Six of the best stocks

By John Abernathy, Clime

Recent market volatility and a lower sharemarket reflect a fundamental shift in share valuations. For the first time in many decades the average price-earnings ratio (P/E) is falling as government bond yields fall. This is most pronounced in the United States equity market, with historical low yields for US bonds and a decline in sharemarket P/E ratios.

Intuitively, the market P/E should rise as bond yields fall. This is because as the risk-free rate of return (a government bond yield) falls, so should the required return from investing in the much riskier equity of a company.

But this is not happening. Markets and investors are nervous about the potential threat of deflation and sustained lower US and European economic growth. However, while market P/E ratios are falling, some companies are seeing a lift in valuation. These are the ones that have and are generating high returns on equity.

Clime focuses on companies it refers to as highly profitable. If deflation occurs or even if there is a marked slowing in economic growth, it is the highly profitable companies with low debt that will shine. This was starkly shown through 2008 to 2010 by companies that reported higher profits and profitability without resorting to raising equity during the global financial crisis.

Thus recent history is important to validate companies that have superior business and financial characteristics.

In particular, we track how much profit companies generate on their employed equity, then track what these companies did with the profit. Retain it and/or pay it out in dividends? Compound earnings when it retained profit? Compound earnings at a higher rate of profitability?

If so, these are companies we focus on. The key is to determine their value and access market opportunities when the price is below the value.

Six companies that meet the criteria

Let us look at some companies' value and compare their shareholder returns to the All Ordinaries accumulation five-year return of 4.7 per cent.

(Editor's note: Do not read the companies below as recommendations, but rather as examples that meet Clime's investment criteria. Do further research or talk to your financial adviser before acting on the information below.)

1. McMillan Shakespeare (MMS)

The core business is the administration of salary packaging services and fleet management. Other services include system design for performance management and remuneration rewards, and financial advisory referral.

In March, MMS announced the acquisition of Interleasing Group, which manages a nationwide car fleet provided through Interleasing and Holden Leasing. MMS has consistently produced a high return on equity and undertaken a sensible capital management policy. This has resulted in strong dividend payments to shareholders, with ample retained earnings to grow the business and compound at high rates. The company does not rely on new capital to fund growth. Clime's FY2010 valuation is $5.41. MMS's five-year total shareholder return (TSR) is 31.6 per cent per annum.

2. The Reject Shop (TRS)

A discount variety retailer of general merchandise, TRS has around 200 stores and a long-term projection of up to 400 across Australia. It focuses on low prices, convenient store locations and a wide variety of merchandise. Management have a proven strategy resulting in an outstanding return on equity for an extended period, while growing organically and requiring little new capital to fund growth. Clime's FY2010 valuation is $14.20. TRS's five-year total shareholder return is 46.9 per cent per annum.

3. Blackmores (BKL)

The company distributes premium-brand vitamins and supplements in Australia and South-East Asia, primarily through retail pharmacies, supermarkets and health food stores. Growth is supported by an ageing population that regularly buys vitamins, and Blackmores commands around 20 per cent market share.

The business recently invested in a new facility at Warriewood that will accommodate growth for many years. It has also purchased Pure Animal Wellbeing, which develops and markets natural dietary supplements and topical products for dogs and cats that are sold in veterinary clinics and specialty stores in Australia, New Zealand and South Korea. Clime's FY2010 valuation is $18.76. BKL's five-year total shareholder return is 16.3 per cent per annum.

4. Monadelphous Group (MND)

This engineering group provides project management, construction, asset management and maintenance services to the resources, energy and infrastructure industry sectors. It has four business divisions: Engineering Construction, Maintenance and Industrial Services, Electrical and Instrumentation Services, and Aviation Support Services.

The competitive advantage of the business stems from the reputation it has earned over 30 years for engineering excellence through quality workmanship, a reliable and flexible service, and developing long-term customer relationships. The business is hugely profitable with a five-year average return on equity of 98 per cent. Clime's FY2010 valuation is $13.63. MND's five-year total shareholder return is 37.7 per cent per annum.

5. BHP Billiton

BHP's key revenue drivers are the price of steel-making commodities, in particular iron ore, the oil price, and base metal prices, primarily copper. Through this, BHP is exposed heavily to the faster-growing regions of the world, in particular China. The business has grown organically without needing large equity injections, has moderate borrowings and maintained a return on equity above 30 per cent over the past five years. Clime's FY2010 valuation is $48.98. BHP's five-year total shareholder return is 16.9 per cent per annum.

6. Cochlear (COH)

The company manufactures and markets Cochlear implants. The device is the industry gold standard for enabling profoundly hearing-impaired patients to hear. A record of product reliability remains the key competitive advantage, and growth also stems from further penetration of existing markets and new under-developed markets such as South America, eastern Europe and China. The business enjoys a market share of around 70 per cent and has performed exceedingly well, achieving a return on equity above 50 per cent in each of the past five years. Clime's FY2010 valuation is $57.74. Cochlear's five-year total shareholder return is 15.3 per cent per annum.

About the author

John Abernathy is director of Clime Investment Management. Clime Asset Management and MyClime are part of Clime Investment Management Limited (ASX Code:CIW). MyClime is Australia's premier online share valuation service. Access a free two-week MyClime trial.

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