Updates to the Alpha quality shares watchlist

The hiking of interest rates from 2021 has increased firms’ cost of capital and frayed the margins of returns, especially for companies that have also experienced significant input cost inflation. Therefore, in a much more challenging financial environment, companies’ pricing power – the ability to pass costs on to customers – is crucial. 

Quality companies exhibit characteristics that make this possible: they provide products or services their customers can’t do without (like components that are essential operating expenses) and they have wide economic ‘moats’ such as patents, brands, distribution channels, high set-up costs to deter newcomers to the industry etc.  

Another aspect to sustaining margins is the degree of operational gearing a company has. If fixed costs are high, then small declines in revenue have a greater impact on profits. The same is true in reverse, so investments in companies with greater operational leverage boosts returns on the upside. This is the sort of cyclical trap which can kid investors into thinking a company that has been on the back of a good run is a reliable quality compounder. 

In an environment of low growth and stubborn core inflation (headline inflation has fallen back as energy prices eased substantially), the ability to defend margins is as important as growth potential but ultimately investors need a company to exhibit both qualities. For a business to be worth holding long-term it must be able to find good projects to invest in, whether that is developing markets for existing products, developing new or improved products for existing markets, achieving efficiency gains, or making earnings accretive acquisitions which are a good strategic fit. 

One silver lining to the increased cost of capital is the fact there is less money around so cash rich companies are less likely to be “crowded out” of good  investment opportunities by highly leveraged private equity and venture capital firms, although there is an argument that expansive government spending can be detrimental in the same way. With interest rates higher, however, so too is the bar for return on investment. The onus on good management decisions – finding the right projects and making them work – is paramount, so this qualitative judgement over leadership teams comes more to the fore in deciding whether to invest. 

Many nuances of valuation

With so many, often conflicting, indicators to get to grips with it is hard to assess what is fair value in our Quality Shares Watchlist. Companies that are expensive relative to interest rates may be so because the market has a better feeling about their ability to grow in better times. If they are cheap or fairly priced against their own history, then when interest rates come down again, such businesses have potential to re-rate. 

Yet that argument assumes the inflationary spiral is done with. Companies that are still expensive relative to rates are vulnerable to any re-acceleration of the hiking cycle which would require a market adjustment. More conservatively priced companies with perhaps less bullish growth prospects but with wide moats and the all important pricing power may be safer investments for the shorter term. 

The key is diversification: investors in quality shares mustn’t lose sight of growth but they also need some of the steadier, less glamorous companies in a balanced portfolio. With the distinction hard to spot from a screen alone, here we run through some important updates that are material to the investment case for some of the companies on our quality shares watchlist. 

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