If you want long-term growth and income from your share portfolio, it’s tempting to focus on high-yield stocks. I certainly own a few of these myself.
One company whose shares I don’t currently own is Lloyds Banking Group (LSE: LLOY). Although the bank’s 5.5% dividend yield is attractive and looks safe enough for now, I think long-term investors may be able to enjoy much greater gains elsewhere.
I’ll come back to Lloyds shortly. But first I want to explain why I’m tempted to buy shares in FTSE 100 engineering conglomerate Smiths Group (LSE: SMIN) after today’s results from the firm.
Smiths operates in sectors including medical technology, defence and oil and gas. Example products include medical devices, airport security scanners and parts for oil and gas refineries.
A long-term performer
Over the last 10 years, Lloyds’ share price has fallen by more than 60%. During the same period, Smiths’ shares have risen by about 50%.
The engineering firm maintained its dividend throughout the financial crisis, and has increased its payout each year since 2011. In contrast, Lloyds paid no dividends from 2009 until 2015.
It’s pretty obvious which company has taken best care of its shareholders over the last decade. Can this continue?
A turning point
Today’s full-year results from Smiths show a mixed picture. Currency headwinds caused revenue to fall by 2% to £3,213m last year. And headline pre-tax profit fell by 8% to £487m.
However, the company says that on an underlying basis — excluding various one-off factors such as acquisitions and disposals — earnings per share of 90.7p represent a 4% increase on the previous year.
I’m normally cautious about such wide-ranging adjustments, but in this case I think they are fair. Analysts expect underlying earnings to rise by about 10% this year, and I don’t see any reason to doubt this.
Cash-backed profits
One reason for my optimistic view is that the group’s statutory (non-adjusted) results seem pretty solid. Free cash flow of £302m represents 108% of the group’s after-tax profits of £279m. This level of free cash flow means the dividend is covered 1.7 times by surplus cash, so it should be pretty safe.
One reason for Smiths’ strong cash generation is that it’s quite profitable. The headline operating profit margin was 16.9% last year, while return on capital employed was 14.6%. Both figures suggest to me that this is a quality business.
What about Lloyds?
Lloyds’ preferred measure of profitability is return on tangible equity (RoTE). This metric has risen from 6.3% in 2016 to 12.1% during the first half of this year.
That’s a respectable figure. What concerns me is that Lloyds’ consumer-focused retail banking model is highly cyclical. In a recession, bad debts usually rise and new borrowing falls. This combination can crush a bank’s profit margins.
What I’d buy today
I don’t think there’s much wrong with Lloyds’ shares at their current price. The forward yield of 5.4% seems affordable and the shares are trading close to their book value.
Smiths Group looks more expensive, with a 2019 forecast P/E of 15 and a yield of just 3%. But I think its superior profitability and diverse mix of business makes it likely to outperform Lloyds over the long term.
If I wanted shares I could buy today and forget for the next 10 years or more, I’d choose Smiths.
