Is the "watch and wait" investing strategy for you?
I walk a potential watchlist candidate through some of my investing criteria.
Mentioned: Rentokil Initial PLC (RTO)
As a cricket and "soccer" loving Brit, American sports aren’t really part of my vocabulary.
Despite this, one of the best books I’ve ever read was by an old NFL coach called Bill Walsh. The book is called ‘The Score Takes Care Of Itself’, and it describes how Walsh transformed the San Francisco 49ers from a rubbish team to an unstoppable one.
As you can guess from the title, a lot of the book is about prioritising things that you can control and thinking more about processes than outcomes. I think these principles have a lot of use for investors.
I say this because it’s easy to obsess over individual stock ideas and opportunities offered up by financial commentators (including us here at Morningstar). Yet allocating more time and thinking to the processes governing your investments is a trade worth making.
At Morningstar we encourage a goal-based approach to investing. Here is a quick overview of what that might look like:
- Set a financial goal (in dollars) and work out your required annual return
- Use that information to decide your allocation between asset classes
- Identify your investing edge (or lack thereof) to guide your approach
- Set investment criteria to help you choose suitable investments
Today I’m going to think a bit about step four and beyond: how an investor might find potential investments that are aligned with their strategy. To do that, I am going to call on the ‘watch and wait’ method for investing in individual stocks.
Introducing the watch and wait method
The ‘watch and wait method’ can be described as follows:
- Find a company that may fit your investing criteria
- Put it through a few tests to see if this is really the case
- Add the company to a watchlist
- Wait for the market to offer the shares at a favourable price
Many of the world’s most famous investors have used a similar strategy to this.
John Templeton used to set up a “wishlist” and set automatic orders to buy whenever their stock price fell below a certain level. You’ll often hear quality-style investors like Terry Smith of Fundsmith say they have an “investable universe” of companies they would consider owning at the right price.
I think this approach has a couple of key advantages.
Advantage #1: It acts as a speed bump to overtrading.
If you spend days or weeks researching a company, it can be tempting to buy a stock purely to justify your time. The “watch and wait” approach gives you other ways to achieve a pay-off.
Adding a share to your watchlist or nixing it from consideration should both be seen as big wins. They should also be a much more common outcome than a purchase. Think about how many annual reports Warren Buffett reads per year versus how many investments he makes.
Advantage #2: You can advantage of market mood swings
Getting to know companies before you even consider buying their shares doesn’t just protect you from impulsive buys. It allows you to swoop in when the market is offering you an unfairly good price relative to fair value.
With millions of capable and smart investors out there, these opportunities don’t usually last for long. You need to be ready and be equipped with enough information to look past the current fear (or at least weigh up the opportunity more rationally).
How to populate your watchlist
Step 1: Set your investing criteria
Investing criteria are the list of characteristics an investment needs to be worthy of consideration for your portfolio in the context of your goals. As I see it, there are three main groups of input here:
1. Your goal, required rate of return and high level strategy
My goal is a comfortable retirement and, as I wrote about in my eye-opening retirement audit, I am a fair bit behind. From my current balance, I need an annual return of 10%+. This dictates my asset allocation: equities. It also means that I will probably have to try and beat the market over the long-run by owning individual shares. Not an easy task.
2. The edge you are trying to exploit
If you are aiming to get a better than average return, you are going to need to have some kind of edge over other investors. There are three main kinds of edge. Informational and analytical edges (access to better information and better use of it) are hard to claim. The only one left is a behavioural or structural edge – the avoidance of mistakes and biases that drag down returns.
How do I aim to do this? I want to buy and hold above average companies that I think have a good long-term outlook. But I want to buy them at times where professional investors are overly pessimistic about the near-term outlook and the price is depressed.
I think this could provide a structural edge because, at any one time, there are going to be companies where short-sighted investors are scared about the impact of a holding on their quarterly performance. Or companies and sectors (even entire countries) where sentiment is so bad that they wouldn’t want to explain the holding to their clients/boss.
Of course, any edge like that will be for nothing if I overtrade to the extent that I did in 2021. You can read more about that calamity here.
3. Your investing philosophy and personality
What kind of companies fit with your personality and favoured approach to investing?
In other words, what attributes will make you more likely to be able to stick with an investment rather than overtrading?
Personally, I have always taken a lot of comfort in high quality assets (be they tangible or intangible) and strong financial positions.
Be picky!
I would encourage you to be picky with your criteria. If you already had some criteria in mind, see if you can tighten them up.
Remember what Warren Buffett said about having a punchcard with a limited number of investments you can make? Imagine that you can only make 2 or 3 really attractive investments per year. Maybe even one.
I have listed some of my main watchlist criteria below. Note there is nothing to do with purchase price here. I am simply trying to decide whether a company might be a suitable investment for our portfolio one day. Not at the current price.
- I understand the company’s business model
- Fair long-term outlook for sector and business
- Company has a strong financial position and healthy cash generation
- Company has high quality assets or a strong competitive position I can instantly grasp
- I have a fairly good idea of the company’s strategy/capital allocation plan going forward
Here is how I recently put Rentokil Initial (LON: RTO) through these paces.
A potential watch and wait candidate
Rentokil Initial is listed in the UK and has two main business segments.
Rentokil (80% of overall revenue according to Pitchbook) sells pest control services worldwide. Initials, on the other hand sells hygiene services. You will often see its soap dispensers, sanitary bins and the like in bathrooms.
To get an idea of Rentokil’s global reach, you’re going to have to excuse the rather weird way it splits up its regional segments:
- Roughly 60% of revenue comes from North America
- 7% stems from the UK and Sub-Saharan Africa segment
- 20% comes from the rest of Europe and Latin America
- 6% comes from Asia, the Middle East and North Africa
- 5% comes from the Pacific region
I told you it was weird. Anyway, an important thing to note here is that the portion of revenues coming from the US has grown to the current 60% from below 44% in 2021.This is mostly because Rentokil bought Terminix for $6.7 billion in cash and stock to become the US’s biggest pest control player. We will talk more about the firm’s acquisition strategy later.
For the rest of this article, we’ll refer to the entire group as Rentokil and run it through my key watchlist criteria to see how it stacks up.
1. Do I understand the company’s business model?
Rentokil’s product and service offerings are not hard to grasp. People and businesses pay them to get rid of bugs and make sure they don’t come back. They also get paid to dispose of and replace the washroom supplies in offices, hospitals, hotels, restaurants and other buildings.
Understanding a product offering and a business model are not the same thing, though. Because it isn’t just about the product or service a company offers, but how it can be provided profitably and how much protection there is from competition squeezing those profits.
Both of Rentokil’s main business segments are route-based businesses: their employees drive around in vans servicing clients. Local scale matters in this kind of business because as more and more clients are serviced within a certain area, the cost of servicing each client goes down and profits go up. More customers can be served per day by the same technician. This means that money spent on wages goes further - it isn’t spent mostly on time driving between jobs. Costs like fuel are also spread over more jobs.
Just as crucially, it also helps the company provide a better service. They should be able to respond to customer requests in their local area faster than peers, which seems like it would be attractive for anybody facing a growing cockroach problem.
As our analyst Grant Slade put it, “Rentokil Initial's strategy is sharply focused on the attainment and maintenance of market share leadership in the highly localised pest-control and hygiene-service markets it competes in.”
I think I understand both the product offering and the core drivers of profits. This has also given me some clues as to what matters in terms of competitive advantage, but we’ll get onto that in a moment.
2. Do the sector and business have a fair long-term outlook?
Let’s stick to the pest control segment for this one. Is there still going to be demand for this service in ten, twenty or thirty years?
Unless insects and rats magically disappear from Earth, I’m guessing yes. And as living standards improve in the developing world, the number of people able to afford it will increase. The sector outlook looks fine to me.
As for the business itself, that really boils down to whether you think it can hold on to a competitive advantage. Let’s take a look at that now.
3. Does the company have a strong competitive position that I understand?
We have already touched on the importance of local scale (often called ‘network density’) in businesses like Rentokil’s. It will come as no surprise to you, then, that scale-based cost advantages are the main source of our Wide Moat rating for the company.
“As a scale player in the majority of localised markets in which it operates, Rentokil Initial benefits from a maintainable cost advantage as its fixed and step-fixed costs are better fractionalised across its larger revenue base relative to players with inferior local market share.”
In simple terms, Rentokil can provide services at lower costs and more profitably than its smaller competitors. The strategy for maintaining this advantage is pretty clear: Rentokil is going to continue buying up smaller players.
4. Strong financial position and healthy cash generation?
Look at Rentokil’s balance sheet and you’ll see that it has a fair amount of debt. To be exact, they had GBP 4.75 billion in borrowings as of their Q2 numbers. Subtract GBP 1.5 billion in cash and cash equivalents and you get around GBP 3.25 billion in net debt.
That sounds like a pretty big number compared to 5 billion or so in annual revenue. And let’s face it, GBP 189 million paid out in interest is a fairly big chunk of the 540 million generated in free cash flow during 2023. But there are a few reasons that Rentokil’s debt load looks manageable.
First of all, consider how cash generative Rentokil’s business is when you exclude the money spent on acquisitions. This is an overview of their operating cash flow, investments in capex and intangibles, and free cash flow (the difference between the two) since 2019:
Rentokil clearly throws off a lot of cash that can be used to cover its interest obligations and even pay down its debt if desired.
What’s more, demand for its main segments – pest control and hygiene – both seem less prone to cyclical downturns than average. People are probably likely to forgo other things before they decide not to deal with an insect problem in their house.
All things considered, the amount of debt might not be ideal. But it isn’t a write-off for me in this case. You can see my previous article on how to assess a company’s debt load here.
5. Do I know what to expect in terms of strategy and capital allocation?
This one is easy. We can expect Rentokil to continue diverting the bulk of its capital towards acquisitions, especially in the pest control segment. The firm has completed some 200+ deals of this kind since 2015 as it seeks to augment its scale advantages.
Our analyst Grant Slade remains supportive of the M&A-focused strategy, noting that it has resulted in the Wide Moat business that Rentokil is today. Given that the global pest control market remains highly fragmented, he says there could even be greater risk in not continuing to take part in the roll-up.
After all, doing so could eventually see a more acquisitive competitor threaten Rentokil’s local scale advantages.
The verdict
I think Rentokil scores pretty highly on most of the characteristics I like to see in a business.
For that reason, I added to it my watchlist and will be keeping a closer eye on its results and valuation going forward. If I was to genuinely weigh up an investment in the company, though, I would need to go a lot deeper in my analysis than I have today.
Do you have a watchlist? If so, how do you decide which companies make it on there? And how do you keep track of it? Let me know at [email protected].
