Share prices fell as the investment climate shifted and inflation and interest rates gradually increased in the wake of COVID-19
Terry Tanaka says that presents a chance for astute investors.
In June, the private-equity behemoth Advent International launched a bidding war for the high-tech precision measurement company Spectris. This takeover stands out in a year with many others. Because it was too inexpensive and a top-notch global leader, it was purchased. This is a serious warning to investors in the most reputable companies in Britain, not just another deal.
A small number of leading UK companies, including Spectris, were the stock market's darlings for over ten years after the 2008 financial crisis. When interest rates were at an all-time low, their consistent growth and dependable profits caused investors to inflate their valuations to unaffordable levels. But this story has evolved since their 2021 peaks. From industrial engineers to manufacturers of specialty food ingredients, many of these once-admired companies have seen a sharp decline in share prices, with some seeing a 50% or more drop.
A fundamental shift in the economic environment, including a sharp increase in inflation and rapidly rising interest rates that offered alluring alternatives to stocks, was the catalyst for this dramatic change. This "repricing" was a necessary correction, but the Spectris takeover raises a new concern: these high-quality companies may have become too cheap, making them alluring targets for private investment.
The estimated future profits of a business are discounted to their current value to determine its value. Earnings from a distance were tremendously valuable when interest rates were close to zero because they were hardly discounted. The present value of those long-term profits was significantly reduced as rates rose and the discount rate rose as well. This mechanism quickly deflated valuations, especially when combined with broader market anxieties.
When a government bond offered a guaranteed 5 percent yield, the very characteristics that had previously excused exorbitant pricesthat is, their steady, long-term earningsbecame liabilities. As the panic to sell started, the question arose: do these fallen stars now present a strong chance for long-term investors, or do they invite opportunistic private buyers to remove them from the public market for good, depriving investors of the chance, as the Spectris deal demonstrates?
High-quality stocks are battered.
When the valuation crunch did arrive, it happened quickly and brutally, sending some companies' share prices plummeting from their exuberant late-2021 peaks. No business better exemplifies this turnabout than Spirax (LSE: SPX). It has been valued for its unrelenting growth and resilience, and for many years it has been considered one of the most reliable global leaders on the UK stock market. Its crucial function in an extraordinarily wide range of industries is the basis for this reputation; its specialized steam systems are essential for everything from the manufacturing of food and medicines to the running of hospitals, chemical plants, and oil rigs. It has become a stable stronghold as a result of its diversification.
However, this titan of industry was not exempt from the shifting economic tide. A startling decline of over 60% occurred as its shares fell from an all-time high of over 172 in November 2021 to about 60 today. This collapse was more than just a drop in price; it was a blatant instance of valuation reset. The forward price-to-earnings (p/e) ratio of the company was drastically reduced from an eye-watering 50 times earnings to a much more sober 20. Once prohibitively expensive, a world-class company is now starting to appear like truly good value after such a dramatic de-rating. Because of this, the business is now firmly back on the radar of long-term investors, and it is the kind of name that now demands careful thought.
A similar situation occurred at Halma (LSE: HLMA), a group of companies specializing in environmental, health, and safety technologies and another FTSE-100 constituent. After peaking at about 32 percent, its shares dropped by almost 40 percent. However, in contrast to Spirax, the shares have recently recovered their luster, reaching all-time highs and demonstrating that substantial profits can be generated when the market acknowledges the fundamental worth of these high-quality companies. Although Halma is a metaphor for what can happen to companies with obvious qualities, smaller businesses that had captured and lost the interest of investors faced harsher penalties. The maker of flavor ingredients, Treatt (LSE: TET), had a genuinely remarkable run, but its share price plummeted by over 80 percent from its peak of over 13 in late 2021.
This wasn't just a few isolated businesses having problems. The collapse was thematic and sector-wide. The highly geared valuation expansion mechanism that had increased gains during the ascent violently reversed course. For many years, investors had been rewarded for consistently high prices in exchange for steady profits. They were now facing harsh consequences for it. Many investors who had piled in near the top were left painfully exposed as the flood of cheap money had gone out.
Interest rates are not the only consideration.
Even though the main cause of this sharp decline was rising interest rates, it would be incorrect to interpret this event solely from a macroeconomic perspective. Operational problems unique to the company that had been obscured by a thriving market were brought into stark focus as the financial climate tightened. Sales and profit margins were negatively impacted by the post-pandemic challenges faced by a number of these companies.
It was a perfect storm for Treatt, based in Suffolk. Due to bad harvests and disease in Brazil and Florida, the price of orange oil, a vital raw material, skyrocketed. Constrained consumers in North America started consuming fewer high-end beverages at the same time, which was a major end market for Treatts natural extracts. A series of profit warnings brought on by this poisonous mix of cost inflation and declining demand destroyed the company's growth narrative and severely damaged its share price. Due to its small size and unique challenges, Treatt now appears more like a speculative opportunity, but in the long run, it might offer an intriguing proposition for risk-takers at the current valuation.
It wasn't the only one dealing with headwinds. A global leader in high-performance polymers used in everything from spinal implants to airplanes, Victrex (LSE: VCT), also struggled. A slow post-pandemic recovery in elective surgeries, which impacted its profitable medical division, hindered its expansion. Concerns about operational problems were raised by the company's early teething issues at its new factory in China. Profits were further strained when production ramped up more slowly than anticipated after opening.
This harsh environment affected all players, even the bigger and more varied ones. The precision measurement expert Renishaw (LSE: RSW) found that its success was correlated with the cyclical spending of its clients in the semiconductor and electronics sectors. Orders for Renishaw's equipment decreased in tandem with the decline in demand for smartphones and other devices. The death of its co-founder, David McMurtry, has caused a significant drop in the share price in recent months. He and his co-founder John Deer own a sizeable portion of the company, which has raised questions about the long-term ownership structure. Notwithstanding the company's operational performance, the market is apprehensive about a possible future sale of these holdings, which can result in a stock "overhang" that can lower the price. Despite a robust order book, cost inflation and supply-chain disruptions put pressure on margins for even the tenacious Rotork (LSE: ROR), a leading manufacturer of industrial valve actuators (devices that regulate the flow of liquids and gases).
Despite the firm's obvious strengths, Tristel's (LSE: TSTL) challenge was different and caused investors to become frustrated for a long time. Based on its exclusive chlorine dioxide chemistry, this outstanding British company is a pioneer in advanced hospital disinfectants. Its products play a vital, non-discretionary part in preventing infections, which is a continuous need in the medical field. Its quality and consistent growth in core markets were undeniable for many years. However, the promise of obtaining US regulatory approval became an undue reliance on the valuation. Even devoted shareholders became impatient when the FDA process took longer than anticipated. The shares stagnated and sentiment soured as deadlines passed, detaching them from the company's sound foundation.
Now that dynamic has changed. In 2024, Tristel at last received FDA approval, opening the door to the biggest and most lucrative healthcare market in the world. This is not incremental; rather, it has the potential to be transformative.
The start of US expansion could result in a step change in growth after years of investment in R&D and regulatory work. Tristel is about to transform from a reputable UK expert into a major player in infection control worldwide. The shares appear appealing.
Do these high-quality stocks offer a good deal?
The key question after three years of suffering is whether these fallen stars offer a compelling opportunity. The investment case is based on weighing the companies' long-term strengths against the risks of a permanently altered economic environment. Are these excellent businesses now available at a fair price, given the sharp compression of valuations?
Their main attraction is still there. They remain, for the most part, outstanding companies. Due to strong barriers to entry, including technical know-how, long-standing customer relationships, and intellectual property, they hold dominant positions in specialized, international markets. This enables them to produce extraordinary cash flow and high returns on capital employed (ROCE).
Spirax is unmatched in its knowledge of steam, which is essential to many industrial operations. Halmas companies handle the non-discretionary, legally mandated requirements for environmental and safety monitoring. These are structural growth markets, not passing trends. Many are also linked to long-term trends that cannot be stopped. Whether it's the desire for increased energy efficiency (a primary market for Spirax and Rotork) or the unstoppable growth of factory automation (a driver for Renishaw), these companies are benefiting from structural change.
One of their main draws is the robustness of their business models. For many, recurring income from consumables, software subscriptions, necessary maintenance, and spare parts accounts for a sizable amount of revenue. The primary reason they were given the "quality" designation in the first place was because of this aftermarket revenue, which evens out the bumps in more cyclical new equipment sales.
And they have much cheaper stocks now. In contrast to the 4050 times earnings observed at the peak, a p/e of 2025 is historically reasonable for a world-leading industrial company. This offers a margin of safety that was just nonexistent in 2021. These days, an investor is paying a fair price for the company's underlying earnings potential rather than a hefty price for the assurance of constantly rising multiples. Moreover, a lot of these companies are acting. Treatt is putting self-help strategies into place to increase productivity and control expenses. Additionally, obtaining FDA approval gives Tristel access to a market that might eventually double its sales. This concrete stimulant has the potential to restore its growth trajectory.
Investor patience will be required.
But investors shouldn't anticipate a quick return to the good old days. The macroeconomic environment has undergone significant transformation. It is unlikely that interest rates will soon drop back to almost zero. This indicates that the strong tailwind of steadily declining discount rates has ended. Real earnings growth, not the market's willingness to pay more for those earnings, will have to account for nearly all future returns. Additionally, there's a chance that the growth rates over the last ten years were unusual. Globalization, especially China's rise, greatly benefited many of these industrial companies. That tailwind may have become a headwind as geopolitical tensions increased and China's own growth slowed. A clear warning sign is the operational problems at Victrex, which have been connected to a decline in Chinese demand.
Moreover, the earlier presumption that they face little competition merits further investigation. The premium prices these companies command and the supply-chain disruption caused by COVID may have prompted some customers to look for "good enough" alternatives from rival companies. Any long-term loss of market share at the margins could limit future expansion and pricing power. Lastly, although the valuations are lower, they are still below the deep bargain level. When compared to the larger UK market, these are still fairly priced as premium companies. A buyer today is placing a wager that their quality will enable them to return to a path of consistent, albeit possibly slower, growth in the face of a more difficult environment.
Qualitative stock criteria.
The key is to be selective and concentrate on the core metrics that characterize a truly high-quality business, rather than just buying the story. So, how should an investor approach this sector? Examine the balance sheet first. Debt is risky in a world with higher interest rates. Give preference to businesses that have substantial net cash reserves or very little leverage. In a downturn, this gives you the resilience and firepower to make bolt-on acquisitions or invest in R&D.
Next, pay attention to the yield on free cash flow (FCF). A much more accurate valuation tool than a straightforward p/e ratio is this metric, which is the annual free cash flow per share divided by the share price. It displays how much actual revenue the company is bringing in for its owners. An appealing offer for a long-term investor is a growing, high-quality company with a sustainable FCF yield of 45%.
Third, search for a track record of innovation and pricing power. Businesses that regularly devote a sizable portion of their revenue to R&D, like Halma and Renishaw, are producing the goods that will propel future expansion. Their capacity to raise prices without alienating clients is a crucial indicator of a robust competitive moat.
Lastly, think about a basket strategy. It could be wiser to create a small portfolio of three to five of these companies rather than attempting to choose just one. In addition to diversifying company-specific risk, this offers exposure to the more general theme of a quality stock recovery. I believe that Spirax, Renishaw, Rotork, and Tristel are all worth seeing.
Those looking for a ready-made, diversified portfolio may also want to consider funds and investment trusts that concentrate on UK-based quality growth companies. Regardless of the route taken, patience will be crucial. It will take time for these companies to be re-rated. The goal should be to build up stakes in great companies at reasonable, long-term prices rather than trying to time the bottom precisely.
A fresh chapter in high-quality stocks.
The tale of Britain's quality champions serves as a helpful reminder that even the best companies can turn into bad investments if they are purchased at the wrong price. There is no doubt that the speculative frenzy of the low-rate era is over. There is nothing wrong with this for possible investors. The underlying fundamentals can now be seen more clearly as the haze of multiple expansion has cleared.
The decline has been healthy, but it has also been painful. In addition to reminding us that long-term returns are ultimately linked to profits and cash flows, it has brought valuations back within reasonable bounds. Spectris's fate, however, provides a potent example of the risks this poses. Its technology, as a supplier of advanced precision measurement instruments, is crucial for innovative industries. Spectris had been undergoing a multi-year, intricate consolidation process. The process of selling legacy businesses to acquire and concentrate on higher-growth areas created a great deal of short-term uncertainty for investors, even though it was strategically sound in the long run. Cyclical headwinds, such as a slowdown in Chinese demand and a cooling of markets associated with the development of batteries for electric vehicles, made this worse. Because the market was so focused on these short-term issues, it punished the shares and drove their valuations down to a point where they did not accurately reflect their long-term strategic value.
A major theme of the current market was brought to light by this risky vulnerability: private buyers will pay for quality if public investors won't. Advent International's takeover bid served as a wake-up call for the market, showing that while public shareholders perceived short-term issues, savvy purchasers saw a top-tier technology company being offered at a reduced price. In addition to being a possible opportunity for new investors, the low valuations that plague Britain's quality companies also pose an existential threat. These companies will unavoidably be bought out and taken private, permanently losing their value to public shareholders, if the market consistently undervalues their inherent worth.
Because of this dynamic, patient investors now have to weigh the chance of a re-rating against the very real possibility of a takeover bid that would remove the stock from the public market. Perhaps a more appropriate title for this new chapter would be "Britains fallen stars: a second chance for quality, or a pathway to private ownership" which would emphasize renewal rather than decline, but with a crucial disclaimer.
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