I have been living with value stock affliction for some time. It can be irritating particularly when the wind is blowing the wrong way. In the past it has led to text messages from colleagues saying “What price did you get into G4M – oh dear you don’t have any” – just after they have doubled. Then he sauntered past my desk saying, “Don’t be short Beeks Financial Cloud”. And in April this year he enlightened me that he was going to offload his Manolete at 520p/share because a 200% return in 4 months was enough.
It was his jibing that made me buy some reassuringly expensive Alpha FX earlier this year. At least it was “only” on a 26X multiple. Since when the share price has continued its orbital trajectory. Now on 39X I checked in with my growth junkie to find he is telling me he isn’t selling any “It’s gonna be my money fountain” he says, “Welcome to the world of superstocks”. I find myself contemplating that he may well be right.
Is this the right time?
The bubble stocks are deflating. A check of Uber, Lyft and Chewy share price charts in the US confirms this. Which in a contrarian way confirms to me that this is a time to be highly selective on growth stocks. While markets look set for a rebound after Christmas. This chart from Panmure Gordon’s chief economist made me wonder how many market commentators will be discussing the “Brexit Bounce” in the new year.
Fast growth stocks that have a formula for profitable growth will soon start to stand out from the bubble stocks. Out of the ashes of these meltdown come the next great performers. An investment in Apple in January 2002 would be worth 130X the amount at the end of October 2019.
Great businesses are built in harsh markets. Once markets get easier it is harder for businesses to win such high-quality clients. I find that easy to understand in the corporate broking market where companies of a £10m market cap are frequently told to find a new broker in difficult markets as brokers are engaged in cost cutting exercise while those that pick them up suddenly find these companies are £50m market cap a few years later and every broker is pitching for their business. That is the story of Finncap which built its business in the credit crunch.
It is a question of building a business where no one is looking. Racal Electronics plc was a FTSE 100 company in the 1980’s selling data recorders and point of sale terminals. It demerged Vodafone in 1991 in order to focus on its undervalued “core” business, finding that their 60% stake in Vodafone was valued at more than the “core” business. Over the subsequent 15 years Vodafone was a 50 bagger while Racal was taken over by Thomson CSF in 2000 at a valuation of £1.3bn.
Banks
The same applies in banking markets today. While the large banks are preoccupied with legacy technology and regulation they aren’t paying attention to their FX spreads. This is proving to be the small area of banking that could turn out to be worth more than the banks themselves. After a decade of decline the FTSE 100 weighting remains 12.2% in banks, while the new breed of foreign exchange providers is not slow to issue a foreign exchange app, card and portal to their customers which includes full banking services as an add-on. Companies such as Revolut, Monzo, Equals Group etc. And once you have the volume of customers monetising becomes easier, as Vodafone found in the electronics market. Owning volume on an exchange is very high ROE business it uses customers capital. The highest two ROE companies on the main market are Rightmove and Autotrader which both are volume related exchanges. It is this ability to capture volumes taking a revenue slice from the middle of a transaction that produces some of the best quality, most predictable, and highest ROE growth I have come across. So called Super Stocks.
Super Stocks
Owning quality businesses is what market participants call it. They always refer to high ROE as one of the indicators. But frequently high ROE may be temporary because the spoils on offer temp in competition who will compete at lower prices thus competing away the high return. Thus, the larger, more established companies that consistently deliver a high ROE are the ones that markets take to.
Two examples of younger stocks that are market superstocks are Judges Scientific and Manolete Partners. Judges Scientific is a high ROE company (41.8%) which has consistently been able to re-invest at similar high ROE’s through acquisitions. And the high ROE is because of underlying intellectual property in the form of scientific know how, brands or patents which can provide a sustainable advantage. It is this “edge” that makes the ROE sustainable. Manolete Partners Plc has a high ROE (31%) which is derived from the intellectual property of legal knowledge in the niche of insolvency. The company can re-invest monies at consistently high ROE’s because the market is large.
Hargreaves Lansdown came to market in 2007 at a price of 160p per share. At the time they were talking of being the Tesco of financial services (though when Tesco subsequently had a profit warning this likeness was dropped). The shares roared to a 29% premium on day one and I found myself unable to pay up. 12 years later they trade at 1758p, a return 1098% ignoring dividends. Another one is AJ Bell which today trades at 53X forecast earnings. There are times we need to put aside our value investor affliction and pay up for the super stock.
Exposure
For those that prefer to invest in funds there are 3 outstanding funds that have adopted processes that direct investment towards Super Stocks; Fundsmith, Lindsell Train and Liontrust Special Situations. The performance of these three funds has been remarkable similar since 2005:
Investors could invest in these funds in the secure knowledge that their money will be invested in quality stocks. But there are two reasons why some investors may prefer to pick their own superstocks. Firstly, these quality funds are reassuringly expensive. Fundsmith ongoing charges figure is 1.05%, Lindsell Train is 1.15% and Liontrust Special Situations comes it at comparative value of 0.87%. The second reason is of course it’s far more fun to choose your own Superstock.
Stocks
These are not cheap stocks trading on an average forward PE of 25X. But the average ROE is 306%! This means that for these stocks if they can continuously invest their capital at such high rates of return the apparently high valuation will ultimately be irrelevant. The necessary factors for that to continue to occur are:
Intellectual Property, whether it is a brand, patent, customer relationship of scientific advantage
Embedded customers who tend to be loyal enabling the joys of compounding to occur
Effective customer acquisition. This is where many of the unicorns fall down. Paying too much to acquire customers.
Large markets. A good business in a small market will remain a small business.
Scalable business model
A selection of stocks I have been watching for whether they fulfil the super stock criteria are below and perhaps it is worth appraising each of them for whether they may fit the bill using the 5 headings above:
Source: SharePad
Rightmove Plc
Intellectual Property This is scale. The largest property portal has 1.1m properties advertised for sale which compares to 1.1m housing transactions in 2018. Zoopla and on the market.com have been attracted by the high returns but yet don’t have the scale of Rightmove. As a result, Rightmove has been able to keep increasing prices each year, despite estate agents coming under pressure.
Embedded Customers This is a weakness of Rightmove in that the estate agents will simply advertise where there is scale. Purchasers and renters will switch apps swiftly and the estate agents will follow.
Customer acquisition With Rightmove’s scale any new estate agent will be obliged to contact Rightmove so very cheap customer acquisition
Large markets Rightmove has probably saturated the UK sales market and so is now diversifying and investing in technology to capitalise on the customer data which it owns.
Scalable This company has already scaled and so faces some new threats but will likely continue to produce a strong ROE for a while.
Conclusion This is a high ROE cash generator and has the potential to use its data. But there are increasing competitive threats from competitors as well as new technologies.
AutoTrader Group Plc
Intellectual Property This is scale. With 2.5m new cars sold in the UK each year and 8m used car transactions Autotrader has a 75% market share of the audience.
Embedded Customers The brand has some loyalty although repeat acquisition of cars is generally only once every few years, so the compounding effect is limited.
Customer acquisition Its market share ensures however that new advertisers are cheap to acquire
Large markets Similar to Rightmove the company has already achieve high market share and so is now diversifying into data and other products
Scalable Already Scaled
Conclusion Like Rightmove this is a high ROE cash generator and has the potential to use its data. But there are increasing competitive threats from competitors as well as new technologies. In the future the car market will change significantly.
Mortgage Advice Bureau Plc
Intellectual Property This is effectively a franchise business model and consequently has a high ROE derived from using franchisees (known as appointed representatives) capital. The scale of market reach by virtue of being the largest mortgage adviser network provides some level of protection.
Embedded Customers Franchisees are embedded as reliant on MAB’s regulatory permissions IT systems, marketing, buying power and extensive market reach. Mortgage customers coming to the end of a fixed term tend to return to the same adviser.
Customer acquisition The company has 1,400 advisers who are effectively self-employed. This number grows slowly over time as new advisers sign up. Though fast growth is harder to achieve.
Large markets The company has a market share of only 4.7% of all mortgages arranged despite being the largest provider, so there is plenty to go for.
Scalable Slowly scalable. As the power of customer data increases it may be that more advisers will need to sign up in order to access the mortgage market and customer data the company owns, particularly in an era of open banking access where all banking data can be provided to the network.
Conclusion As mortgages have become a financial product that is now traded every few years Mortgage Advice Bureau has an enviable position with repeat customers. As the power of the data the company has amassed around customers financial well being the company has significant potential to keep growing.
K3 Capital Group Plc
Intellectual Property This is the largest business sales agent in the 0-£100m agency market. Their intellectual property is in direct marketing. C 5m direct emails are sent each year and website traffic is harvested using business sales websites. This competes with traditional firms of accountants and corporate financiers who are typically reliant on a network.
Embedded Customers Business owners generally only sell their business once so little compounding effect here.
Customer acquisition is comparatively cheap. The company spends c £1m on direct marketing each year which is a relatively fixed number.
Large markets K3 Capital estimates it has less than a 1% market share in its space
Scalable The model is more scalable than competitors. Each part of the sale process is handled in a systematic manner by specialist in that field such as publishers for investment memoranda, negotiators for negotiation and field sales teams for new clients.
Conclusion With the exception of repeat customers this looks to be a hugely scalable and differentiated model. It is however still small and so revenues are lumpy which has resulted in bit upgrades and downgrades. This will reduce as the company scales. One to pick up on downgrades and hold for the long term.
Manolete Partners Plc
Intellectual Property The level of expertise and knowledge required to pursue directors of insolvent companies in litigation is high. More specialist than the general litigation funds. Also, the model of sharing returns with insolvency practitioners enable a more capital light model and consequently higher ROE. This involves a high level of trust between insolvency practitioner and litigation funder which is not easy to replicate.
Embedded Customers Few directors of insolvent companies are repeat customers.
Customer acquisition This is through relationship with insolvency practitioners so is a network
Large markets There are in the region of 14,000 insolvencies per annum and c 1,700 licensed insolvency practitioners. With under 61 new cases in the last 6 months market share remains small
Scalable The model is highly dependent on high levels of expertise so it is hard to scale
Conclusion It is the difficult to scale part that makes me feel this is a high ROE cash cow fund rather than a growth stock. As such it should better be values as a high return fund which makes it overvalued rather than a growth stock.
Alpha FX Plc
Intellectual Property The software that the company has developed to be embedded in a customer accounting system which delivers a regular stream of methodologically calculated FX trades to make customer FX hedging programs efficient gives it an edge over rivals.
Embedded Customers Customer churn is very low, so compounding is highly effective as new customers are added
Customer acquisition Salespeople are highly incentivised to develop new CFO customers from a slight sophisticated version of a call centre as sales staff develop on going annuity income from their embedded customers
Large markets The FX market is estimates to be $2.7trillion a day in the UK.
Scalable The sales model uses incentivised salespeople and this can be rolled out by geography and also in scale at each hub.
Conclusion This one is a genuine compounder of revenues with a genuine high ROE unique selling proposition.
Personal View
These are all highly rated stocks achieving high ROE’s. With such high ratings the share price downside in the event of getting it wrong is large so it is important to be selective. Alpha FX is therefore the only highly rated stock I could persuade myself to hold for the medium term.
Summary
The value affliction has led me to miss out on the powerful compounding returns that Superstocks offer. It also led me to sell AJ Bell too early. Occasionally when a stock has a genuine edge it is still right to pay expensive multiples to own them. But we need to be choosy. There are many wolves cloaked as sheep. The only stock where I can gain a level of confidence that it is a young Superstock is AlphaFX. Alternatively, investors who are attracted by the Superstocks could invest in one of the 3 funds which all have strong long-term performance records.
Forthcoming Events
Below are the results dates but we may well have trading updates some 2-3 months ahead of results as companies go into closed period.
Weekly Commentary: 25/11/19 – Superstocks
Superstocks
I have been living with value stock affliction for some time. It can be irritating particularly when the wind is blowing the wrong way. In the past it has led to text messages from colleagues saying “What price did you get into G4M – oh dear you don’t have any” – just after they have doubled. Then he sauntered past my desk saying, “Don’t be short Beeks Financial Cloud”. And in April this year he enlightened me that he was going to offload his Manolete at 520p/share because a 200% return in 4 months was enough.
It was his jibing that made me buy some reassuringly expensive Alpha FX earlier this year. At least it was “only” on a 26X multiple. Since when the share price has continued its orbital trajectory. Now on 39X I checked in with my growth junkie to find he is telling me he isn’t selling any “It’s gonna be my money fountain” he says, “Welcome to the world of superstocks”. I find myself contemplating that he may well be right.
Is this the right time?
The bubble stocks are deflating. A check of Uber, Lyft and Chewy share price charts in the US confirms this. Which in a contrarian way confirms to me that this is a time to be highly selective on growth stocks. While markets look set for a rebound after Christmas. This chart from Panmure Gordon’s chief economist made me wonder how many market commentators will be discussing the “Brexit Bounce” in the new year.
Fast growth stocks that have a formula for profitable growth will soon start to stand out from the bubble stocks. Out of the ashes of these meltdown come the next great performers. An investment in Apple in January 2002 would be worth 130X the amount at the end of October 2019.
Great businesses are built in harsh markets. Once markets get easier it is harder for businesses to win such high-quality clients. I find that easy to understand in the corporate broking market where companies of a £10m market cap are frequently told to find a new broker in difficult markets as brokers are engaged in cost cutting exercise while those that pick them up suddenly find these companies are £50m market cap a few years later and every broker is pitching for their business. That is the story of Finncap which built its business in the credit crunch.
It is a question of building a business where no one is looking. Racal Electronics plc was a FTSE 100 company in the 1980’s selling data recorders and point of sale terminals. It demerged Vodafone in 1991 in order to focus on its undervalued “core” business, finding that their 60% stake in Vodafone was valued at more than the “core” business. Over the subsequent 15 years Vodafone was a 50 bagger while Racal was taken over by Thomson CSF in 2000 at a valuation of £1.3bn.
Banks
The same applies in banking markets today. While the large banks are preoccupied with legacy technology and regulation they aren’t paying attention to their FX spreads. This is proving to be the small area of banking that could turn out to be worth more than the banks themselves. After a decade of decline the FTSE 100 weighting remains 12.2% in banks, while the new breed of foreign exchange providers is not slow to issue a foreign exchange app, card and portal to their customers which includes full banking services as an add-on. Companies such as Revolut, Monzo, Equals Group etc. And once you have the volume of customers monetising becomes easier, as Vodafone found in the electronics market. Owning volume on an exchange is very high ROE business it uses customers capital. The highest two ROE companies on the main market are Rightmove and Autotrader which both are volume related exchanges. It is this ability to capture volumes taking a revenue slice from the middle of a transaction that produces some of the best quality, most predictable, and highest ROE growth I have come across. So called Super Stocks.
Super Stocks
Owning quality businesses is what market participants call it. They always refer to high ROE as one of the indicators. But frequently high ROE may be temporary because the spoils on offer temp in competition who will compete at lower prices thus competing away the high return. Thus, the larger, more established companies that consistently deliver a high ROE are the ones that markets take to.
Two examples of younger stocks that are market superstocks are Judges Scientific and Manolete Partners. Judges Scientific is a high ROE company (41.8%) which has consistently been able to re-invest at similar high ROE’s through acquisitions. And the high ROE is because of underlying intellectual property in the form of scientific know how, brands or patents which can provide a sustainable advantage. It is this “edge” that makes the ROE sustainable. Manolete Partners Plc has a high ROE (31%) which is derived from the intellectual property of legal knowledge in the niche of insolvency. The company can re-invest monies at consistently high ROE’s because the market is large.
Hargreaves Lansdown came to market in 2007 at a price of 160p per share. At the time they were talking of being the Tesco of financial services (though when Tesco subsequently had a profit warning this likeness was dropped). The shares roared to a 29% premium on day one and I found myself unable to pay up. 12 years later they trade at 1758p, a return 1098% ignoring dividends. Another one is AJ Bell which today trades at 53X forecast earnings. There are times we need to put aside our value investor affliction and pay up for the super stock.
Exposure
For those that prefer to invest in funds there are 3 outstanding funds that have adopted processes that direct investment towards Super Stocks; Fundsmith, Lindsell Train and Liontrust Special Situations. The performance of these three funds has been remarkable similar since 2005:
Investors could invest in these funds in the secure knowledge that their money will be invested in quality stocks. But there are two reasons why some investors may prefer to pick their own superstocks. Firstly, these quality funds are reassuringly expensive. Fundsmith ongoing charges figure is 1.05%, Lindsell Train is 1.15% and Liontrust Special Situations comes it at comparative value of 0.87%. The second reason is of course it’s far more fun to choose your own Superstock.
Stocks
These are not cheap stocks trading on an average forward PE of 25X. But the average ROE is 306%! This means that for these stocks if they can continuously invest their capital at such high rates of return the apparently high valuation will ultimately be irrelevant. The necessary factors for that to continue to occur are:
A selection of stocks I have been watching for whether they fulfil the super stock criteria are below and perhaps it is worth appraising each of them for whether they may fit the bill using the 5 headings above:
Source: SharePad
Rightmove Plc
Conclusion This is a high ROE cash generator and has the potential to use its data. But there are increasing competitive threats from competitors as well as new technologies.
AutoTrader Group Plc
Conclusion Like Rightmove this is a high ROE cash generator and has the potential to use its data. But there are increasing competitive threats from competitors as well as new technologies. In the future the car market will change significantly.
Mortgage Advice Bureau Plc
Conclusion As mortgages have become a financial product that is now traded every few years Mortgage Advice Bureau has an enviable position with repeat customers. As the power of the data the company has amassed around customers financial well being the company has significant potential to keep growing.
K3 Capital Group Plc
Conclusion With the exception of repeat customers this looks to be a hugely scalable and differentiated model. It is however still small and so revenues are lumpy which has resulted in bit upgrades and downgrades. This will reduce as the company scales. One to pick up on downgrades and hold for the long term.
Manolete Partners Plc
Conclusion It is the difficult to scale part that makes me feel this is a high ROE cash cow fund rather than a growth stock. As such it should better be values as a high return fund which makes it overvalued rather than a growth stock.
Alpha FX Plc
Conclusion This one is a genuine compounder of revenues with a genuine high ROE unique selling proposition.
Personal View
These are all highly rated stocks achieving high ROE’s. With such high ratings the share price downside in the event of getting it wrong is large so it is important to be selective. Alpha FX is therefore the only highly rated stock I could persuade myself to hold for the medium term.
Summary
The value affliction has led me to miss out on the powerful compounding returns that Superstocks offer. It also led me to sell AJ Bell too early. Occasionally when a stock has a genuine edge it is still right to pay expensive multiples to own them. But we need to be choosy. There are many wolves cloaked as sheep. The only stock where I can gain a level of confidence that it is a young Superstock is AlphaFX. Alternatively, investors who are attracted by the Superstocks could invest in one of the 3 funds which all have strong long-term performance records.
Forthcoming Events
Below are the results dates but we may well have trading updates some 2-3 months ahead of results as companies go into closed period.