UK stock markets have been confronted with numerous challenges in recent years. Headlined by the major impacts of Brexit and the pandemic, the Russian invasion of Ukraine, the mini-budget calamity, and the vengeful return of inflation, these headwinds have led to a number of companies with attractive fundamentals being unfairly derated.
As a result, corporate and private equity buyers are increasingly being drawn to the discounted valuations on offer across many high-quality resilient companies. However, as major headwinds persist, it is crucial to dig deeper to discover the true discounted gems.
By carefully evaluating specific indicators, investors are best placed to identify robust revenue streams and mitigate overall portfolio risk. Below, we highlight six essential rules to guide investors through the selection of resilient stocks.
Ongoing agility
A competent management team is crucial in order to achieve long-term success. Executives must not only demonstrate industry expertise but also the flexibility to adapt to all eventualities as being able to embrace change early can greatly impact a company’s ability to navigate challenges.
To assess whether a team possesses these qualities, we look for proven track records and skill sets that align with the business strategy. Two crucial components to the continuity of success in this area are an incentive structure that rewards outperformance, motivating the management team to meet shareholder expectations, and competitive packages to retain top talent.
Cash generation
Cash generation is a key financial indicator of the resilience of a business. Cash drives returns through reinvestment into growth and allows distributions to shareholders.
Businesses with asset-light models are typically more cash generative, due to the lack of investment needed in physical assets, which often require capital to be set aside for depreciation, repairs, and maintenance.
More than 80% of our portfolio is comprised of services or software businesses, which carry modest capital expenditure requirements. Additionally, 90% of our investments are in companies we consider to have low capital intensity, with a capex-to-sales ratio of less than 10%.
Safety margins
Resilient companies often have one common trait: high margins. Alongside potentially helping increase shareholder returns, high margins provide a buffer enabling businesses to absorb cost inflation and other setbacks caused by the tougher environment.
As a rule, we invest in businesses with high and sustainable margins – our top 10 holdings have EBITDA margins of 21% on average and the majority have margins in the double digits.
Businesses with a competitive edge or operating within a growing structural market can often benefit from robust gross and net profit margins due to strong pricing power.
Consequently, we also target companies with inherent operational leverage, as these businesses can increase revenues without corresponding cost growth, leading to margin expansion. Without a doubt, strong business fundamentals are essential for maintaining high margins.
Sustainable growth
An attractive feature of a company is its growth potential. For businesses with structural and sustainable growth opportunities, it is crucial to identify long-term market trends. To do this, management teams must develop solid strategies and demonstrate an ability to carefully execute growth plans.
One way to assure sustainable growth is to have net cash positions or low leverage which is particularly important in tougher environments. Our investment strategy leans towards companies that do not consume cash excessively or expand too rapidly. Instead, we opt for businesses pursuing manageable growth, and therefore maintain capacity to reinvest.
Consistent dividends
Another indicator of resiliency is the ability to pay dividends. Despite it being a multifaceted aspect to measure, as it requires sustainable earnings streams, healthy profit margins and strong cash generation, we are drawn to the dividend cover metric. This is the ratio of a company’s profits divided by the dividend paid to shareholders.
A high dividend cover means a company can reinvest while maintaining consistent payouts. The businesses in our portfolio typically have a 2x dividend cover, or 50% pay-out ratio, which means reinvesting 50% of profits and returning 50% to shareholders.
This ensures a safe margin for maintaining dividend payments even during economic uncertainty. In the current climate specifically, identifying businesses with sustainable dividend growth over inflation is important to deliver a positive real return.
Stable earnings
A company’s earnings quality is crucial for survival during turbulent times. Evaluating the visibility and predictability of future income streams requires a careful examination of a company’s revenue line. We favour recurring revenue over transactional business, as the latter can be less predictable.
We also examine a company’s customer base and the concentration of revenue across specific clients, demographics, sectors, and geographies to understand the diversification of revenue streams. This is essential for maintaining resilience during unexpected events.
We also examine a company's cost-base capacity. If a company needs to add an office or new facility, this could represent a significant increase in fixed costs and reduce cash generation. As a result, we look for companies with ample existing capacity, whenever possible.
One prime example of a company meeting all six criteria is Bloomsbury Publishing, best known for the Harry Potter series. It has a dividend yield of 2.5%, generated 25% more cash in the past year than in 2021, and reached an 11.7% EBITDA margin at the end of 2022.
The company’s robust financial position, along with its strategic acquisitions, underpins its long-term growth strategy. Additionally, its unique approach of combining academic and general publishing has proven effective in producing solid earnings — balancing the volatile nature of trade publishing with the consistent, high margins of academic publishing.
Moving forward, we anticipate these key metrics to remain instrumental in navigating the future investment landscape.
Ken Wotton and Brendan Gulston at co-managers of the LF Gresham House UK Multi Cap Income fund. The views expressed above should not be taken as investment advice.