5th June 2014 by Edmund Shing
Okay, let’s start with a quick disclaimer: as a fund manager, I admit that I have a bent towards stocks that display a combination of value (cheap), quality (profitable) and momentum (prices moving higher) characteristics. So given Asos’ (code: ASC:L) lofty 2014 forecast P/E ratio of 77x as of yesterday, it was clearly never going to be one of my favourites.
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A quick glance at Asos’ long-term weekly chart (Figure 1) tells you why this online fashion retailer has long been a favourite of retail investors, with a share price that multiplied by over 15 times from a low around 430p in early 2010 to a high of over £70 hit in March this year.
Asos has today informed the market that sales growth is slowing and, even more importantly, that profit margins will be a lot lower than expected (4.5% rather than around 6.5%). This follows a warning in March that earnings would be impacted this year by increasing levels of investment.
Today’s warning has now taken Asos’ share price down to around £31 at time of writing (Figure 2), less than half of its March peak but still representing a 2014e P/E valuation of 52x, before the analysts even take out their red pens and cut their earnings forecasts. So in reality, Asos’ valuation will turn out to be far higher than 52x… This at a time when the overall UK stock market is rated at 14x this year’s earnings, falling to 12.8x for 2015.
The lesson to be learned here is that blindly following momentum is a dangerous strategy, once that momentum has turned. Remember that following the first warning from Asos in March, the share price had already fallen from over £70 to a mid-May low of £38.50. Investors had been given plenty of fair warning to sell their stocks at a level far higher than today’s £31…
The problem is this: as long as a highly-valued glamour stock like Asos continues to deliver on promises of fast top-line and profit growth, all well and good. But the day that a glamour stock disappoints these high-flown expectations, woe betide any investor left holding the shares! The share price typically suffers a double whammy: not only are the earnings forecasts downgraded (Asos profit forecasts had already fallen 10% since March prior to today’s warning), hurting the shares, but the P/E multiple applied to these earnings also collapses, as in the case of Asos (so far from 77x to 52x).
Instead of chasing these dangerous glamour stocks, I prefer to follow the large body of academic research that highlights that companies with a combination of four factors tend to outperform from year to year:
An excellent academic study demonstrating the outperformance of stocks that fit these 4 criteria in the US over 1963-2007 by Robert Haugen can be found here, for those you are sufficiently curious!
There are a number of ways you can look for these types of stocks; the best system for retail investors that I have come across in the UK for doing this type of “stock screening” is Stockopedia (http://www.stockopedia.com; disclaimer: I have no links to this company, I am just impressed by their product).
Scouring the constituents of the FTSE 350 index, a number of names pop up which have (a) performed well over the last 12 months; (b) remain on relatively cheap valuations; (c) are very profitable and growing profitability, and (d) are not volatile, including but not limited to:
So stop chasing glamour stocks higher, and hunt for stocks using the four favoured factors instead!
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