Where Are The UK’s Quality Compounders?

19th May '23 by Megan Boxall

20 comments 3122 reads

Earlier this week I published an article about implementing a compounding quality strategy. It’s a subject I am passionate about as I love to scour the markets for quality companies and constantly seek stocks which allow me to invest with Warren Buffett’s famous mantra in mind: “Our favourite holding period is forever”.

But the article sparked an interesting conversation, on a topic which is a perpetual concern to quality investors: does the UK have enough quality companies to build a well diversified portfolio based on the principles of compounding?

My first hunch is that the answer to that question is ‘no’.

I run a screen which aims to identify high quality large caps using the following metrics:

5yr average ROCE: greater than 15%
5yr average operating marketing: top 20% of market
Cash return on investment: greater than 10%
Net gearing: lower than the market average
Market capitalisation: greater than £10bn

If I restrict that screen to just the UK market, I am normally faced with the following outcome…

Opening up the screen to the European market takes my current possible selection up to eight stocks.

And in the US, the choices are even more plentiful with 32 companies qualifying for my screen. This are the 10 largest.

These results hint at one of the major problems that quality investors have when they hunt for stocks in the UK: scale.

Is the UK too small for compounding quality companies?

The screen I have used above limits stock selection only to companies with a market capitalisation of over £10bn. In the UK that does present a challenge because there aren’t that many companies which grow that big. Even without all of the quality metrics, only 41 British stocks qualify for my screen. By comparison, the US has 529 stocks worth over £10bn and Europe has 253.

The reason I restrict my selection is that scale is important for compounding quality businesses. These are stocks which investors seek to buy and hold forever. If they are restricted by the potential size of their market, how can they continue compounding indefinitely?

This is the problem facing two of the UK’s highest quality stocks, which appear in my screen if I remove the size restriction: Games Workshop and Bioventix.

Bioventix produces sheep monoclonal…

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jjis

19th May '23

I think you write off Next's Share Buy Back policy too readily. They set out some clear guidance on this in their FY Report & Accounts / results in 2013 Pages 13-15 . Hopefully you can see the image below extracted from there or see the link above for the full details.

Brilliant Leader

We are being spoilt this week with some outstanding articles. Thanks again Megan - another screen for me to play with. And for the record, I totally agree with this sentiment,

“I have a bit of a complex about dividends. I hate it when companies like Vodafone and BT spend billions every year returning ‘profits’ to their shareholders when those profits have relied on increasingly expensive borrowing. ‘Get your balance sheet and growth prospects in line before you start paying your investors,’ is my opinion on the matter.”

Rusty2

Megan, There are still problems buying overseas stocks, not available and dealing/forex fees are high, also there can be issues with tax on dividends.

Even LVMH Moet Hennessy Louis Vuitton SE (EPA:MC) is not available on some platforms such as IG. Can buy on HL but £12 plus 1% forex.
Why does LVMH Moet Hennessy Louis Vuitton SE (EPA:MC) not qualify for your screen?

Coverage of foreign stocks on Stockopedia is almost non existent.

I did have the European region, for a while, but it is quite expensive, if you don't buy many European shares and even on HL quite a few were not available and IG is much worse.

I do hold Adobe (NSQ:ADBE) but it has not done very well, almost halved from peak around 18 months ago.

I looked Sage (LON:SGE) and it compares quite well with Intuit (NSQ:INTU) apart from size, the ROCE figures were ahead for the last year, surprised no one has taken over.

Why does it have to be over 10bn, I agree most of out large caps are not very good, I only hold some because of income, such as Shell (LON:SHEL) BP (LON:BP.) Aviva (LON:AV.) and Legal & General (LON:LGEN).

peterthegreat

With regard to Bioventix, I would agree with the article that the global antibody is not unlimited but the subsector in which Bioventix works, i.e. monoclonal antibodies for diagnostic reagent is worth about $8 billion per year and growing in double digit percentage figures each year. Of course, not all parts of this market can be addressed by sheep monoclonal antibodies but I think Bioventix's growth is limited by the company's conservative strategy rather than the overall size of its markets (hence the high profitability).

Adobe (NSQ:ADBE) don't pay dividends either.

Fundsmith did hold Intuit (NSQ:INTU) until last year but sold it due mounting losses, has since bought Adobe (NSQ:ADBE).

Games Workshop (LON:GAW) are in talks with Amazon, if this develops then it could be a big deal.

RJS89

fundsmith has also since sold Adobe! (NSQ:ADBE)

Really, so much for holding for a long time. I see they bought some Procter & Gamble Co (NYQ:PG).

Saxonboy57

20th May '23

Another great article. I currently invest through Etoro but often they do not have access to the stocks I want to buy. Any suggestions for another platform, particularly with access to Australian shares?

BnB

The reason for excluding Bioventix isn’t scale. It’s the fact that such a high proportion of profits are paid out in dividends - the very opposite of re-investing for growth.

MiserableJacktPotato

GAW’s total market opportunity is no smaller than any of the big media or toy companies. Sure, for now, they concentrate on sci fi and fantasy but there’s no reason why they can’t expand that in the future. And think about it this way, Wizards of the Coast are just about the only thing keeping Hasbro afloat, investors don’t seem to think WotC are limited.

No position on GAW but I do have a lot of their products. My avatar would be of a space marine but the Stocko avatar cropper doesn’t (or at least didn’t) work properly.

Have a look Interactive Brokers (NSQ:IBKR), I don't know about Australian shares but that have wide coverage of other markets and their fees are very reasonable. You can do a trial. I will be opening an ISA with them soon.

rhomboid1

There are a number of U.K. stocks that have compounded v well over the years…including my largest holding Goodwin (LON:GDWN) to pick one not entirely at random, I also hold Games Workshop (LON:GAW) as my number 2 holding as their addressable universe is vast imho…& they’re only now touching on mainstream with the Amazon Warhammer TV series

Epitychia

22nd May '23

There is a difference between quality and growth. For me quality is a high profitability business, that has a strong moat, so it is consistent and reliably profitable, making it a long term hold. Asking for it to have high growth as well is asking too much. Therefore the profits should go back to the shareholders who can compound their money elsewhere.

Also not sure why there is a £10bn cut off. Small companies can be quality businesses, in fact it is more likely that they will be. Growth is frequently bought by having low margins, so large behemoths usually sell commodity type products.

Growth is frequently bought by having low margins, so large behemoths usually sell commodity type products.

In the UK maybe. Tell that to Microsoft, Alphabet and Nvidia - or a hundred other international firms with market caps ten times £10bn, from healthcare, to quality industrials, to luxury stocks, to data platforms. The problem is the location, not the size.

Aislabie

28th May '23

Thank you for this excellent article, I very much agree with your concerns. In particular the institutional preference for dividends is entirely at odds with the need to invest for growth, and seems to indicate a mindset that simply does not trust growth. A recent example has been CentralNic (LON:CNIC) where an aggressive (and in my mind, successful) bid to reach global scale by debt and stock based acquisition has been reined in by the market. The company’s new CEO seems to have been pressured to reduce debt and pay an completely irrelevant dividend from cash derived from the successful previous policy.

UK companies lack scale and the institutions do not seem to have the necessary winning culture to achieve it. In so many industries we have observed that “playing safe” is not safe!

Paul Hill

Hi Megan

BTW, how will RELX's digital publishing, advertising & data analytics businesses be impacted once generative AI (eg ChatGPT) is fully rolled out?

Thanks

How will RELX's digital publishing, advertising & data analytics businesses be impacted once generative AI (eg ChatGPT) is fully rolled out?

I really don't think anyone knows, Paul. But the weight of opinion is that data providers, as owners of the source IP for learning, should be able to use AI to embed further into their clients' processes. The alternative is that they become disrupted. And I guess different data houses will fall into one or other camp depending on their efficacy in managing the transition.

Maddox

13th Jun '23

BVXP only produces a few grams of antibodies in its lab - it also earns royalty income - so it's growth is far from limited by its small number of staff or (new) lab. Also, unlike many firms, it benefits from an extremely capital light business model that doesn't require a large reinvestment of development capital; hence the fantastic margins, cash conversion and dividend pay-out.

BVXP is in the race to develop what is the holy grail in future diagnostic tests - an early test for Alzheimer's - which could be a 'block-buster' in revenue terms. Still at an early stage, but the published research is highly positive - their academic collaborators at the University of Gothenburg have a 50+ research team just on this project.

BVXP is also pioneering use of their diagnostic testing for the biomonitoring of people's exposure to pollution. This is, somewhat surprisingly, a novel area which does present it with challenges in developing the market once they have developed an effective PCR test.

Nothing guaranteed on the success of the new initiatives of course, but the current business is growing steadily (Troponin Test roll-out) and highly profitable.

So, the UK has some very exciting potential multi-bagger growth compounders such as BVXP.

30th Jun '23

yes, a very short holding period indeed! they sold it around the time of their acquisition of Figma for $20B(!)

a deal that is now being probed by regulators as they (Adobe (NSQ:ADBE)) essentially bought out one of their upcoming and growing rivals

Fundsmith got that a bit wrong, Adobe (NSQ:ADBE) are up around 40% since they sold. I do hold some Fundsmith but it has been disappointing recently. Sold most of my Adobe (NSQ:ADBE) now.

Where are the UK’s quality compounders?

Is the UK too small for compounding quality companies?

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Megan Boxall

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