Why investors should focus on profits rather than sales

Each week, a professional investor tells us where he'd put his money. This week: Chris Garsten of Waverton European Capital Growth Fund selects three promising stocks.

There is no one right way to run a company and likewise no one right way of managing money. But we are amazed how many companies and investors target sales growth on the assumption that if this is achieved, earnings growth will follow. The reality is not that simple. It is very difficult to drive volumes while maintaining prices, which means margins can suffer when the focus is on sales growth.

We do not mind how fast our companies grow their sales. Our key criteria is to invest in quality companies that are growing their earnings per share (EPS) and have a management commitment to returning excess cash to shareholders. Being disciplined on valuations and trying not to overpay for an opportunity is how we seek to limit downside risk. The fascination of the job for us is that industries fragment or consolidate and corporate managers change. The ability to purchase a lowly rated stock just before it becomes an earnings growth stock can generate considerable investment returns.

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A major acquisition

One of our biggest positions is in the German industrial gas company Linde (Frankfurt: LINU). Following the merger with its American competitor Praxair, this previously highly acquisitive company now fulfils our criteria of focusing on profits rather than market share and we expect excess cash to be returned to shareholders.

We met the retired chief financial officer of Praxair, who made the comment that prices should increase until the company starts losing clients, emphasising a philosophy of profits over sales volume. This gives a flavour of management thinking in the US. Profit growth will become more likely after the merger, as the global big four in this industry (Air Liquide, Linde, Praxair and Air Products) consolidate into the big three.

Benefiting from rising prices

We have owned the sausage-casing manufacturer Viscofan (Madrid: VIS) for most of the last decade. We bought the stock when American players Viskase and Teepak (number two and three in this market respectively) were in financial difficulties following a price war and an excess in capacity. Viscofan bought Teepak in early 2006; the company had good technology, but was not efficient. As a result of this consolidation in the industry, product prices which fell 40% from 1996 to 2005 fully recovered in 2011.

Viscofan now has several initiatives underway, but one that may be of note is its recent purchase of Transform Pack. This firm makes innovative seasonings and marinade sheets that can be applied to beef, pork, poultry or seafood to produce a product with consistent flavour. Viscofan thinks this product could achieve sales of over €100m, or 50 times the acquisition price of $2m.

An unloved, quality sector

Finally, we love a quality sector that is out of favour with many investors. Currently a lot of consumer stocks are unloved, with the view being that the internet makes it much easier to launch and market new brands. This is true, but we feel that, in some cases, the sell-off in the shares has gone too far. We very much like British American Tobacco (LSE: BATS), which is still growing earnings and developing next-generation, less harmful products in the heat-not-burn category.