UK Edition
The FTSE 250 index turned 30 years old last week. Few investors celebrated the milestone, of course, since the mid‑cap index has delivered thoroughly disappointing returns over recent years. It is down by 13pc over the past five years and has fallen by 27pc so far this year.
The index’s poor performance is a relatively new phenomenon. In its first 25 years, it generated an annualised total return of around 12pc. Although factors such as Brexit and a challenging economic outlook have recently held back the index, whose members generate half of their revenue domestically versus a quarter for the FTSE 100 index, its historical performance suggests a return to capital growth is almost inevitable over the long run.
Therefore, in Questor’s view, the FTSE 250’s recent slump presents a stunning long‑term buying opportunity.
Mid‑sized industrials company Diploma has tracked the index lower this year in spite of its impressive financial performance. The company, a supplier of specialist technical products such as wiring, cable, seals and gaskets to a multitude of sectors and regions, has either retained or upgraded full‑year financial guidance in each of its trading updates.
It expects to generate a low double‑digit percentage increase in organic revenue for the full year in spite of a rapidly slowing global economic growth rate.
Encouragingly, it has been able to raise prices to offset higher costs. This led to a 0.2 percentage point rise in the company’s adjusted operating margin in the first half of the year; it is now expected to be at the top end of its 18pc‑19pc guidance range for the full year. Given the likelihood of a sustained period of high inflation, the company’s pricing power is likely to hold significant appeal for some time.
Pricing power also suggests the business has a clear and sustainable competitive advantage that could be further enhanced by its aggressive acquisition plans. Last year, it made 10 acquisitions and has supplemented them with three further purchases in the current financial year.
Its latest update stated that its acquisition pipeline remained “encouraging”, while its solid financial position gives it the capacity to prey on attractive businesses that are temporarily undervalued because of the uncertain near‑term outlook for the world economy.
Its net debt‑to‑equity ratio stood at 49pc at the time of its most recent half‑year results. Net interest costs were covered nearly 10 times by operating profits in the first half of the year. This suggests it can sustain higher borrowing, should it be required, to make further acquisitions. And with strong operating cash flow that amounted to 111pc of operating profits last year, it could emerge from the current economic slowdown in an even stronger position relative to rivals.
Given its wide range of operations and the highly fragmented nature of the industries in which it operates, acquisition opportunities could be plentiful as the world economy’s growth rate falls. At the same time, an expected fall of nearly 50pc in the global economic growth rate this year, according to the IMF, means operating conditions for many of its own businesses could come under pressure in the short run.
As a result, Questor would be unsurprised if Diploma’s share price exhibited a relatively high degree of volatility over the coming months. Although it generates 85pc of its revenues abroad, the FTSE 250’s unpopularity in an era of economic and political turbulence may weigh against its near‑term share price prospects. And, since it continues to trade on a relatively high 23 times forecast earnings, some investors may be tempted to buy cheaper stocks.
However, the company’s long track record of growth over the past decade, which equates to an annualised rise in adjusted earnings per share of 12pc, highlights its long‑term potential as the global economic outlook improves.
Alongside its solid financial health, clear competitive advantage, pricing power and capacity to strengthen its market position through acquisitions, this means the stock is worthy of its premium valuation.
Questor says: buy
Ticker: DPLM
Share price at close: £24.44
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