Simon Shields from Monash Investors recently discussed “2 undervalued stocks (and why they the market mispriced them”
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By my nature, I’m not all that interested in investing in fairly priced companies. The question is, should it be possible to reliably identify some of those companies in advance that are not fairly priced? The short answer is Yes, which is why I founded Monash Investors almost 10 years ago, and our track record demonstrates that we have.
We established our first unit trust, the Monash Absolute Investment Fund in 2012 and it has returned about 12.9%pa after fees to 30 November 2021, despite average cash holdings in the fund of 20%, beating both the ASX 200 (10.8%pa) and the Small Ords (8.6%pa).
And we established an ASX listed fund using the same strategy which is available as an ETMF – The Monash Absolute Active Trust (Hedge Fund) (ASX: MAAT). Since it started six months ago it has returned 11.1% after fees despite a similar cash holding, also beating the ASX 200 (3.1%) and the Small Ords (7.2%).
Going back further, I’ve been an equity analyst and portfolio manager for over 30 years, having worked across different approaches to growth and value investing, at several of the largest fund managers in Australia.
This placed me in a great position to see the strengths and weaknesses of their processes, and learn lessons through analysing companies and making investment decisions over many years.
It’s been a front-row seat visiting businesses, getting to know their management, and understanding their industries.
The equity market is filled with lots of smart professional and amateur investors, all with good access to information, so it should not come as much of a surprise that most companies are fairly valued most of the time. By that I mean, they are priced within 10 or 15% of what they are worth given what is reasonably knowable.
But that still leaves many companies, albeit a minority, whose prices rise or fall each year very differently to the share market, even without considering share market manias or crashes.
Finding mispriced stocks
Our approach to finding mispriced stocks is to identify those companies where we are seemingly able to predict future business outcomes better than others in the market. We then calculate the price the stock should be trading at, if the market was to agree with us, and compare that to the current price.
There is a lot we could unpack in that paragraph, but I will only deal with one part of it here: predicting future business outcomes better than the market. My experience has been that we can find in advance some mispriced stocks, some of the time, because of recurring business situations that allow us to predict future business outcomes better than the market.
It doesn’t mean we don’t get it wrong, or that unpredictable events won’t conspire against us, but there is enough opportunity out there to build a portfolio that can deliver double digit per annum returns over a cycle.
Here are two recurring business situations where the market tends to habitually underprice stocks.
1. Store roll-out
2. Organic growth + growth by acquisition.
A new store concept that resonates with shoppers or is better than existing alternatives for consumers can be highly profitable. It could be for any good or service. We have seen the birth of large retailers and restaurant chains time and time again. It’s not just that the ultimate scale of a store rollout can be very hard for the market to assess in advance. It’s also whether the market can appropriately assess the risk as to whether it will be executed well. Often in these situations, the market can be far too conservative.
There are many examples of stocks where their price has risen strongly for many years as a result. The “party” will end one day. But until then, there can be an extended rollout growth phase, and the share market is playing catch up, trying to price the stock.
A store rollout example that we currently own, and have owned for some time, is Lovisa (ASX: LOV). Lovisa is a jewellery retailer that mostly operates from shopping centres, and has been accelerating its rollout of new stores.
They have about 150 in Australia and another 400 around the world, mostly in Europe and with a lesser presence in the USA and Asia. Their stores tend to pay back their setup costs within a year. With their cookie-cutter approach to running their shops, they have good same-store sales growth and reliable margins.
Their competitive edge is being a vertically integrated manufacturer of “fast fashion” affordable jewellery, with a product range that responds quickly to social media and celebrity fashion trends.\
There is a long runway of growth for Lovisa from setting up new stores. Not just in the existing markets of Europe, Asia and North America, where they are making strong progress.
The board of Lovisa has signalled their intention to aggressively continue with this strategy. They recently appointed Victor Herrero, who comes from the global retailing group that owns Zara among other brands.
He led the company’s expansion, rolling out 800 stores across multiple countries including China and India, where Lovisa does not yet have a presence.
Over the 5 years to 30 November 2021, during which time their store numbers approximately doubled, Lovisa’s share price has increased from $3.30 to $20.60.
Organic growth plus growth by acquisition
Many industries have businesses that grow their revenues and profits steadily. Where this occurs within the existing footprint of a firm’s locations or distribution network this is organic growth. Mature businesses, with single-digit organic growth rates, are generally well understood by the market and fairly priced.
However, some industries are quite fragmented, with many businesses being held privately. These smaller businesses can bring scale benefits as bolt-on acquisitions. For example, by providing greater efficiency in shared services or improved buying power to the combined group. More sophisticated management systems may also be applied to the acquisitions increasing their capacity utilisation and profitability quickly.
Finally, if these acquisitions are made at cheap prices, there is an arbitrage between the Price-to-Earnings (“P/E”) multiple the stock is trading compared to the acquired businesses, which in itself provides a boost to the earnings per share (“eps”).
In this way, a stock that makes bolt-on acquisitions may boost its eps growth from single digits to low twenties percentages.
Stock markets have demonstrated time and time again their inability to think beyond the existing scale and profitability of a business in these circumstances. Analysts are good at near term forecasts.
However, in this case they are typically too conservative with their medium and longer-term forecasts and stock markets are slow to look through that conservatism. As a result the market often does not correctly price such a stock’s likely future revenue, profit and balance sheet outcomes.
A recent example of this is People Infrastructure (ASX: PPE) which we currently own. Despite COVID, in FY20 it was on track to achieve eps growth of 16% through a combination of organic growth and acquisitions. This near term outcome was accurately forecast by analysts. But at the same time, consensus analyst eps growth forecasts for the next year (FY21) were only 7%.
Our internal PPE forecast for FY21 was much higher at 22%. Our FY21 forecast incorporated the benefit of acquisitions that the company had not yet made. We were confident in making this assumption because the stated strategy of the business is to make these acquisitions. They had been making them steadily for several years and they regularly stated their intention to continue to do so.
Sure enough, during FY21 the analysts raised their forecasts because PPE ended up making acquisitions, and the actual FY21 eps growth was 27%.
The combination of earnings upgrade and P/E multiple re-rating saw the PPE share price double over the 12 months to 30 June 2021. A somewhat extreme example, because of the volatility of PPE’s P/E rating due to Covid worries. The 5-year track record is also very impressive. In November 2017 it was listed at $1. It now trades around $4.
These are just two examples of recurring business situations and patterns of behaviour where the market habitually underprices stocks. There are many more we have discovered over the years which we use to make money for our investors.
It really is a case of learning from the past to improve future returns.