Investors looking for quality companies capable of delivering a high return on equity and compounding earnings over the long term don’t need to limit themselves to growth stocks, as there are a number of cyclicals that exhibit these characteristics as well.
This is according to Eric Marais, an investment analyst at Orbis.
Most growth stocks have suffered heavy losses this year, with higher inflation and interest rates leading to a reappraisal of valuations.
Unprofitable companies with unproven business models have been hit hardest, but even quality-growth companies that have delivered solid results so far this year have been punished.
Performance of index in 2022
Source: FE Analytics
In an article published on Trustnet last week, quality-growth manager Nick Train of the Finsbury Growth & Income Trust said: “I rub my eyes in disbelief at the prices of our worst performing shares in 2022.
“Financially sound, highly profitable companies really ought to be successful investments, but these and other holdings seem friendless in current stock market conditions. We buy more of them when we can.”
Marais said that despite the falls experienced by quality-growth stocks this year, many of them still look expensive, especially when compared with their value counterparts.
However, the analyst claimed that it is still possible to buy quality cheaply, if you are willing to let go of the growth label it is usually associated with.
“Quality cyclical is probably not a term you're familiar with, because I sort of just made it up,” he said.
“It might be funny to see the words quality and cyclical together like that, but to us it makes a lot of sense. There are companies out there that do a great job of compounding earnings over long periods of time, with good balance sheets and high returns on capital – the classic things you look for in a quality business.
“But they just happen to be cyclical and so that growth doesn't come in a straight line.”
As an example of a quality cyclical, Marais pointed to Global Payments, a payments-processing company which makes it easier for small- and medium-sized businesses to accept payments from their customers.
He said that while this may sound simple, it is “surprisingly complicated when you get into the nitty gritty”.
“That’s because, as a small business, you’ve got to make sure that your customers can pay with any card from any bank, handle fraud, refunds, online and offline payments, credit cards, debit cards, and so on.
“It gets complicated and that's obviously not the kind of stuff that your local coffee shop wants to deal with. And so they outsource it to a company called Global Payments.”
Marais said that the company has a strong track record, growing earnings per share at about 20% per annum over the past decade, and a “solid” management team. However, the biggest impact on revenues for the company is the amount of spending/the number of transactions it processes.
This means it will expand when the economy is growing, and contract as we enter a recession – which looks more likely in the short term.
An even bigger problem for payments processors is the number of fast-growing competitors that have entered this area in the past few years, taking market share. Marais said the market has extrapolated their progress far into the future and assumed that the legacy players such as Global Payments will get disrupted in the process.
As a result, the stock has gone from trading at a price-to-earnings multiple of about 30% higher than the S&P 500 pre-Covid, to a 30% discount today. Marais said the market has made two mistakes in de-rating the company to such an extent.
Performance of stock over 5yrs
Source: Google Finance
“The first is that the overall market for digital payments continues to grow at about 8% to 12% a year,” he explained.
“You may be surprised by this, but a lot of payments in the US are in hard cash, which are still moving to card. Then of course, you’ve got the total growth in personal consumption and how much money people spend. To some degree, there's room for all of these companies to grow.”
The second reason, according to Marais, is that “not all legacy players are created equal”. In Global Payments’ case, he said it has successfully bought or partnered with numerous software companies, highlighting one in particular that helps doctors’ surgeries run more efficiently.
“It didn’t do that because it wanted to be in the software business, it did it because it allowed it to process all the payments running through the doctors’ backend operations,” he added.
“The legacy peers haven't done that. And Global Payments has grown faster as a result, so it looks to us like a classic ‘baby in the bathwater’ situation. We own Global Payments today in the Orbis Global Equity strategy at about 13x P/E [price-to-earnings], and we think that's phenomenal value for a business that can grow earnings per share at almost 20% a year for the next five-plus years. It strikes us as a great value business.”