Get rich slow: 3 stocks with ROE, cash flow and profit

Don’t buy Quality stocks if you’re looking to get rich quick. That said - if done right - you might get rich slowly. 

That’s one of the overarching messages I’ve drawn from this three-part series. Quality investing means finding companies capable of grinding out consistent returns of around 10% to 15% for around a decade, not piling into the five- or 10-bagger “stonks” we’ve heard so much about since last May.

To recap: in part one we heard from Fairlight Asset Management’s Ian Carmichael about Quality stocks as anomalies, and Kelli Meagher from Sage Capital highlighted three core attributes of the Quality style. A handy comparison with Value was also cited by Jason Teh of Vertium Capital, pointing to Virgin Australia (ASX: VAH) as a prime example of recent years.

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The next 12 months will be crucial for Quality

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And in the final instalment below, they name a few stocks that have passed their screens. The local names you’ll likely know well, but the global stock – while a mature, diverse business – will probably be a stranger to many readers.

“A perpetual innovator” to believe in

Kellie Meagher, portfolio manager, Sage Capital

A quality stock that we like at Sage is ResMed (ASX: RMD). We’re big believers that a company, especially a healthcare company, whose products result in both superior outcomes for patients and save the healthcare system money, is in a good starting position.

If the company can also harness data, technology and innovation and has demonstrated the ability to extract attractive returns on capital from its business model over time, that’s a company we want to own for the longer term. We also like that ResMed has a clear set of growth opportunities ahead of it.

ResMed is a global medical device company that produces machines and masks to treat Obstructive Sleep Apnea (OSA). The OSA industry has been growing at between 6% and 8% a year but is still a condition that is considered underdiagnosed, so it has a long runway of growth ahead of it. In terms of industry structure and competition, it is essentially a duopoly, so competition is strong yet rational.

The company has proven itself a perpetual innovator. This has translated into ResMed having the most technologically advanced products in the market, which has, in turn, allowed it to gain market share and build pricing power. 

Some of its newer products have also resulted in a higher proportion of revenue being more “annuity-like” and predictable, which is also attractive.

RMD earns a high return on capital, generates good cash flow and has plenty of opportunities to reinvest that cash flow back into the business, allowing the company to innovate and expand into other areas of healthcare without having to tap shareholders for capital.

Management has a proven track record of execution and has allocated shareholder capital wisely. This is reflected in management’s track record of making strategically sound investments such as the move into software-as-a-service and the willingness to return capital to shareholders, when appropriate, through buybacks.

The regulatory environment for ResMed is as favourable as it has been in many years as price pressure from the competitive bidding process in the US has now peaked. The board is diverse and has a good mix of skills.

ResMed's share price is not cheap and it may be pressured if bond yields rise. The company is facing some short-term headwinds as it cycles through some very strong sales of ventilators during the peak of the COVID crisis last year. Currency and freight costs are also short-term headwinds. But on the positive side, referrals to sleep labs were interrupted by lockdowns and this will begin to recover. As a quality stock, any weakness in the share price can be seen as a buying opportunity for those who have the patience to wait and watch the longer-term growth story unfold.

Less sexy but fundamentally mispriced

Jason Teh, CIO and founder of Vertium Asset Management

We like two quality stocks with different growth profiles – ResMed and Aurizon (ASX: AZJ). Like many other quality stocks, it has underperformed the "junk" rally in recent months.

ResMed is a high-quality business with all the attributes we look for, including high return on equity, earnings predictability and a strong balance sheet. In the near term, it is launching a new product called AirSense 11, which has been seven years in the making. The last time ResMed had a product launch, the company experienced strong sales growth for several years. The strong earnings growth profile of ResMed will drive its share price higher over time.

Aurizon, Australia’s largest rail freight company, does not have a high ROE but it is respectable at 12%. The company’s earnings are relatively stable, with more than half driven by regulated monopoly assets. And it’s balance sheet is strong as it has used its excess capital to perform share buybacks over several years.

Aurizon is not as sexy as ResMed because of its lower growth profile but it is mispriced based on its fundamentals. Aurizon’s closest peer is Dalrymple Bay Infrastructure, which trades on 15-times enterprise value-to-EBITDA, with a geared balance sheet of 10-times net-debt-to-EBITDA. Aurizon is trading at about half the valuation multiple at 7-times and with a fraction of the gearing at 2.5-times net-debt-to-EBITDA.

A rare focus on profit

Ian Carmichael, portfolio manager, Fairlight Asset Management

Kakaku is a Japanese company with the ticker 2371-JP. It's an internet services company.

And they're fairly unique in that Japanese companies don’t always have a strong focus on profitability, but Kakaku has a distinct capital allocation culture with a focus on profitability.

There are three core parts to the business:

1. Kakaku.com – a product discovery website featuring cameras, televisions, health insurance and almost anything else a consumer could buy. This is where you go to for both product and price information. It has elements of a price comparator website, but it’s much more than that. Something like Amazon reviews, it's the starting point for consumer purchases. It’s also a very successful and mature business that generates a lot of cash for reinvestment into new ideas.
2. Tabelog is in some ways like the restaurant booking and reviews website OpenTable. This business has obviously been impacted by COVID, with Japan today remaining largely locked down, so earnings are very suppressed. But as we’ve seen in other offshore markets like the US, the pent-up demand once lockdowns are lifted can very strong. The recovery at Tabelog is still six months away, but when it comes, it will surprise on the upside.
3. New Media, an idea incubator that tests startup ideas – basically throwing a lot of ideas against the wall to see what sticks. And if something works, then it invests and scales up the idea quickly. And within that is an employment classifieds website called Kujin Box, which is growing at an impressive rate of around 50% to 60% a year - it looks very promising.

Overall, this is a Japanese internet company that is very innovative and has market-leading capital allocation skills. Those two attributes alone, combined with the fact that it will be a beneficiary of Japan opening up, we find a really interesting idea.

Parting thoughts

In normal times (whatever those are), market returns rise on an escalator but fall in an elevator. It seems Quality stocks are more suited for a "normal" environment - or at least something less unusual than what we've seen over the last 12 months. Patiently seeking out the mispricing potential of companies - whether Australian or global; large, mid or small-cap - with good cash flow, sustainable return on equity (ROE) and control over their own destinies should be rewarded in the years ahead if our above contributors are correct.

Make sure you "FOLLOW" my profile to read the rest of this series. In part one, the three portfolio managers defined Quality and outlined characteristics they look for; and in part two they discussed how long a Quality rally could last.

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