Often the real stock market winners are not the shares that look obviously cheap compared to book value or earnings but are instead the slightly more expensive high quality operators with improving outlooks.
Hikma Pharmaceuticals (LON:HIK) might be one of them. Here's why.
Capital allocation - it's harder than it looks
Top analysts and investors such as Warren Buffett and Michael Mauboussin say capital allocation - the deployment of company time, money, ideas, and people - is the key to building moat-like quality and profitability characteristics.
Unfortunately, CEOs are not generally promoted based on their ability to allocate capital, even though this is what they then go on to spend time doing. Buffett sums it up nicely in his 1987 letter to shareholders:
“Most bosses rise to the top because they have excelled in an area such as marketing, production, engineering, administration or, sometimes, institutional politics.
Once they become CEOs, they face new responsibilities. They now must make capital allocation decisions, a critical job that they may have never tackled and that is not easily mastered. To stretch the point, it’s as if the final step for a highly-talented musician was not to perform at Carnegie Hall but instead, to be named Chairman of the Federal Reserve.”
So if you’re only looking at sales and earnings growth, there is a vital question not being considered: how is this growth being funded?
Screening for upwardly mobile, high quality companies
That’s where ratios like return on equity (ROE) come in. ROE measures how efficiently a company uses Shareholders’ Equity to generate profits. It is calculated by dividing net income by book value of equity.
It’s no coincidence that Buffett is a fan of the measure - companies with high ROEs tend to exhibit the high-quality, moat-like business traits that he is so fond of gaining exposure to.
To find high ROE stocks whose fantastic business models are being rewarded by the market, you can create a screen that selects only stocks with both positive one-year relative strength and upgraded current year broker forecasts. The former ensures these shares have been outperforming the market and the latter suggests outperformance can continue.
One of the stocks that currently qualifies for this simple screen is Hikma Pharmaceuticals. The group has:
- A trailing twelve month return on equity of 21.5%
- An average current year EPS forecast upgrade of 0.85% from brokers, and
- A one-year relative strength of 4.01%
Stocks exhibiting these traits are typically a solid mix of quality and momentum. We can see this using the StockRanks: Hikma Pharmaceuticals has a Quality Rank of 85 and a Momentum Rank of 93.
Studies indicate that combining factors such as Value, Quality and Momentum is a more effective way of outperforming the market over longer time frames. That's why we have constructed our StockReports to give an instant impression of how well exposed Hikma Pharmaceuticals (LON:HIK) is to these three factors. We go into greater detail on factor investing in this video.
Stockopedia helps you to identify return-enhancing factors such as Quality, Value and Momentum by analysing thousands of data points every day. To find out more about you find investment opportunities and analyse your portfolios then take one of our two-week free trials and have a look around.