Over the past couple of months, concerns over European sovereign debt and its implications for the banking system have eased. Actions taken particularly by the European Central Bank have eased liquidity concerns and improved confidence.
However, there are still reasons to remain concerned as a convincing vision for the future of the eurozone has yet to be formulated. Furthermore, the requirement to reduce debt means growth is likely to remain muted in mature markets due to austerity measures and restricted access to credit.
In these difficult circumstances, it remains important to focus on companies that offer healthy organic growth, internationally diversified revenues, robust balance sheets and leading competitive positions that provide strong pricing power.
They also need to be attractively valued. Numerous studies have highlighted the significance of dividends and their reinvestment in generating returns. So companies with attractive dividend yields and the ability to grow them over the long term should also be a key focus. Based on this, I’d expect the following three companies to generate attractive returns.
The first is Compass (LSE: CPG), a leading global contract catering company. It should benefit from continued growth from outsourcing. At present around half of the £200bn market is outsourced, with healthcare and education particularly under-penetrated. There is also scope to gently increase margins via cost savings in areas such as labour scheduling and procurement.
Compass is increasing its exposure to emerging markets, for example India and Brazil, and also moving into support services, a market that is growing at around twice the pace of catering. The cash generative nature of the business allowed the company to recently announce a significant share buy-back. The combination of likely high-single-digit earnings growth, a dividend yield above 3% and the share buy-back provides an attractive total return.
My second choice is the Swiss pharmaceutical company Roche (VX: ROG). Over the past decade, the pharmaceutical sector has been de-rated due to concerns over the paucity of new drug approvals, poor research and development efficiency, government healthcare budget pressures and the threat of competition from generic substitutes.
However, these issues have been more than factored into Roche’s valuation and, with a dividend yield above 4%, the market is overlooking the company’s significant strengths. These include a very strong oncology franchise with an interesting pipeline that includes breast cancer therapies pertuzumab and T-DM1 (which should provide future growth as Herceptin comes off patent).
Furthermore, the company has a world-class diagnostics business that has excellent scope to grow earnings. There is also the potential for further cost savings and efficiencies. Overarching all of this is the long-term outlook for growth in emerging markets where increased wealth will provide new demand for the company’s products.
The third company that warrants your attention is Sage (LSE: SGE), a leading supplier of accounting and business management software to smaller companies. It has a diversified revenue base of over six million customers. Sticky, high margin support contracts are a key part of the company’s offering and provide a significant barrier to entry for rivals. Although the products tend to be low value, they are critical for the operation of a businesses where regulatory and fiscal developments tend to drive the product upgrade cycle.
Growth should come from new products and cross-sales of payments software and premium support packages, alongside operating leverage. From a cashflow perspective, the capital-light model and upfront subscriptions are attractive and the company maintains a very strong balance sheet. Overall, it is very well placed to deliver attractive earnings and dividend growth.