Learning Trade Me's lessons

If you ever wanted proof that long-term focused investors are a tiny minority, consider this. Only 0.7% of votes cast at the April Scheme Meeting were against the Trade Me takeover.

What were the other 99.3% thinking? That private equity acquirer Apax Partners was somehow buying a lemon? Greed is a powerful motivator, and virtually all shareholders apparently believed a 27% takeover premium was adequate compensation to discard this wonderful business.

Ultimately the takeover succeeded and we must move on. But before we do let's examine the lessons of the Trade Me recommendation. In the end the outcome was pleasing, with an annualised return of about 15% since James Carlisle's 2014 upgrade (more if you bought stock in 2015 when we reiterated our Buy with 'the stock is one of our better buying opportunities at present').

So what lessons can we learn from Trade Me?

Boards can be clueless

Trade Me was reasonably well managed. However, during our period of ownership, senior management spent significant time employing new staff and developing products to drive long-term growth. This period of investment resulted in weak profit growth, resulting in a sustained underpricing in the stock (hence our long-held Buy recommendation).

Investments in staff and new products can take years to show up in profits. In fact, they were only just starting to pay off as Apax launched its takeover. For example, premium listing revenue in Trade Me's property segment doubled in its final year of listed life.

In our view the board failed to understand these business drivers, partly as a result of a management vacuum. Apax launched its bid after the resignation of long-serving chief executive Jon Macdonald, intuitively understanding that managers who have mentally checked out are unlikely to fight for their company to remain independent.

Directors don't necessarily have a good understanding of how to value businesses. In the absence of a management advocate, the temptation must have been to assume that the market price was 'right'. Therefore a 27% takeover premium must have seemed a 'good deal' to the board.

Look for growth to come

Trade Me's profit growth was sluggish during our period of ownership. It also operated in the small and relatively mature market of New Zealand. These two factors were not negatives but were in fact the source of the buying opportunity.

As we've seen, the company's investment in staff and product temporarily depressed net profit growth. And by temporarily, we mean 'over multiple years'. Seek's management is fond of pointing out that the benefits of investment show up in operating metrics first, revenue second and profit last.

The investments were undertaken because Trade Me was lagging its peers in Australia and elsewhere. While premium listing products have been driving growth at Australian online classified companies for years, they were relatively new in New Zealand.

The small size of the New Zealand market was in fact an advantage. Management could review what was going on elsewhere and then copy the best ideas, secure in the knowledge the New Zealand market was probably too small for others to bother with.

Companies perceived as low growth but that have unrecognised potential can be excellent buying opportunities. Trade Me was an example; it's just a shame it was snatched away before that growth came through.

'High' multiples are just fine

Trade Me traded on a PER of 20 or above most of the time we recommended it. This is a perfectly rational and indeed normal multiple for a high quality, cash-generative business. That Apax paid 25 times earnings for Trade Me clearly indicates its belief in the company's potential under new management.

Of course it's better still when high-quality stocks decline to PERs of 16, as Trade Me did briefly in 2015, but these periods tend to be rare and fleeting. You'll improve your returns waiting for similar opportunities but you'll also miss plenty being so picky. While many value investors struggle to pay PERs of 20 or above for high-quality stocks, it's often sensible to do so.

Price decline? No worries

Trade Me shows how a stock can end up producing impressive returns despite regular and sustained price declines. Ignoring falling prices is necessary to become a successful investor; and if you can train yourself to buy when bad news hits, all the better.

Trade Me's share price had two major declines over our five-year ownership period. In fact, the stock declined by 22% over 18 months following our initial recommendation - before going on to double the next year. Develop the patience to see these periods through.

The second major decline was - tellingly - after Trade Me had doubled. Between our downgrade to Hold in September 2016 and Trade Me: Still quacking in November 2017 the stock fell 30% to $3.90 (at which point we suggested buying more). There was an air of bad news about Trade Me through this period, with concerns that Amazon and Facebook were about to take a chunk out of its Marketplace business. This is how good opportunities in quality companies come about.

The perfect buy?

Trade Me was exactly the type of buying opportunity we love at Intelligent Investor: a high quality, cash-generative business trading at a reasonable price. It's noteworthy that better buying opportunities appeared after the initial upgrade, showing that patience and a staggered entry often pays off.

We were sorry to see Trade Me leave the ASX last month but that's sometimes the lot of the small shareholder. We're now on the lookout for the next opportunity. Thanks for the lessons, Trade Me - we're CEASING COVERAGE.