Halma (LSE:HLMA) has been a top FTSE 100 stock for long time now. A £1,000 investment in the company’s shares 10 years ago would have a market value today of £3,807.
That’s an average return of around 14% per year, not including dividends. This is significantly higher than the average for the FTSE 100, so the question for investors is whether or not it can continue.
Returns on invested capital
According to Charlie Munger (Warren Buffett’s right-hand man at Berkshire Hathaway) whether or not a stock will do well comes down to one thing:
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Over the long term, it’s hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years, and you hold it for that 40 years, you’re not going to make much different than a 6% return – even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive-looking price, you’ll end up with one hell of a result.
Charlie Munger
There’s a lot for investors to take in here. But the central point is that the return from investing in a company’s stock will largely match the returns on invested capital the underlying business generates – regardless of price.
This has certainly been true in the case of Halma. Over the last decade, the company has achieved an average return on invested capital of 14% and its share price has increased by an average of 14% per year.
Halma shares
So the question for investors is whether or not Halma can maintain its high returns on invested capital in the future. If it can, then shareholders can expect more strong returns over the long term.
The company is a conglomerate – a collection of smaller businesses that operate in different industries. That means it attempts to increase its earnings not only by growing its existing subsidiaries, but also by acquiring new ones.
Halma has had terrific success with its acquisitions in the past and this has been an important part of its stellar performance. But acquiring well becomes more difficult as the company gets bigger and this marks the biggest risk with the stock.
With a market cap of £8bn, I think there’s some way to go until the company starts to run into real headwinds here, though. And even if returns on invested capital drop by a couple of percentage points, a 10% or 11% return still looks good to me.
A stock to buy?
Halma’s shares don’t look cheap – at a price-to-earnings (P/E) ratio of 34, they trade at a significant premium to the FTSE 100 average. But Charlie Munger seems to think investors should focus instead on the performance of the underlying business.
The company’s 14% average return on invested capital over the last decade is impressive. And the share price has behaved almost identically over the same period.
I wouldn’t bet against the underlying business managing similar results over the next 10 years. So for investors looking to buy a quality FTSE 100 stock to hold for the long term, I think Halma is worth serious consideration.
