As equity investors continue to ponder the outlook for stocks in 2023 and beyond, the prevailing view suggests that the US Federal Reserve’s hawkish monetary policy stance will subside in short order and that a mild recession is likely, either in the back half of 2023 or in 2024. Even if these recession predictions do not materialize, the successive interest rate increases witnessed over the past year will undoubtedly lead to a lower growth environment going forward. In fact, many macroeconomic indicators (i.e., employment, elevated corporate profits, etc.) suggest that we are in the later innings of the current economic cycle. Although the current S&P 500 forward earnings multiple of 18x is lower than it was back in January 2021, it reflects few of the macroeconomic headwinds facing investors today and offers a limited margin of safety should earnings fail to meet current market expectations.
In this elevated risk environment, we’ve advocated using a balanced approach to portfolio construction including holding franchises with defensive characteristics as well as using a counter-cyclical approach to investing. In this vein, we also believe investors should additionally consider the merits of including quality compounders within their diversified portfolios. What are quality compounders? Quality compounders are businesses that produce steady earnings growth across economic cycles while also generating relatively high returns on invested capital. These franchises usually exhibit a sustainable competitive advantage (i.e., scale, pricing power, brand reputation) which enables them to sustain these high returns over long periods of time while also being able to re-invest profits into their business at attractive incremental rates. Many of these franchises also possess strong balance sheets and generate high levels of free cash flow. Although quality compounders generally trade at higher valuation multiples than traditional value stocks, they are perennial value creators as they consistently increase their intrinsic value over time and tend to outperform the broader market, often by a wide margin. Being able to acquire such franchises at attractive prices (i.e., at or below intrinsic value) can enhance the quality and expected return characteristics of any strategy.
QV’s Global and US strategies currently hold shares of AutoZone (NYSE: AZO), a leading retailer and distributor of automotive replacement parts and accessories with locations in the U.S., Mexico, and Brazil. The AZO franchise is our best example of a true quality compounder held within our strategies today. Over the past decade, AZO’s revenues and EPS have grown at an average annual rate of 6.7% and 18.9% respectively. In fact, the business has not experienced an annual decline in revenues or EPS for over two decades.
Source: Capital IQ, QV Investors, Consensus estimates 2023-2025
Its 10-year average return on capital stands at nearly 47% (top decile within our strategies) and current incremental returns are comparable to the long-term average. What is management’s “secret sauce”? Provide best-in-class customer service, support team members, and re-invest in the business to build in scale and distribution capabilities. At 18x forward earnings, AZO shares trade at a slight premium to their LT average but at a discount to our estimate of intrinsic value for the franchise. How does AZO’s share price return compare to the S&P 500 over the past decade? 564% for AZO vs. 163% for the market.
Shares of Starbucks (Nasdaq: SBUX) are also held in QV strategies. The SBUX franchise similarly possesses many of the characteristics of a quality compounder. Up until recently, revenues had compounded at high single-digit annual rates over the past 15 years while EPS and cashflow had compounded at a mid-teens rate over the same period. Today, management is upping its level of re-investment in the business to position the franchise for a post-pandemic world. These investments will enable SBUX to take advantage of an evolving business mix which includes increasing digital penetration and a higher proportion of food and cold beverage sales. As a result, we expect SBUX to resume its historical growth cadence and increase intrinsic value at attractive rates going forward.
The case for owning quality compounders within a diversified strategy and holding these over the long-term is compelling. Resilient growth across cycles and outsized returns on capital underpinned by sustainable competitive advantages are some of the attributes which can enhance the quality and expected return characteristics of any strategy, regardless of the market environment.