Three quality stocks going cheap

Professional stock picker Ian Lance looks for companies that generate lots of cash - and use that cash wisely. Here, he tips three high-quality stocks available at low valuations.

Each week, a professional investor tells MoneyWeek where he'd put his money now. This week: Ian Lance, portfolio manager, RWC Partners.

We look for high-quality businesses, which are soundly financed, have a history of making good returns on assets, generate lots of cash and use that cash wisely. We recognise, however, that paying too much for a quality business does not generate good returns. Hence we look to buy decent businesses only when they are lowly valued in relation to the cash they generate. With this in mind, here are three businesses that we believe meet all our quality criteria, but are available at low valuations.

First up is Microsoft (Nasdaq: MSFT). Nearly everyone reading this article is likely to have used Microsoft software at one time or another and will probably do so again in the future; it is one of the most established technology franchises in the world and remains hugely profitable. Sales have grown at an average rate of 10% for the last five years and are forecast to continue to grow. Profit margins are exceptionally high at 38% and return on capital is also very high at just below 40%.

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All of this means that the firm throws off vast amounts of cash (approximately $20bn a year), which represents 9% of its current market capitalisation. The accumulation of this cash over time has meant that the firm is very conservatively financed. Although Microsoft doesn't pay an enormous dividend, the current yield is still 3% and it uses $6bn-$8bn each year to buy back its own shares. Incredibly, worries about the threat from the move to tablet and cloud' computing mean the stock is available on a price/earnings (p/e) ratio of eight (or six if you include the cash in the valuation).

Next up is Next (LSE: NXT). Investors consistently overlook companies like Next, which have a tremendous record of creating value for their shareholders in the long term and yet lack the wow' factor of, for instance, an emerging-market play. So they remain perpetually undervalued. For the buyer of the shares this is great news. Under the stewardship of Lord Wolfson, Next has delivered compound growth in earnings per share (EPS) of 17% per year for the last decade and reported 18% EPS growth for 2010/2011. It also delivers profit margins of 16% and returns of 20%, the sorts of numbers that most retailers can only dream of. Because most hedge fund managers are too busy rushing around looking for the latest hot stock, this performance can be bought today on a p/e ratio of ten with a dividend yield of 3%.

My final tip is Johnson & Johnson (NYSE: JNJ). Many readers will know the firm through its skin and haircare products, but may be less familiar with its large pharmaceutical and medical device businesses. The company has an AAA-rated balance sheet (higher than the US government) and a consistent record of growing earnings and dividends. The dividend has now been increased for 48 consecutive years, irrespective of the economic cycle, which is testimony to its resilience.

Since 2000, EPS has increased 186% and dividends per share by 211%, and yet the share price is roughly the same level that it was 11 years ago. This is simply because 11 years ago the company was far too expensive even for a wonderful business. In 2000, the shares sported a fancy p/e ratio of more than 30. Today, having de-rated for a decade, they are trading at closer to 12 times earnings, which is a great entry point to a quality franchise.