The price conundrum for stock market winners
Every now and again you come across a stock which keeps churning out good news, fuelling a share price rally.
Backing winners is an obvious strategy for investors; after all, surely there is merit in putting your money into a business that is going places rather than one that is stuck in the mud?
Therein lies the problem. Do you pay a high premium to own the shares of a ‘winning company’? Or do you pay a discount to own a slice of a company that needs fixing?
Two months ago Shares looked at Games Workshop (GAW) and concluded that it was a brilliant business but the valuation was too rich. The stock has subsequently risen by 22% after trading continued to beat expectations, leaving us looking silly for being too cautious.
We’re now at the same crossroads with Avon Rubber (AVON), another high-flying stock that keeps issuing positive news. If you put valuation to one side, this business has much to offer.
It has become the global market leader in advanced CBRN (chemical, biological, radiological and nuclear) respiratory protection systems for the world’s military, homeland security, first responder, fire and industrial markets. Avon Rubber has also progressed from being a liner and tubing manufacturer for the dairy industry to being an innovator and having the market leading milking point systems brand in Milkrite.
Helping to fuel momentum this year has been a run of contract wins in the defence industry and a deal to sell its dairy business, meaning it will soon solely focus on the protection market. The disposal proceeds will help top up the pension fund and facilitate acquisitions where it can hopefully make higher returns.
Deals are already being forged, including the proposed acquisition of Team Wendy which is a leading supplier of helmets/helmet liner and retention systems. This will complement Avon Rubber’s existing ballistic helmet business.
The strategic progress seen across the business in recent years hasn’t gone unnoticed by the investment community. As the chart shows, investors have been happy to pay a much higher multiple to own the shares, going from sub-20 times before 2019 to now trading on circa 40 times earnings.
Operating margins have been improving in every year bar one since 2009 and Avon Rubber has a long track record of delivering strong returns from the investments it makes in the business. It is now capitalising on an opportunity to extend its product range so it can offer more to existing and new customers.
There is a lot to like about this high quality business, but any interested investor should think hard about whether they want to pay the current rating. The market is pricing in a lot of future success today which makes the stock vulnerable to a large correction if Avon Rubber cannot deliver the expected growth.
Avon Rubber and Games Workshop are near the top of our list of stocks to buy when the market next goes through a sticky patch. We simply cannot justify paying today’s prices.