sheets

That’s key, because it prevents a company from being beholden to banks, bond investors or the stock market to continue financing growth, says Chuck Severson, who manages the Baird Mid Cap Growth Fund. “That’s a plus at times like this,” says Severson.

Companies with financial strength must not stop doing research and development. They must not stop opening shops.

“And they come out stronger because their competitors are facing tough challenges,” says Severson. “These companies participate in this environment.”

TO READ Investors are looking to bank earnings season for signs of a recession

Here’s another bonus: During recessions, weaker companies cut workforces to maintain margins. Thus, stronger companies have the opportunity to pick up talent.

Severson is worth listening to, because his fund has outperformed its category and Morningstar Mid-Cap Growth Index by one to two percentage points, annualized, over the past three to five years, according to Morningstar Direct.

Quality mid-caps are trading at attractive discounts right now, Severson says.

This is their logic: the group has declined by about 30%. That’s in line with the typical 30% drop in earnings in most recessions. But this recession, if we have one, could be milder.

Because? The economy is getting a boost from the fallout from the coronavirus, as well as negative real interest rates and strong employment.

“It would be unlike any recession we’ve ever had,” he says. “We’re going to see earnings estimates come down pretty generally. But I don’t believe as broadly as the stock is saying. There are a lot of our businesses that I’m happy to buy with a one-year time horizon.”

From its portfolio, consider Synopsys and Cadence Design Systems, which offer automation software that engineers use to design and test chips. Its shares have fallen sharply with the rest of the tech sector, but business performance has held up.

Synopsys reported revenue growth of 25% to $1.28 billion in the first quarter and operating cash flow grew 29% to $905.7 million. The company expects sales growth of 20% to produce $1.6 billion in operating cash flow this year. Cadence reported first-quarter revenue growth of 22.5% to $901.7 million. Operating cash flow grew 61.5% to $336.6 million. Sales growth of 15% this year to $3.43 billion is expected at the high end of guidance.

Argent Capital Management portfolio manager Kirk McDonald also puts cash flow on his short list of signs of quality in companies. Look for companies that generate higher cash flow than their peers. He also likes to see above-average profitability, high asset returns, dividend growth or share buybacks, and some change that can serve as a catalyst, such as a new management team or new products.

Here’s one company that ticks enough boxes to qualify as a quality name: Cheniere Energy, which exports liquid natural gas from the US.

Cheniere has used its huge cash flow to buy back shares and increase dividends. The company will return $2 billion this year to shareholders through buybacks, McDonald says. It also uses cash to pay off debt. Cheniere has been increasing its return on assets every year since 2016. ROA was 8.2% last year, compared to 3.5% in 2017. The big change in the mix here is the increased demand for American LNG in Europe as the continent tries to untangle itself. Russian supplies.

McDonald is worth listening to because, since its inception in 2014, Argent Capital Management posted an annualized return of 12.75%, compared with 11% for the Russell Mid Cap Index, through the end of March.

Businesses with wide moats

Moats help companies produce long-term outperformance. Warren Buffett is a big fan of moats, which probably helps explain his success. These protective barriers are also a core part of investment analysis at Morningstar.

Moats are created by strengths such as strong brands, proprietary technology, economies of scale due to large size, or network effects (more users make a service more valuable). Companies with moats “generate long-term excess returns and are best able to withstand economic disruptions,” says Sekera, Morningstar’s U.S. strategist.

In the current sale, you can find an unusually large number of companies with a large moat with ratings of four and five stars (Morningstar’s highest). The list includes several that have “rarely traded at such large discounts to our intrinsic valuations,” Sekera says.

Three to choose from

First, consider chip design company Nvidia, which makes high-performance graphics processing units used in gaming, data centers, artificial intelligence, computer-aided design, video editing, and autonomous vehicles. Nvidia derives its moat from the R&D prowess that powers its GPU technology.

“This is the first time since November 2012 that Nvidia has had a four-star rating,” says Sekera.

Then consider credit rating agencies S&P Global and Moody’s. These four-star companies have financial moats because of their track record and reputation, and the regulatory challenges facing potential new competitors.

Price setting power

Bill Ackman of Pershing Square says that pricing power is a key characteristic that defines “quality” in companies. After all, if a company can raise prices without losing business, it’s a sign that customers really like what it does. That appears to be the case with Chipotle Mexican Grill, Ackman’s second-largest position at Pershing Square (at 17% of the portfolio).

Chipotle raised prices 4% in the first quarter. That helped drive respectable revenue growth of 16% to $2 billion and an increase in earnings. Despite the price increases, comparable restaurant sales were up 9%, which tells us customers weren’t worried about the increases. (The rest came from new restaurant openings.) Higher prices helped operating margins increase slightly to 9.4% from 9.3%.

But for real price increases that beat inflation, consider Severson’s other major holding in the Baird Mid Cap Growth Fund: Pool Corp. The world’s largest wholesaler of pool supplies, Pool raised prices by 10% to 12% in the first quarter. which helped increase sales by 33% to $1.4 billion.

The company’s operating profit margin rose 4.5 percentage points to 16.7%. Operating income rose 83% to $235.7 million.

Expect more of the same. The company raised its full-year earnings per share target to $19.09 from $17.94 at the high end of guidance. The pool is growing through acquisitions, but is also benefiting from migration to southern states where pools are more common than in the north.

This article was published by MarketWatcha stock of the Dow Jones Group

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About the Author: Chaz Cutler

My name is Chasity. I love to follow the stock market and financial news!