We tend to focus on valuation measures such as the price/earnings ratio when considering a stock. But focusing only on price can mean missing out on some of the best quality stocks — companies with high profitability and strong growth.
As you’d expect, such stocks aren’t usually cheap. But they can still outperform the market for long periods of time.
One example is specialist engineer Renishaw (LSE: RSW). This FTSE 250 firm’s share price has doubled over the last year, thanks to a 97% increase in earnings per share and strong forecasts for the year ahead.
From what I understand, the group’s precision measurement and healthcare technology is specialised and has relatively few competitors. The firm’s financial results certainly suggest that it has good pricing power.
Renishaw’s operating margin has averaged 23.5% since 2012, and was 21.7% last year. This helped to generate a return on capital employed of 21%. That’s well above the 15% level that I use as a benchmark for highly profitable companies.
This Gloucestershire firm certainly has my vote when it comes to profit margins. And the outlook seems to be improving as well. Broker consensus forecasts for 2017/18 earnings have doubled over the last year, suggesting very strong growth momentum.
However, this focus on growth and profitability doesn’t mean we can completely ignore valuation. The stock’s rapid growth has left it looking quite pricey. Renishaw currently trades on a forecast P/E of 35, with a dividend yield of just 1.1%.
Although this valuation might look reasonable if earnings rose by perhaps 50% over the next year, this isn’t expected to happen. Broker forecasts for 2018/19 suggest earnings growth will slow to around 10% next year.
In my view, the potential return from these shares isn’t high enough to outweigh the risk of a correction if the market decides the shares are overpriced. I’d continue holding, but I wouldn’t buy any more.
One stock I might buy
Another engineering stock that’s caught my eye recently is Birmingham-based IMI (LSE: IMI). The group’s main focus is products which control the movement of fluids. As you can imagine, the firm’s customers include many of the world’s largest industrial concerns, as well as the energy and power sectors.
In a trading update today, IMI said that its sales rose by 3% during the third quarter, or by 11% when exchange rate tailwinds were included. The group now expects full-year earnings at constant exchange rates to be “slightly ahead of expectations”.
IMI has many of the same attractions I see in Renishaw. The group’s return on capital employed has averaged 22% over the last five years, and cash generation is very strong.
Indeed, this means that it’s able to offer a well-covered dividend yield of 3.2%, even though its shares trade on a forecast P/E of 19.8.
In my view, IMI’s valuation could still leave room for growth. And although this business might slow in a major recession, I think it’s a quality stock that would be worth buying on the dips, rather than selling.
Averaging down on quality stocks during difficult periods gives you the chance to increase your dividend yield on cost, and boost your long-term capital gains.
Roland Head has no position in any of the shares mentioned. The Motley Fool UK has recommended IMI and Renishaw. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.