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The stocks which are precariously balanced thanks to premium valuations
Thursday 12 Apr 2018 Author: Tom Sieber

It is fair to say that 2018 is shaping up to be a difficult year for investors. Stocks are volatile, and the market is in very unforgiving mood with even the hint of bad news prompting big falls in company share prices.

Already this year funerals provider Dignity (DTY) announced a complete change to its business model which sparked an immediate halving of its share price while technology firms Sophos (SOPH), Alfa Financial (ALFA) and, in perhaps the most dramatic example, Micro Focus (MCRO) have also been heavily punished for their own disappointing updates.

So what have these companies all got in common? It’s simple: they all had high price-to-earnings ratios (PEs) relative to the wider stock market at the point of issuing disappointing news.

As a case in point, Alfa Financial was trading on around 40-times forward earnings when its 8 March update sparked concern about the timing of new contracts. However, a 20% fall in the share price compared with just a 5% reduction in the earnings forecast by stockbroker Numis.

PRICED FOR PERFECTION

For companies on high PE ratings a profit warning or earnings disappointment typically has a double whammy effect. The shares fall to reflect a reduction in earnings expectations and the company is also de-rated to a lower PE as investors react to a more uncertain growth picture.

FP Octopus UK Micro Cap Growth Fund (GB00BYQ7HN43) manager Richard Power says managing expectations is a key element of running a business in the public markets. ‘When newer companies are heading for IPO (initial public offering) there’s a temptation to put out stretch forecasts to the market because you’re in that shop window.

‘However, it is much better to put a 50% revenue growth forecast into the market and beat it than start off with a 100% target which leaves little margin for error.’

Power says as a typically long-term, supportive shareholder it’s a conversation he has had with a number of companies.

NO MARGIN OF SAFETY

The father of value investing, the late Benjamin Graham, described the difference between the price you purchase shares and their intrinsic value as the ‘margin of safety’.

Investing in a highly rated growth stock means investing without a margin of safety and can leave you exposed if something emerges to undermine the anticipated growth.

You need to think very carefully about your investments which are trading on premium valuations.

To illustrate this point, in this article we have identified stocks which are trading on PE ratios of 20-times or more, and we flag identifiable risks which could undermine the share price.

We highlight four names which look particularly vulnerable alongside two examples which, in our view, more than justify their bumper valuations.

It’s not just a case of looking at the PE in isolation; you should also be prepared to make your own wider assessment of a company’s prospects for cash flow and profit growth and what you are prepared to pay to gain access to them.

‘When to sell a company is something we discuss all the time,’ says Richard Power at Octopus. He says you need to have a clear view on what the business will look like in three or four years’ time and what the journey will look like.

Examples of companies which Power holds despite high earnings multiples include life sciences firm Abcam (ABC:AIM), which he says has ‘always looked expensive’; patent translation specialist RWS (RWS:AIM) and cyber security play GB Group (GBG:AIM).

Crucially he says, ‘for all these firms it is possible to see a much bigger global opportunity’. It is when such potential can no longer be identified that Power considers an exit.

GOODBYE FEVERTREE

‘We recently sold out of Fevertree Drinks (FEVR:AIM) having got in at IPO,’ he says. Having significantly exceeded his expectations with its capture of the premium white spirits mixers market, Power and his team were concerned a step into the dark spirits space could be more difficult.

‘It remains an extremely well-managed company but for us the risk/return had shifted as it required a new product range to be successful.’

There are other excellent companies on AIM where the valuation has got ahead of events. Examples include online musical instruments retailer Gear4Music (G4M:AIM) which at 679p trades on a forward PE of 60.2-times despite some pressures on margins.

Independent cinema operator Everyman Media (EMAN:AIM) trades on a forward PE of more than 40-times at 250p despite a risk the current squeeze on UK consumer spending will damage demand for the premium cinema experience it offers.

You do not have to sell out of a successful position all in one go, as Power notes ‘we take some profits along the way across all of our mandates’.

WEIGHING UP THE TECH STOCKS

In hindsight some investors may look back and wish they had taken some profit in runaway US technology stocks earlier this year as a data scandal and the threat of greater regulation weighed on the likes of Amazon and Facebook.

The Scottish Investment Trust’s (SCIN) fund manager Ally McKinnon comments: ‘Today, shares in Facebook and Amazon cost more than six times as much as they did five years ago. You’d need to pay 12 times more for Netflix shares and even Google costs 2.5 times more than it did in 2013.

‘It’s certainly possible that these shares will continue to do well, but we see better opportunities elsewhere: in stocks that are arguably valued to reflect a pessimistic view of their prospects and so have much more potential for positive surprises.’ (TS)


FOUR STOCKS IN THE DANGER ZONE

EasyHotel (EZH:AIM) 111p Forward PE: 139.4

EasyHotel (EZH:AIM) is a classic case of an interesting business trading at the wrong price to warrant buying the shares.

We like its low-cost business model and ability to leverage the EasyGroup brand strength. It is expected to see significant earnings growth over the next three to four years as new hotels are built and extra franchised hotels are added to the estate.

The company has taken advantage of a market gap beneath Premier Inn and Travelodge in price terms by offering a no-frills, purely functional experience. It posted a strong trading update on 11 April.

Unfortunately, investors are being asked to pay for tomorrow’s growth today. At 111p, it is trading on a 36% premium to forecast net asset value (81.6p) at the end of its financial year in September 2018.

It is expensive on other valuation metrics: it trades on a PE (price to earnings) ratio of 139.4 for the current financial year, falling to 36 times in the following year based on consensus forecasts.

EV/EBITDA (enterprise value to earnings before interest, tax, depreciation and amortisation) is 40.3-times for the current financial year, falling to 15.5 next year.

You could argue that it deserves to trade on a premium because a low accommodation price point makes it more resilient during tougher economic conditions. However, other hoteliers could cut their prices in more difficult times and there is also a growing competitive threat from Airbnb. (DC)

Metro Bank (MTRO) £34.60 Forward PE: 54

Metro Bank (MTRO) has been a darling of the challenger banks, recording record deposit growth to £11.7bn in 2017, a 47% increase on the previous year.

The bank’s loans increased by 64% to £9.6bn and its overall assets were up by a similar amount to £16bn. It exceeded its loan to deposit ratio target by 2%, coming at 82%. Also commendable was its maiden £20.8m profit for the year but there are some less positive signs for this highly rated bank.

Its return on equity for 2017 was just 1.2% despite management targeting 14% by 2020. Its fast growth rates in deposits and lending come at a cost, its common equity tier one (CET1) ratio dropped by 2.8 percentage points to 15.3%, a material drop in the bank’s ability to withstand economic shocks.

In its fourth quarter of 2017 alone, its record loan growth of £1bn shaved 2.1 percentage points off its CET1 ratio.

Ian Gordon, analyst at broker Investec, says without a capital raise its CET1 ratio is ‘too low for comfort’. It is also arguable whether the company is truly laying the foundations for future growth having opened just seven new branches in 2017, below its target. It has now downgraded its branch target for 2020 to 100 from 110. (DS)

Ocado (OCDO) 534.8p Forward PE: 205 times*

Online grocer Ocado’s (OCDO) ludicrously frothy valuation, based on forecasts from Peel Hunt it will remain loss-making until the November 2020 financial year at which point it trades on a PE of more than 200, reflects hype around the business and its potential for growth with international retailers.

A ‘marmite’ stock often in the sights of short-sellers, Ocado’s shares soared in the wake of the inking of agreements to power overseas supermarkets with its technology known as the OSP (Ocado Smart Platform).

These include deals struck with France’s Groupe Casino and Canada’s Sobeys, building upon CEO Tim Steiner’s long-promised first overseas deal with a mystery regional European retailer. While these deals put the squeeze on short-sellers, bears will have the last laugh. An eye-watering valuation leaves Ocado susceptible to sell-offs on any setbacks.

Full year results (6 Feb) revealed a lurch from pre-tax profit of £12.1m to a £500,000 loss, rising net debt, a dilutive placing and a warning 2018 profits will be constrained by ongoing investment to ‘accelerate’ growth.

Competition in the groceries space remains fierce and Ocado was cold-shouldered again as first quarter retail sales growth of 11.7% to £363.4m disappointed, deliveries impacted by winter storms and investors unimpressed by a 0.4% decline in Ocado’s average order size to £110.45.

Shares makes no apologies for repeating the words of Shore Capital’s head of research Clive Black from February: ‘The placing, also announced today, reflects the magnitude of cash burn for its NASA like projects; high in technological detail but one just never sees their benefit from Planet Earth. Oh to be such a charming company...’. (JC)

*For Nov 2020 financial year according to Peel Hunt forecasts

Renishaw (RSW) £45.48 Forward PE: 28.1

Shares in precision engineer Renishaw (RSW) have rattled along for about two years, roughly doubling to the recent record high of £57.75.

Renishaw is a world leading developer and manufacturer of high precision, automated metrology equipment, or very high-specification measurement kit. Products are used widely in aerospace, automotive, healthcare and other industrial markets.

Driving demand is uniformly solid, if not spectacular, global growth. Organisations are also investing in technology areas capable of widening and improving their own routes to market while streamlining operating models.

The weakened pound also makes its equipment and services less expensive for overseas customers, hugely important considering 95% of first half revenue stemmed from exports.

That’s the optimistic case. Alternatively, it could be argued that Renishaw remains, and has always been, a cyclical business and we are at, or close to, the top now.

Revenue and profits fell in 2009/2010 (partly due to the financial crisis) and diverted from the growth path again in 2016.

The company’s expertise is not in doubt but unpredictability remains a long-run problem, with both positive and negative shocks. Management admit little more than six weeks visibility on the order book.

Yet even after January’s steep sell-off the stock continues to trade at a hefty premium to peers, about 50% on a price to earnings measure, based on the next 12 months data from Reuters. (SF)


AND TWO WHICH JUSTIFY A PREMIUM

Accesso (ACSO:AIM) £22.75 Forward PE: 42

A price to earnings multiple of around 40 would normally scare off most investors. But attractions ticketing and queuing software supplier Accesso Technology (ACSO:AIM) is no ordinary company.

Since 2012 it has seen revenue soar from $46m to $133.4m, including last year’s (2017) 30% jump, and has an equally impressive record on profits. It has been free cash flow positive in every one of those years.

Analysts anticipate future compound annual growth of about 18%, which puts it one track for $215m of revenue by 2020.

Accesso has cleverly worked out how to leverage its technology platform, providing solutions for everything from buying tickets, queue-busting, merchandise purchasing and more. It has some very big-name clients (Merlin (MERL) and Six Flags, for example) and emerging opportunities across Latin America, the Middle and Far East, including China.

Accesso is also applying its tried and tested solutions beyond its core theme parks to sporting events, music gigs, ski resorts, museums and theatres, of which there are thousands of potential new operators and venues.

Expect a steady stream of acquisitions to continue to bolster increasingly reliable organic growth in the future. (SF)

Hotel Chocolat (HOTC:AIM) 347.5p Forward PE: 38.9

High-end chocolatier Hotel Chocolat (HOTC:AIM) trades on a rather rich PE ratio, yet we believe the rating is palatable given the growth being generated across retail stores and digital wholesale, where new accounts partnering with Amazon and Ocado (OCDO) hold promise.

Floated at 148p in May 2016, Hotel Chocolat is a high-quality concern with the brand differentiation essential to maintain its customer base and support price increases.

We’re fans of its disruptive innovation and vertical integration and see scope for continued market share gains.

Sales, profit before tax and earnings per share all fattened up by 15% in the first half to December, all the more impressive given the tough consumer backcloth. Nevertheless, potential de-rating catalysts are in place, among them a prolonged squeeze on consumers’ disposable income and rising interest rates, which could sap spending on posh chocolates.

A highly competitive market place cannot be discounted, while an additional risk factor to monitor is currency, as the increased cost of purchasing some premium ingredients in euros is constraining margins.

On the plus side, improving free cash flow and a strong balance sheet - with net cash of £18.3m at last count - has enabled Hotel Chocolat to hit the dividend trail, only adding to its allure with growth and income hungry investors. House broker Liberum Capital’s 410p price target implies there’s some 18% near-term upside left on the table too. (JC)

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