Three top-quality cash-generating stocks

Professional investor Simon McGarry tips three high-quality, reasonably priced cash-generating stocks to buy now.

Each week, a professional investor tells MoneyWeek where he'd put his money now. This week:Simon McGarry, senior equity analyst, Canaccord Genuity Wealth Management.

Fighting in Ukraine, a slowdown in China, deflation in the eurozone and uncertainty over both the political situation in Greece and the UK election it may seem surprising that the FTSE 100 made a new all-time high last month. But the European Central Bank's decision to embark on a larger-than-expected programme of quantitative easing has helped brush these concerns aside. The FTSE 100 climbed by 6% in the first two months of 2015.

The universe of UK stocks we pick from (FTSE 350 excluding investment trusts) is now on a 12-month forward price/earnings (p/e) ratio of 16.7. This is 36% above the ten-year average. However, some stocks are much more expensive than others.

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Consumer goods companies, such as Diageo and Unilever, trade on p/es of 20 or above, despite slowing growth. These punchy multiples are surely being supported by low gilt yields, whose valuations are in turn being propped up by longer-term fears about deflation. Against this backdrop we'd rather buy high-quality, cash-generative companies at reasonable valuations.

With the UK economy growing at 2%-3%, employment and wages are recovering, which should benefit retailers such as Pets at Home (LSE: PETS). It has a dominant market position, with more stores than its five largest rivals combined.

Analysts expect high single-digit revenue growth over the next two years. Management reckons the UK can support 500 stores, from 392 today. Its high-margin veterinary joint ventures are growing too, with roughly 60 set to open this year.

The loyalty club has 2.9 million members and accounts for 61% of revenues, from 57% in the first half of 2014. Online retailers have had limited success as they struggle to cover delivery costs, given small basket sizes and bulky products. This makes its click-and-collect option more compelling. The shares are on a p/e of 16.

British Land (LSE: BLND) is a leading UK property and investment firm. Its portfolio is heavily invested in the City of London (23%) and the West End (18%). Both regions are expected to outperform in 2015. Occupancy rates are 98%, putting the landlord in a good position to drive through rental growth. The average lease lengthof 11 years is more than double the market average.

That should help to protect yields during any downturn. Management has been recycling the older, lower-yielding assets (3% yield) into higher-yielding new projects (with yields of 5%-6%). With 7% rental growth, 8% capital growth and a 3.5% dividend yield (covered 1.2 times), this provides an interesting, predictable and unlike banks lightly regulated income stream.

Iron-ore miner Rio Tinto (LSE: RIO) has come a long way since sacking its CEO after reporting $14bn of write-downs on aluminium and coal assets in January 2013. Boss Sam Walsh has spent the last two years pursuing better capital discipline, cost cutting and shareholder returns. The cost cutting has beaten expectations, particularly in iron ore, which accounts for 78% of earnings. Rio has the lowest "landed in China" cost in the industry at $31 (current spot price $63).

This should enable it to weather any price slump until the high-cost supply (from China) leaves the market. Shareholders have started to be rewarded for their patience the dividend has grown at a double-digit rate for five consecutive years, putting it on a 4.7% yield. Debt has also fallen sharply, which may allow for more returns to shareholders via share buybacks.

Simon McGarry is senior equity analyst at Canaccord Genuity Wealth Management.