Britain’s fallen stars: a second chance for quality stocks

In June, Spectris, the high-tech precision measurement firm, was bid for by private-equity giant Advent International, which prompted a bidding war. In a year marked by a large number of takeovers, this one stands out. It was bought because it is a high-quality global leader that was too cheap. This is more than just another deal – it’s a profound warning for investors in Britain’s most respected companies.

For more than a decade following the 2008 financial crisis, a select group of top UK firms, including Spectris, were the darlings of the stock market. Their reliable profits and steady growth, in an era of rock-bottom interest rates, led investors to push their valuations to unsustainable heights. Since their peaks in 2021, however, this narrative has changed. Many of these once-admired firms, from industrial engineers to specialist food-ingredient makers, have seen their share prices plummet, some by more than 50%.

This dramatic shift was triggered by a fundamental change in the economic environment, with a surge in inflation and aggressively rising interest rates that provided attractive alternatives to equities. While this “repricing” was a necessary correction, the Spectris takeover highlights a new risk that these quality businesses have become not just cheap, but too cheap, making them irresistible targets for private capital.

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A company’s value is derived from its expected future profits, discounted to their present worth. When interest rates were near zero, distant earnings were barely discounted, making them immensely valuable. As rates rose, the discount rate increased, drastically reducing the present value of those long-term earnings. This mechanism, combined with broader market anxieties, swiftly deflated valuations.

The very attributes that once justified sky-high prices – that is, their predictable, long-duration earnings – became liabilities when a guaranteed 5% could be earned from a government bond. The rush for the exits began, raising the question: do these fallen stars now offer a compelling opportunity for long-term investors? Or, as the Spectris deal shows, does their undervaluation invite opportunistic private buyers to take them off the public market for good, starving investors of the opportunity?

Quality stocks take a battering

The valuation crunch, when it came, was swift and brutal, with the share prices of some firms tumbling from their giddy late-2021 peaks. No company illustrates this reversal of fortune better than Spirax (LSE: SPX). For years, it has been regarded as one of the most consistent world leaders on the UK stock market, prized for its relentless growth and resilience. The source of this reputation is its critical role across an incredibly broad scope of industries; its specialist steam systems are indispensable for everything from food production and pharmaceuticals to the operation of hospitals, chemical plants and oil rigs. This diversification has made it a fortress of stability.

Yet even this industrial titan was not immune to the changing economic tide. Its shares plummeted from an all-time high of more than £172 in November 2021 to roughly £60 today, a shocking fall of more than 60%. This collapse was a clear case of valuation reset, not just a price decline. The company’s forward price-to-earnings (p/e) ratio was slashed from an eye-watering 50-times earnings to a far more sober 20. After such a dramatic de-rating, a world-class business that was once prohibitively expensive is now beginning to look like genuinely good value. This has brought the company firmly back on the radar, and for investors with a long-term view it is precisely the kind of name that now warrants serious consideration.

It was a similar story at fellow FTSE-100 constituent Halma (LSE: HLMA), a group of businesses focused on safety, health and environmental technologies. Its shares fell by nearly 40% from a peak of around £32. But unlike Spirax, the shares have regained their lustre in recent months, hitting new highs and showing that, when the market recognises the underlying value of these quality businesses, significant returns can be made. Halma represents what can happen to businesses whose qualities are clear, but the punishment was more severe for smaller companies that had captured and lost the imagination of investors. Treatt (LSE: TET), the flavour ingredients maker, which had enjoyed a truly spectacular run, saw its share price collapse by more than 80% from its peak of more than £13 in late 2021.

This was not just a case of a few isolated firms hitting trouble. It was a sector-wide, thematic collapse. The very mechanism of highly geared valuation expansion that had amplified gains on the way up went into a violent reverse. For years, investors had been rewarded for paying ever-higher prices for reliable earnings. Now, they were being punished severely for it. The tide of cheap money had gone out, and many investors who had piled in near the top were left painfully exposed.

It's about more than just interest rates

While rising interest rates were the primary catalyst for this dramatic derating, it would be a mistake to view this story through a purely macroeconomic lens. As the financial environment tightened, company-specific operational issues, previously glossed over by a buoyant market, were thrown into sharp relief. For several of these firms, the post-pandemic world brought a host of challenges that hit both sales and profit margins.

For Suffolk-based Treatt, it was a perfect storm. The price of orange oil, a key raw material, soared because of poor harvests and disease in Florida and Brazil. Simultaneously, squeezed consumers in North America began to cut back on premium beverages, a key end-market for Treatt’s natural extracts. This toxic combination of cost inflation and slowing demand led to a string of profit warnings that shattered its growth narrative and hammered its share price. Treatt now looks more like a speculative opportunity due to its small size and specific challenges, but at the current valuation could present an interesting long-term proposition for those comfortable with risk.

It wasn’t alone in facing headwinds. Victrex (LSE: VCT), a world leader in high-performance polymers used in everything from aeroplanes to spinal implants, also faltered. Its growth was hampered by a sluggish recovery in elective surgeries post-pandemic that affected its lucrative medical division. The company also faced early teething problems at its new factory in China, prompting concerns over operational issues. Once open, production also ramped up more slowly than expected, piling further pressure on profits.

Even the larger, more diversified players were not immune to this punishing environment. Renishaw (LSE: RSW), the master of precision measurement, found its fortunes tied to the cyclical spending of its customers in the electronics and semiconductor industries. As demand for smartphones and other gadgets cooled, so too did orders for Renishaw’s equipment. In recent months, the share price has declined considerably following the death of its co-founder, David McMurtry. His significant stake, combined with that of his co-founder John Deer, has created uncertainty over the long-term ownership structure. The market is wary of a potential future sale of these holdings, creating a stock “overhang” that can suppress the price regardless of the firm’s operational performance. Even the resilient Rotork (LSE: ROR), a dominant force in industrial valve actuators (devices that control the flow of liquids and gases), faced margin pressure from cost inflation and supply-chain disruptions, even as its order book remained healthy.

For Tristel (LSE: TSTL), the challenge was different and resulted in prolonged frustration for investors despite the firm’s clear strengths. This is a great British business: a leader in high-level hospital disinfectants, built on its proprietary chlorine dioxide chemistry. Its products serve a critical, non-discretionary role in infection prevention, a constant need in healthcare. For years, its quality and steady growth in core markets were never in doubt. But the valuation became overly reliant on the promise of securing US regulatory approval. When that FDA process dragged on longer than expected, even loyal shareholders grew weary. As deadlines slipped, sentiment soured and the shares stagnated, becoming divorced from the company’s solid fundamentals.

That dynamic has now shifted. Tristel finally secured FDA approval in 2024, unlocking access to the world’s largest and most profitable healthcare market. This is not incremental – in fact, it could be transformational.

Years of investment in research and development and regulatory work may now deliver a step change in growth as US expansion begins. Tristel is on the cusp of evolving from a respected UK specialist into a global force in infection prevention. The shares look attractive.

Are these quality stocks a bargain?

After three years of pain, the crucial question is whether these fallen stars represent a compelling opportunity. With valuations significantly compressed, are these high-quality businesses now available at a fair price? The investment case rests on balancing the enduring strengths of these companies against the risks of a permanently changed economic environment.

Their core appeal has not vanished. They are, for the most part, still exceptional businesses. They command dominant positions in niche, global markets, protected by high barriers to entry, such as intellectual property, long-standing customer relationships and technical know-how. This allows them to generate high returns on capital employed (ROCE) and prodigious cash flow.

Spirax’s expertise in steam, a critical component in countless industrial processes, is unparalleled. Halma’s businesses address non-discretionary, regulation-driven needs in safety and environmental monitoring. These are not fads, they are structural growth markets. Many are also plugged into unstoppable long-term trends. Whether it’s the drive for greater energy efficiency (a core market for Spirax and Rotork) or the inexorable rise of factory automation (a driver for Renishaw), these firms are on the right side of structural change.

The resilience of their business models is a key attraction. For many, a significant portion of revenue is recurring, coming from essential servicing, software subscriptions, consumables and spare parts. This aftermarket income smooths out the lumps in more cyclical new equipment sales, a core reason they earned the “quality” moniker in the first place.

And their stocks are now much cheaper. A p/e of 20-25 for a world-leading industrial business is historically reasonable, a far cry from the 40-50 times earnings seen at the peak. This provides a margin of safety that simply did not exist in 2021. An investor today is paying a sensible price for the underlying earnings power of the business, rather than an exorbitant price for the promise of ever-expanding multiples. Furthermore, many of these firms are taking action. Treatt is implementing self-help measures to improve efficiency and manage costs. And for Tristel, securing FDA approval opens up a market that could potentially double its sales over the long term. This is a tangible catalyst that could put it back on its growth trajectory.

Investors will have to be patient

However, investors should not expect a swift return to the glory days. The macroeconomic landscape has fundamentally changed. Interest rates are unlikely to return to near-zero levels any time soon. This means the powerful tailwind of ever-lower discount rates is gone. Future returns will have to be driven almost entirely by genuine earnings growth, not by the market being willing to pay more for those earnings. There is also the risk that the growth rates of the past decade were an anomaly. Globalisation, particularly the rise of China, provided a huge boost to many of these industrial firms. With geopolitical tensions rising and China’s own growth slowing, that tailwind may have turned into a headwind. The operational issues at Victrex, linked to weaker demand from China, are a clear warning sign.

Furthermore, the previous assumption that they do not have much competition deserves fresh scrutiny. The combination of Covid-induced supply-chain disruption and the premium pricing commanded by these firms may have encouraged some customers to seek out “good enough” alternatives from competitors. Any permanent erosion of market share at the edges could cap future growth and pricing power. Finally, while valuations are lower, they are not yet in deep bargain territory. These are still rightly priced as premium businesses compared with the wider UK market. An investor buying today is betting that their quality will allow them to navigate a more challenging environment and resume a path of steady, if perhaps slower, growth.

What to look for in quality stocks

So, how should an investor approach this sector? The key is to be selective and focus on the fundamental metrics that define a truly high-quality business, rather than simply buying the narrative. First, scrutinise the balance sheet. In a higher interest-rate world, debt is dangerous. Favour firms with strong net cash positions or very low levels of leverage. This provides resilience and the firepower to invest in research and development, or make bolt-on acquisitions during a downturn.

Second, focus on the free cash-flow (FCF) yield. This metric (the annual free cash flow per share divided by the share price) is a far better valuation tool than a simple p/e ratio. It shows how much real cash the business is generating for its owners. A sustainable FCF yield of 4%-5% from a growing, high-quality business is an attractive proposition for a long-term investor.

Third, look for a proven ability to innovate and maintain pricing power. Companies that consistently invest a high percentage of their sales in research and development, such as Halma and Renishaw, are creating the products that will drive future growth. Their ability to pass on price increases without losing customers is a key sign of a strong competitive moat.

Finally, consider a basket approach. Rather than trying to pick the single best company, it may be more prudent to build a small portfolio of three to five of these businesses. This diversifies company-specific risk while still providing exposure to the broader theme of a recovery in quality stocks. To me, Renishaw, Rotork, Tristel and Spirax seem well worth a look.

Funds and investment trusts that focus on UK quality growth companies can also be a good option for those seeking a ready-made, diversified portfolio. Whichever path is chosen, patience will be paramount. The re-rating of these businesses will not happen overnight. Attempting to time the bottom perfectly is a fool’s errand; the focus should be on accumulating stakes in excellent firms at sensible, long-term prices.

A new chapter for quality stocks

The story of Britain’s quality champions is a salutary tale of how even the best businesses can become poor investments when bought at the wrong price. The speculative fever of the low-rate era has definitively broken. For potential investors, this is no bad thing. The fog of multiple expansion has lifted, allowing a clearer view of the underlying fundamentals.

While the decline has been painful, it has also been healthy. It has returned valuations to the realm of sanity and reminded us that long-term returns are ultimately tethered to profits and cash flows. However, the fate of Spectris serves as a powerful illustration of the dangers this creates. As a provider of high-tech precision measurement instruments, its technology is essential for cutting-edge industries. Spectris had been undertaking a complex, multi-year consolidation. While strategically sound for the long term, this process of selling legacy businesses to acquire and focus on higher-growth areas created significant short-term uncertainty for investors. This was compounded by cyclical headwinds, including a slowdown in demand from China and a cooling in markets related to electric-vehicle battery development. The market, fixated on these immediate challenges, punished the shares, pushing down valuations to a level that failed to reflect its long-term strategic value.

This created a dangerous vulnerability, highlighting a key theme of the current market: if public investors will not pay for quality, private buyers will. The takeover bid from private-equity firm Advent International was a wake-up call to the market, demonstrating that, while public shareholders saw short-term problems, sophisticated buyers saw a world-class technology business on sale at a discount. The low valuations afflicting Britain’s quality companies do not just represent a potential opportunity for new investors; they also represent an existential threat. If the market undervalues the intrinsic quality of these firms for a pronounced period, they will inevitably be acquired and taken private, lost to public shareholders forever.

This dynamic means patient investors must now balance the opportunity for re-rating with the very real risk of a takeover bid that removes the stock from public markets. Perhaps a more fitting title for this new chapter is not one of decline, but of renewal, albeit one with a significant caveat: “Britain’s fallen stars: a second chance for quality, or a pathway to private ownership?”.

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