Quality stocks are rarely cheap, but at what point does the price become too high?
That's the dilemma faced by potential investors in non-food consumables distributor Bunzl (LSE: BNZL) and corporate catering firm Compass Group (LSE: CPG). These two companies are undoubtedly quality businesses. Both have a long track record of profitable growth. But they're also extremely expensive on most measures.
Today, I'll ask whether now could be a good time to buy each firm. I'll also consider today's trading update from Bunzl, which seems to have triggered a small drop in the firm's share price.
Should you buy bond proxies?
Defensive firms like Bunzl and Compass Group have become known as bond proxies in recent years. Investors have been buying them for their reliable dividend yields, instead of bonds. But shares are never equivalent to bonds, which provide far greater protection against capital losses and loss of income.
June's Brexit vote sent shares in Bunzl and Compass Group rocketing higher, thanks to the devaluation of the pound. Both companies make most of their money abroad, so the cheaper pound means that their earning are worth more for UK investors.
Bunzl has risen by 17% this year to trade on 21.4 times 2016 forecast earnings, with a prospective yield of just 1.9%. Compass Group has climbed 24% to trade on 24 times forecast earnings, with a prospective yield of 2.2%.
As a value and income investor, buying at these levels isn't attractive to me. But I might be wrong.
One reason to buy
Highly-respected fund manager Terry Smith believes it's worth paying more for companies that generate a high return on capital employed. The logic behind this is simple -- a high ROCE generally means that companies can fund their own growth without borrowing money or issuing new shares.
This leads to more rapid earnings and dividend growth for shareholders. Companies such as Diageo, Compass Group and Bunzl are all good examples of this. They've beaten the FTSE 100 by between 40% (Diageo) and 142% (Bunzl) over the last five years.
I'm not buying
I don't know if Mr Smith would buy Bunzl or Compass Group at current levels. But I know that I'm not buying.
The combination of the weak pound, low interest rates and the trend for investing in so-called bond proxies won't last forever. When growth slows at these firms -- or other sectors start to outperform -- I believe their share prices could fall significantly.
Is growth slowing?
Today's Q3 trading statement from Bunzl suggests that underlying growth may indeed be slowing. Although revenue rose by 7% at constant exchange rates compared to the same period last year, this was due to acquisitions (3%) and additional trading days in the quarter (4%). There wasn't any organic growth.
Compass has fared slightly better, with organic growth of 5.6% during the third quarter. But both companies are relying on exchange rate effects for much of their expected profit growth this year. In its Q3 update, Compass described the outlook for Europe as "uncertain" and for the Rest of the World (excluding US and Europe) as "challenging."
I'd like to add both shares to my income portfolio, but won't until they're cheaper.
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Roland Head owns shares of Diageo and Compass Group. The Motley Fool UK has recommended Diageo. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.