This article is excerpted from Tom Yeung’s Profit & Protection newsletter. To make sure you don’t miss any of Tom’s picks, subscribe to his mailing list here.
The Quality Stocks of the Profit & Protection Playbook
On Tuesday, I introduced the Profit & Protection definition of a “quality” stock:
A company that can generate high and stable returns over long periods of time.
And believe me, I know…
… that’s a boring definition.
Can’t “quality” mean something flashier, like having a great product? A well-known brand? Maybe even fat margins in a hyper-growth market.
But as we saw when we looked at the data, none of that particularly matters.
Instead, companies from Home Depot (NYSE:HD) to Apple (NASDAQ:AAPL) have outlasted Crazy Eddie and Compaq in their ability to generate superior returns. For every $1 of investor capital those two winners touch, they can return $20 within a decade, thanks to their 35% rate of return on invested capital (ROIC).
Today, we will look at five other companies with similarly high ROIC and stability that look set to sizzle this summer. And in tomorrow’s newsletter, I’ll unveil which of these five high-quality picks make it onto the Profit & Protection’s core “buy” list.
5 High-Quality Stocks Sizzling this Summer: Align Technology (ALGN)
ROIC Score: A+ | Stability Score: A-
The parent company behind the brand Invisalign has quietly built a $20 billion empire from its invisible orthodontic sets. A stunning 99% ROIC puts it squarely atop 99% of companies in the broad-based Russell 3000 index.
Those familiar with the dental industry will immediately understand why:
Align’s (NASDAQ:ALGN) iTero scanner.
The company’s proprietary intraoral scanner creates a steep barrier to entry. Scanners are sold at a discount, and Align makes up the difference by charging more for orthodontics over time.
Dentists also have incentives to stick to one system. Align gives increasingly significant discounts based on the volume of Invisalign cases, making it financially unattractive for dentists to invest in a second system.
The system has created a pseudo-monopoly in the invisible braces market, where Align has three times the market share of all of its competitors combined. ALGN has generated no less than 20% ROE over the past five years.
Shares are also cheap from a historical standpoint. A return to more typical valuations gives the firm a 110% upside — making for a potentially phenomenal summer of investing.
That said, there are some issues with ALGN. Shares have fallen 58% since the start of the year on valuation concerns. Margins have also faltered on weaker demand over the past two quarters; belt-tightening customers can switch to metal bracers or forgo them entirely. Morningstar analysts have cut their price target from $650 in March to $440 today.
Still, investors have good reason to take the opportunity to buy the dip. As historical data shows, buying these stable, high-ROIC companies is the recipe to generating phenomenal returns.
ROIC Score: A | Stability Score: A
The software maker should also come as no surprise to industry watchers. As an early mover to a subscription-based cloud offering, Adobe (NASDAQ:ADBE) has managed to increase margins and sales at the same time. Software piracy has become a relic of the past.
Analysts expect the company’s ROIC to top 45% in the coming year, earning the software maker an “A” grade on the Profit & Protection’s “quality” scale.
All this creates a perfect storm for buying the dip this summer. Adobe’s shares are down nearly 25% this year on a broader tech slowdown; an investor pivot to quality will quickly send shares back up to their previous heights.
Malibu Boats (MBUU)
ROIC Score: A- | Stability Score: A+
When I first covered Malibu Boats (NASDAQ:MBUU) one year after its IPO, the company was a well-run value stock. Shares traded at $14, pricing the company at under 9x forward price-to-earnings.
Fast forward to the present day and MBUU has now become a stunningly high-quality play.
Over the past five years, the company has consolidated the boating market by acquiring high-value brands including Cobalt, Pursuit and Maverick. Combined, the firm now controls 32% of the performance sports boat market and 36% of the 24-foot to 29-foot sterndrive market. Its closest competitor is less than half its size.
Malibu’s scale has also translated into phenomenal capital returns. The company has generated an average of 47% ROIC over the last five years, and analysts expect no less than 24% in the coming decade — not bad for a consumer-discretionary firm.
The firm also looks set for a sizzling summer this year. Q3 sales rose 26%, benefiting from 21% pricing growth; demand-hungry customers have shrugged off inflationary concerns.
That said, investors should remain wary. The boating market is highly cyclical; demand for RVs is already sagging and a prolonged recession could also put the boating industry on the back foot. Interest rates are also an issue; third parties finance around 80% of Malibu’s sales.
Still, Malibu Boats is a firm that scores extraordinarily well on the Profit & Protection “quality” scores. And in the long run, it’s the type of firm that the P&P system says will outperform.
ASML Holding (ASML)
ROIC Score: A | Stability Score: A-
Chipmaker stocks have long captured investor imagination for their cutting-edge products and … well… ability to create fun. Nvidia’s Titan V processor now crams 21 billion transistors onto a video card, giving gamers yet another reason to spend $3,000 on a computer part.
But all these chipmakers have one company to thank:
ASML Holding (NASDAQ:ASML).
This Netherlands-based firm is the world leader in photolithography machinery, the process for physically creating micro-sized chips and transistors. By using extreme ultraviolet light (EUV), ASML’s equipment can etch silicon elements as small as 10 nanometers.
Competitors have had a tough time keeping up. Nikon (OTCMKTS:NINOY) and Canon (NYSE:CAJ) dropped out of the EUV race in 2020, and Chinese makers seem to be at least a decade behind. ASML has almost a 90% share of the chipmaking market.
That’s translated into large, consistent margins. Analysts expect ASML to generate 40% ROIC, putting the company in the top 6% of all firms in the Russell 3000 index. And though semiconductor shortages will moderate by 2023, ASML looks set to ride out the coming supply glut.
Bonus Pick: Meta Platforms (META)
ROIC Score: A- | Stability Score: A
Finally, Facebook parent Meta Platforms (NASDAQ:META) makes a surprise appearance on the Profit & Protection quality list. It’s 33% expected ROIC and its high ROE stability score put the firm ahead of other FAANG stocks by a reasonable margin.
The quality score might surprise some readers, as it did me. Uncertainty around Facebook’s advertising growth rates and data privacy issues have dogged the company for years. And a sudden resignation by COO Sheryl Sandberg points to internal politicking.
But the numbers don’t lie:
Facebook has generated superior profits.
The social media firm has long… leaned in… on data of its 2.9 billion monthly users to become an advertising giant. It arguably knows more about its users than any other social media firm, giving it a pricing edge in targeted advertising. Operating margins have consistently remained above 35%, or two-thirds higher than Alphabet’s (NASDAQ:GOOG, NASDAQ:GOOGL).
CEO Mark Zuckerberg has also kept the company on the offensive. A pivot to virtual reality expands on Facebook’s ambitions as an entertainment hub. And smart acquisitions of companies like Kustomer and Giphy have helped the firm grow into neighboring territories.
If you needed to pick between the FAANG stocks, the “F” of Facebook would be the natural place for quality-minded investors to start.
(Or is it “de-MANGAed?”)
The EV/S Ratio
The Profit & Protection concept of “quality” can often create unintuitive outcomes.
Yet this type of investing works. $10,000 invested in each of those three companies in 2000 would have turned into:
- Verisign. $187,450
- McDonald’s. $82,790
- Coca Cola. $23,260
The unfortunate truth about investing is that brands, customer loyalty and management ability are only contributors to high stock returns. A company can just as quickly run a network with extreme regulatory barriers or send enough lobbyists to Congress to fill a mid-sized swamp.
That occasionally creates perverse incentives. Companies from tobacco firm Altria (NYSE:MO) to gunmaker Smith & Wesson (NASDAQ:SWBI) have long lobbied politicians to help them maintain their businesses (often with extreme side effects).
But there are still plenty of firms doing good in addition to doing well. And though hum-drum firms like Verisign might never make a “most innovative list” (as Enron once did), these are the under-the-radar firms that can power a Profit & Protection portfolio for the long run.
On the date of publication, Tom Yeung did not have (either directly or indirectly) any positions in the securities mentioned in this article.
Tom Yeung, CFA, is a registered investment advisor on a mission to bring simplicity to the world of investing.