Trading Strategies: a FTSE 100 company with solid fundamentals

Investors may currently feel a sense of unease about the stock market’s near-term prospects. After all, several known risks that could have a significantly detrimental impact on the world economy’s performance are set to play out over the coming months.

Notably, the pace of monetary policy easing seems to be continually subject to delay as a result of sticky inflation. In the US, for example, the Federal Reserve recently changed its forecasts regarding interest rate cuts. While it previously expected to reduce the Federal funds rate by 25 basis points on three occasions in both 2024 and 2025, it now anticipates that just one cut will be made this year and four reductions will be implemented next year.

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Similarly, the Bank of England appears to be highly cautious about the prospect of interest rate cuts, even though inflation recently declined to its 2% target. It believes that inflation will rise from its current level between now and the end of the year, thereby making the case for monetary policy easing less convincing. And while the European Central Bank has already begun to unwind its restrictive monetary policy, with a 25 basis point reduction in interest rates announced in June, inflation in the eurozone is still 50 basis points higher than the central bank’s 2% target.

In addition to monetary policy uncertainty, investors are likely to feel somewhat uneasy about the upcoming US presidential election. It could have significant implications for ongoing geopolitical risks, notably with regards to the war in Ukraine and a potential trade war between the US and China. Both of these threats have already had a major impact on the stock market’s performance in the recent past and could do likewise in future.

An efficient use of time

Investors, though, ultimately have no way of accurately knowing how any of the above events will pan out. Therefore, spending too much time trying to deduce the most likely outcome, when it will occur and what its eventual impact on the stock market could be is nothing short of impossible. Moreover, there are infinite number of other risks that cannot be identified by investors ahead of their occurrence and which could have an even greater impact on share prices than today’s known threats.

A better use of time, therefore, is to accept that investing in shares carries ongoing risks. And instead of seeking to forecast them and their outcome, investors should focus on buying stocks that can survive short-term woes to generate attractive long-term returns. Although such a strategy may sound obvious, implementing it can prove to be more challenging. Investor emotions can easily be swayed by sharp share price movements, downbeat news regarding potential threats and the opinions of other investors.

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All investors, though, operate with the same handicap of not being able to accurately predict the future on a consistent basis. Given the limited time available to unearth high-quality companies trading at low prices, individuals who accept the inherent unpredictability of stock market investing are likely to be the most successful in the long run.

Fundamental strength

Undoubtedly, judging whether a company is of sufficient quality to merit purchase is subjective. But investors who continually seek to acquire firms that have low debt levels, substantial interest coverage and which post a consistently high return on equity are likely to be heading in the right direction. Buying such stocks when they trade at a justifiable multiple of earnings or cash flow, given their high-quality status, is likely to provide greater scope for significant capital growth over the long term.

While the UK stock market has made strong gains in recent months, its members continue to trade at discounts to intrinsic value in many cases. As such, investors who are able to use their time efficiently to unearth stocks offering favourable risk/reward ratios are unlikely to be disappointed over the coming years.

A high-quality business

Source: SharePad as at 22 July 2024.

FTSE 100 member Diploma (LSE:DPLM) is fundamentally sound. The firm produces a wide range of highly specialist products including cabling, seals and fasteners to a variety of end markets.

Although it is undoubtedly a cyclical business, in terms of the economy’s prospects having a significant impact on its financial performance, it has nevertheless delivered annualised earnings growth of 15% over the past 15 years. The array of difficulties it is likely to have experienced during that time, highlights the company’s sound strategy and strong competitive position.

Acquisitions are a key part of its growth strategy. It made 12 purchases in its latest financial year and expects the majority of its full-year revenue growth to be generated by the positive impact of recent acquisitions.

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Fortunately, the company has a strong financial position through which to continue its spending spree. Its net debt-to-equity ratio stood at just 39% at the time of its latest half-year results, while net finance costs were covered over 12 times by operating profits in the first half of the year. Should asset prices fall in the short run due to any of the aforementioned risks, thereby creating opportunities to make acquisitions at discounted valuations, the company is well placed to capitalise.

This could be in stark contrast to some of the firm’s sector peers, which may have less robust financial positions. They may simply seek to survive a period of tough operating conditions, as opposed to seeking expansion via acquisition or reinvestment, thereby potentially further enhancing long-term prospects.

A clear competitive advantage

Alongside acquisitions, Diploma’s strong competitive position is set to be a key catalyst of future profit growth. The company’s return on equity amounted to 21% last year, which suggests it has a significant competitive advantage when combined with a modestly leveraged balance sheet.

The firm was also able to grow its operating profit margin by 80 basis points in the first half of the current year to 19.6%. Given the presence of challenging trading conditions, this also suggests it has an excellent competitive position. The company expects profit margin of 20.5% for the full year.

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In the short run, the company’s cyclical status could mean that its share price is relatively volatile if some or all of the aforementioned risks come to fruition. Its financial performance could also suffer from a tough economic environment, although its recently released third-quarter trading update stated that performance during the period has been in line with expectations. Its update also confirmed that recent acquisitions had been successfully integrated into the wider firm.

In terms of valuation, there is a plethora of cheaper stocks than Diploma in the FTSE 100 index. Having risen by 25% since the start of the year, thereby outperforming the wider index by 19 percentage points, the company’s shares currently trade on a price/earnings ratio of 34, or 29.4 on a forecast basis. While this is relatively rich, the firm’s sound financial position, clear competitive advantage and highly effective strategy of acquisition-led growth mean that it offers good value for money on a long-term view.

Robert Stephens is a freelance contributor and not a direct employee of interactive investor.