Over the past 12 months Unilever’s shares have added 9.7%, Reckitt’s shares have jumped 18.8% and ARM has racked up gains of 22.9%. In comparison, the FTSE 100 has struggled to keep its head above water, only adding 0.6% excluding dividends over the same period.
After these gains, it’s starting to look as if the shares of these three market leaders are overheating. Indeed, both Unilever and Reckitt are currently trading at or near all-time highs. Meanwhile, ARM is trading 15% below its all-time high of 1,200p reached at the end of March.
There’s a certain physiological barrier that stops many investors buying a stock when it reaches an all-time high. However, sometimes you have to be prepared to pay a premium for quality, which is why Reckitt and Unilever still look attractive after recent gains.
Reckitt currently trades at a forward P/E of 24.3 and offers a dividend yield of 2.1%. Unilever currently trades at a forward P/E of 21.7 and is set to yield 3.1% this year. As a value investor, usually I would be wary of such lofty valuations. P/E ratios in the mid-20s leave plenty of room for disappointment, and there’s no margin of safety.
But Unilever and Reckitt are high-quality businesses, which produce a selection of essential everyday household items, the sales of which are easy to predict. Therefore, the businesses are defensive by nature, and there are unlikely to be any negative surprises on the horizon.
Moreover, Unilever and Reckitt are both able to generate high returns on invested capital (ROIC). In fact, over the past ten years Unilever’s average annual ROIC has been in the region of 22%. Reckitt’s has come closer to 30% per annum.
Track returns on capital
Over the long term, share prices tend to track returns on capital. For example, if a business earns 6% on capital over ten years, and you hold it for ten years your return will be around 6% per annum. Conversely, if a business earns 18% on capital per annum, you’re bound to end up with a fine result and outperform over the long term, no matter how much you pay in the first place.
The same logic applies to ARM. Last year ARM produced an ROIC of just under 30%. This year City analysts expect the company’s ROIC to top 46%. What’s more, shareholder equity is expected to increase by 50% during the next two years. And with being the case, ARM deserves to trade at a large premium to the wider market.
Indeed, ARM currently trades at a forward P/E of 32.5, around double the FTSE 100 average P/E of 15.
However, the company’s earnings per share are set to leap higher by 73% to 37.7p this year, which means that ARM is trading at a relatively undemanding 2016 P/E of 27.5 and PEG ratio of 0.4. A PEG ratio lower than one implies that the company’s shares offer growth at a reasonable price.
The bottom line
So overall, even after recent gains, all three of ARM, Unilever and Reckitt still look attractive despite their lofty valuations.
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Rupert Hargreaves has no position in any shares mentioned. The Motley Fool UK has recommended ARM Holdings. The Motley Fool UK owns shares of Unilever. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.