|Summary: For investors, there’s always a fine line between outperformance and being overpriced. This article analyses three companies that have achieved solid, consistent results, and which have provided existing shareholders with strong capital appreciation. But, at current levels, they are all very expensive.|
|Key take-out: The three stocks – ARB Corporation, TPG Telecom and Super Retail Group – have been bid up to levels well above reasonable estimates of intrinsic value.|
|Key beneficiaries: General investors. Category: Growth.|
Having reviewed most of the stocks in the Clime Growth Portfolio recently, this week I am analysing and explaining the valuations and value-to-price ratios (safety margin) for three quality stocks not in the portfolio, but which I would like to own at the right price.
The three stocks – ARB Corporation, TPG Telecom and Super Retail Group – all posted pleasing earnings results in the last profit reporting season and delivered consistent growth in profitability and dividends in recent years.
Their share prices, however, have been bid up to levels well above reasonable estimates of intrinsic value, and I would like to show readers how to understand the unrealistic expectations implied by current share prices.
ARB Corporation Limited (ASX:ARP)
ARP has a great record for shareholders, with average normalised return on equity (NROE) of 34% and compound annual growth in dividends per share of 13% over the last 10 years. The company designs, manufactures and distributes 4WD accessories in Australia and internationally.
Expertise in product innovation, marketing, exporting, distribution network expansion and capture of production efficiencies make ARP one of the market’s best small caps. Its management is also as accomplished and credible as any in the sector. In particular, management has understood the competitive advantages it could develop, and has stuck to investing in these rather than diversifying away into dilutive, wasteful distractions.
I am sufficiently confident in ARP’s future profitability to choose a forecast NROE of 34%, above consensus expectations of 31.5% for FY14, as shown in Figure 1 below. Note also my forecasts for 12.8% growth in intrinsic value in FY14 and FY15. Double-digit annual growth in value makes for a good investment, but only at the right entry price.
The problem with ARP is not the company but the price. Figure 1 indicates ARP is moderately (5%) overvalued compared with my FY14 valuation, and it is necessary to look out to FY15 to find value. The expectations for required return (RR) and NROE implied by current prices are in Figure 2.
I think an average RR of 13% is justified, as ARP still has small-cap risk despite its strong record. Current prices of $12.54 imply a 11.7% RR, which I believe is too low even for a stock with this company’s record. Alternatively, a 37.8% NROE would produce a valuation equal to current prices with the 13% RR. A 37.8% NROE is not impossible, but I would prefer to be a little conservative to protect my downside. A forecast of 34% NROE is still significantly above consensus.
I would be more interested in the stock at prices around $10.70, but if I owned it at present I would not be too perturbed.
TPG Telecom Limited (ASX:TPG)
Consumer, wholesale and corporate telecommunications services provider TPG also posted a strong FY13 profit result recently, with 9% revenue growth and a 64% jump in earnings. The group added 130,000 subscribers to its home phone and broadband bundle plans. The result exceeded broader market expectations and TPG excited the market with plans to connect more buildings to its high-speed metro fibre network.
My analyst team lifted TPG’s forecast NROE from 25% to 26% to reflect improving profit and profitability forecasts and also lowered the RR from 13% to 12.5% to acknowledge the debt-free balance sheet and strength in cash flows, margins and profitability. TPG has a 10-year average NROE of 13% but the ratio is rising, with five and three-year figures of 20% and 25% respectively.
The market, in an overreaction to the excellent profit result, sent the shares to levels where the prospective return is now negative. Figure 3 below predicts a 25% fall in the share price if the stock converges to my $3.25 FY14 valuation. Should this happen, the small dividend would provide little comfort. Significantly, my 26% NROE is only marginally below the 26.9% market consensus. I don’t need to adopt a dramatically lower NROE to conclude the stock is overvalued.
The market is making aggressive assumptions of either a 9.9% RR or a 33% NROE to justify the current share price. A 9.9% RR implies no individual equity risk premium for TPG, which is unacceptable.
Super Retail Group Limited (ASX:SUL)
SUL, which retails car parts, leisure equipment, leisure apparel, sports equipment and sports apparel, is a younger company but one with an impressive record.
Driven by retailing nous and successful acquisitions, SUL averaged 26% NROE and compounded dividends per share at 25% over the last five years. The acquisition of Rebel Sport in 2011 leveraged SUL to the growth in sports apparel and equipment retailing, which is growing with the population’s increasing interest in health and fitness.
The company has also used its growing size to gain better buying terms, leases with landlords and deals with advertisers.
Tight margin management and healthy asset turnover drive my 23% forecast NROE, which is at a premium to the 13.4% RR. Value growth is mid to high single-digit.
SUL’s financial performance and share price rally have attracted plenty of interest from investors and the stock is now trading at a 50% premium to my $8.32 FY14 valuation. These prices can be justified only by a 9.7% RR or a 32% NROE, as seen in Figure 6. This RR does not contain enough of a company risk premium and the implied NROE is uncomfortably high in my view. Now is not the time to buy.
John Abernethy is the Chief Investment Officer at Clime Asset Management, one of Australia’s top performing equity fund managers. To find out more about Clime Asset Management, visit their website at www.clime.com.au.
Clime Growth Portfolio Statistics
Return since June 30, 2013: 9.68%
Returns since Inception (April 19, 2012): 28.99%
Average Yield: 6.33%
Start Value: $141,128.64
Current Value: $154,786.66
Dividends accrued since June 30, 2013: $2,375.74
Clime Growth Portfolio - Prices as at close on 8th October 2013
|BHP Billiton Limited||BHP||$31.37||$34.70||5.02%||$38.33||10.46%|
|Commonwealth Bank of Australia||CBA||$69.18||$71.10||7.62%||$68.69||-3.39%|
|Westpac Banking Corporation||WBC||$28.88||$31.98||8.13%||$30.97||-3.16%|
|The Reject Shop Limited||TRS||$17.19||$17.65||3.89%||$16.98||-3.80%|
|McMillan Shakespeare Limited||MMS||$16.18||$10.85||6.45%||$12.47||14.93%|
|Mineral Resources Limited||MIN||$8.25||$10.97||8.59%||$13.41||22.24%|
|SMS Management & Technology Limited||SMX||$4.55||$4.38||7.18%||$5.29||20.78%|