Emma Wall: Hello, and welcome to Morningstar. I'm Emma Wall and I'm joined today by Sam Morse, Manager of Fidelity European Values (FEV), to give his three stock picks.
Hello, Sam.
Sam Morse: Hi, Emma.
Wall: So, what's the first stock you'd like to highlight today?
Morse: Well, the first stock I'd like to highlight is L'Oréal (OR). It's important to remember what I like to invest in. Typically, I'm looking for companies that are attractively-valued and are able to deliver consistent dividend growth over time. And I think L'Oréal is a particularly interesting one.
It's obviously well-known probably to your viewers as being the global leader in the cosmetics market. Interestingly, it only has about a 12% market share, global market share, which seems quite low for the leader, and I think shows that it has plenty of potential to grow its market share organically and also, through bolt-on acquisitions over time.
It's a very high-return business. It's invested a lot in its brands over time. It achieves a sort of 20% cash flow return on cash invested and that's been very stable over the years. And its growth really has been driven through the aging of populations in developed markets and through an emerging middle class in the emerging markets.
Now, I think, the main complaint people will have about L'Oréal is the valuation. It sells on around 25 times next year's earnings. But it's important to remember that the beauty market is very resilient. So, if, as I expect we will over the next three to five years, we have some sort of a downturn in the economy, this is the company that will be able to continue to grow its earnings. The beauty market actually grew 1% in 2009 when everything else was seeing a very difficult time.
So, I think, it's a very resilient company, pays a 2% dividend yield, growing at close to a double-digit rate. And I think the sort of total shareholder return you will get from L'Oréal in the next three to five years will be very attractive relative to the market.
Wall: And what's the second stock today?
Morse: My second stock is probably a little bit more contrarian. It's a healthcare company. The healthcare sector has performed poorly over the last couple of years, partly due to the weakness of the dollar relative to euro, partly because of pricing pressures in the U.S. and also, because I think when everything else is flying in terms of earnings, healthcare looks a little bit lackluster.
I think Roche (RO) is at a very interesting juncture. It's a company that generates a lot of cash. It's currently selling at about a 7% to 8% free cash flow yield. It pays a decent dividend, has a very long-term track record in terms of dividend growth. But over the last three years, actually, the dividend growth has been disappointing.
They've only grown the dividend about 1% per annum. And I think that's because the Board have been cautious looking forwards, because they know that their three big cancer drugs are at threat from biosimilar competition. And the key question is, whether they will be able to offset the negative impact that of this biosimilar competition through their product pipeline.
Now, we think at these current prices a lot of this bad news is factored into the share price and we are actually quite confident that the business will be able to grow, and that dividend growth will accelerate from here. So, you've got a 4% dividend yield. We think accelerating dividend growth in a very strong company, we think that's an interesting one to look at right now.
Wall: And what's the third and final stock?
Morse: So, the third and final stock is KONE (KNEBV), which is, I guess, in U.K. terms, a lift company or an elevator company. And this is a business that has very high returns, mainly because the maintenance business tends to have very high returns. If you've ever been stuck in an elevator, you'll probably know why. And in a sense, KONE has been a victim of its own success. Because it was very early into China, established a number one position there, did a very good acquisition of a business called GiantKONE.
And unfortunately, though the competition sort of noticed that China was growing very well and put a lot of capacity down. This resulted in overcapacity. And what had been a very profitable new equipment market, began to become a little bit less profitable. So, KONE saw its margins come down from about 15% currently around 13%.
Now, we think they are through the worst in terms of the Chinese market. We think that there will be more pricing discipline going forwards in that market as a result of the increase in raw materials that's putting quite a lot of pressure on some of the smaller players and we think the market itself is beginning to stabilise.
And as a result, KONE, which pays a very attractive 4% dividend yield, we expect that dividend growth to start to accelerate from here, has a very strong balance sheet, a lot of cash on the balance sheet. That gives it a lot of optionality in terms of M&A, et cetera. So, we think that's an interesting stock at this point in time.
Wall: Sam, thank you very much.
Morse: It's been a pleasure.
Wall: This is Emma Wall for Morningstar. Thank you for watching.
