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Questor: there’s no doubt that Croda is a quality stock, but does it deserve this pricey valuation?
Questor share tip: a price-to-earnings ratio of 26 sits uneasily with a lack of growth in sales and profits so far this year
There may seem to be little or no point in trying to pick holes in the investment case for a company that has a powerful market position in its chosen area, generates returns on capital of more than 20pc as a result and can point to a two-decade dividend growth streak for good measure. And Croda is indeed a very good, very well-run company.
But it is the valuation paid for such security that is the ultimate arbiter of return, not the strength of the narrative, and it is here that caution is required, at least for now.
If there was ever a share that deserved the “quality” tag it is Croda, the speciality chemicals company. Its innovations in the areas of personal care (ingredients for skin creams), life sciences (for crop care), high-performance coatings and lubricants mean it provides products on which its customers rely heavily and for which they are prepared to pay up as a result.
That pricing power underpins Croda’s 24pc operating margins and its excellent return on capital and cash flow.
This is undeniably a strong story and Croda can point to the right numbers to prove it. Sales have grown at an annual rate of 4.4pc over the past decade and earnings per share have advanced at a double-digit clip over the same 10 years.
But a forecast price-to-earnings multiple of about 26 and a yield of less than 2pc mean the investment case is well understood by the market and investors are already paying a very full price to access it.
Sales and earnings were broadly flat in the first half of the year, after all, and management aims to make select acquisitions in what it terms “adjacent technologies”, something that could raise the risk profile of the stock (although the balance sheet is sound).
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The chances of the shares attracting an even higher multiple feel low, especially as the “value” investment style is trying (again) to make a comeback, as discussed in Questor’s Thursday column in recent weeks, and “quality” names are finding it harder to make progress, held back as they are by their lofty valuations.
Although they have different business mixes, it is interesting to see chemicals sector rivals such as Victrex, Elementis and Germany’s Fuchs Petrolub start to suffer a lowering in their valuations from very high levels, even if their actual share prices are not yet coming under undue pressure, and it may be that there will be a better entry point to be had with Croda in the next year or two.
So, while it remains a high-quality company, we will wait for a better opportunity to buy.
Questor says: avoid
Ticker: CRDA
Share price at close: £49.64
Update: British American Tobacco
It may seem perverse to steer gently clear of Croda and continue to embrace British American Tobacco, especially when we are (unfortunately) sat on a large book loss on the latter, following our analysis in August 2017.
But this again comes down to valuation and the daunting challenges faced by BAT are hardly news to investors, judging by its forecast p/e ratio of 9.5 and prospective yield of 6.9pc.
In addition, last week’s year-end trading update from the company featured little by way of additional bad news. Management was able to stick to sales and earnings growth targets, despite the slowdown in sales of next-generation products thanks to regulatory pressure against vaping in America.
A strong sales mix and firm pricing at the core cigarette business are the reason for that and, while the direction of travel seems clear when it comes to tobacco volumes, this business still makes operating margins of around 40pc and generates copious cash flow.
There can be no denying that we have got this one wrong so far, but it does not feel right to bail out now either.
Questor says: hold
Ticker: BATS
Share price at close: £30.50
Russ Mould is investment director at AJ Bell, the stockbroker
Read the latest Questor column on telegraph.co.uk every Sunday, Tuesday, Wednesday, Thursday and Friday from 6am.