Is Carsales a good investment?

Everyone likes the idea of investing in a quality business. In fact, you have to wonder why you would invest in any other kind of business. In investing circles quality has a specific meaning.

For a company to be classified as quality, it has to meet certain criteria. Whilst there is no fixed definition as to what those criteria are, there is broad agreement as to the attributes of a quality company.

The attributes of profitability, stable earnings and low debt are what quality investors normally look for.

How do you pick a high-quality stock?

Stocks are selected as high or low quality based on an analysis of their financial statements which measure the performance of the business.

Once a system of measuring quality is established, companies can be ranked by a quality score and compared with each other.

Even better than a quality company, is a quality company that is able to compound its returns over long periods of time.

Investors who target these types of companies are looking to buy and then hold the investment for a long period and let their returns compound over time as the company grows its business.

UK fund manager Terry Smith uses the tagline, "Buy good companies, Don't overpay, Do nothing". Warren Buffett states that when he finds a great business his favourite holding period is "forever".

Needless to say, companies that meet these attributes are few and far between.

We have developed a screen within Stockopedia to try and filter for these types of companies, looking at their performance over the past five years.

Of course, a storied past does not guarantee a glorious future, but often companies that have figured out a winning formula tend to keep on winning.

When this screen is applied to the ASX, only 10 companies make the grade.

What is Carsales?

One of those is carsales.com (ASX:CAR). Carsales.com needs little introduction.

As the name suggests, it is a website for the buying and selling of cars. But there is a bit more to it.

They operate across four main geographies. Australia, USA, Brazil and Korea. In each of those markets they are the number one marketplace in the space where they compete.

In the US, they do not list cars, but rather trucks, RVs, powersports and equipment. The Australian market also covers those along with boats.

The business derives revenue in a number of ways. First is through vendors paying to advertise, both dealers and private sellers. The majority of revenue comes from dealers.

Next is selling advertising on the site, and there are also a number of ancillary services that are provided.

How has Carsales.com increased revenue?

Albert Einstein said, "Compound interest is the eighth wonder of the world; he who understands it, earns it, he who doesn't pays it."

Carsales has increased their revenue at a compound annual growth rate of 15% over the last 16 years. Something compounding at 15% doubles in value every five years.

Consequently Carsales has grown its revenue from $100 million in 2007 to $942 million today (assuming the full amount from the US and Brazil businesses in which they became majority holders part way through the year).

Revenue can sometimes grow due to acquisitions which may not always lead to growth in earnings per share (EPS), which ultimately is the metric that determines the returns available to shareholders.

Carsales' growth has included acquisitions, but it also grew EPS at a compound rate of 8.1% over the last 10 years, meaning that it has more than doubled.

How profitable is Carsales as a business?

These are impressive rates of growth, but to determine the quality of the business we need to survey the profitability as well as the balance sheet.

The profitability metrics are very strong. The average operating margin over the last five years has been 54.3%. Net profit margins have averaged 38.4% over the same period.

Returns on capital employed are also impressive with a long-term average of 21.4%. The profits are also being turned into cash with a strong level of cash generation.

As for the balance sheet, debt is low with a debt-to-assets ratio of 26% and interest cover is 18 times meaning that there is plenty of leeway to cover debt servicing costs.

What is the outlook for Carsales shares?

The most recent results, released on August 14, impressed the market which has responded by sending the share price 20% higher since.

All the key markets where they operate experienced double digit earnings and revenue growth. Analysts responded by upgrading their future EPS expectations resulting in a Stockopedia Momentum Rank of 99 from a possible 100.

As is the case with most of these quality compounding stocks, they are rarely cheap.

The market is well aware of the favourable characteristics and prices the stock accordingly. CAR trades on a forecast PE ratio of 34 and a dividend yield of 2.1%, which is 50% franked.

Advocates of the compounding quality investment approach generally have the view that over the long-term it will be the growth in the underlying value of the business that is the biggest determinant of return rather than the price paid.

Of course, paying a lower price will also boost the returns, but investors need to be careful not to fall into the trap of always waiting for the value metrics to hit a certain level and therefore failing to ever get on board.

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