The hunt for genuine industry ‘disruptors’

 

The quest for “ten-bagger” stocks – those that soar tenfold – is usually associated with speculators and penny-dreadful exploration stocks. Not conservative investors, who are allocating part of their superannuation to the next hot small-cap stock.

Record-low interest rates and falling dividend yields are forcing trustees to move further along the risk curve to lift portfolio returns. The prospect of spotting the next Seek, REA Group or Carsales.com has great appeal as trustees look for genuine industry “disruptors”.

The true believers

The reality is it is hard to find genuine industry disruptors that are creating markets or reinventing existing ones, let alone buy them below fair value. True disruptors are hard to value because they are creating uncontested market space, at least at the start.

Seek, REA and Carsales.com, for example, looked expensive for years, yet kept rising. Investors, who worried about high Price Earnings (PE) multiples, overlooked their potential for exponential revenue growth and snowballing profits, thanks to super-high profit margins.

They also underestimated the barrier to entry derived from “network effects” – having the largest audience that attracts the largest advertising base, which in turn attracts more users and makes it impossible for rivals to compete. Look at how many online segments are dominated by one firm and the daylight between the market leader and number two or three player.

Technology’s capacity to disrupt established markets has never been greater. Think of Airbnb’s disruption of the accommodation industry; what Alibaba is doing to e-commerce; or how Uber is hurting the global taxi industry and its likely effect on the transportation of small goods.

Watch the trends

SMSF trustees with a multi-year or multi-decade focus need to think carefully about emerging long-term trends and the companies best placed to capitalise on them. Investing overseas is becoming more important to gain exposure to trends, such as robotics, self-driving cars, the internet of things (devices talking to each other via the web), and so on. Companies involved in these industries have low or no representation on the ASX.

A jump in tech listings on the ASX is at least giving investors more choice. Micro-jobs website Freelancer kick-started the tech IPO trend in 2013 when its soaring valuation after listing encouraged other aspiring tech ventures. More followed in 2014 and market talk is that several tech IPOs, some of them reasonably large, are considering listing on the ASX this year.

Nevertheless, it is often better with small- and mid-cap IPOs to wait a year or two after listing before buying. This allows time for IPO hype to fade, to assess how the company performs as a listed entity – if its prospectus was fact or fiction – and for seed investors to sell restricted securities once escrow provisions expire.

Freelancer

Consider Freelancer’s experience. It raised $15 million in November 2013 at 50 cents a share, soared to an intraday high of $2.60, and slumped to 52 cents in December. The company admits it misjudged the IPO share allocation, selling too few shares and creating illiquidity in its stock.

Freelancer has recovered to 98 cents and has further to run in the long term. It was overpriced above $2 and chronically undervalued at 52 cents. It does not suit risk-averse investors, but there is much to like about its industry, market position and prospects.

Chart 1: Freelancer

^[1]Source: ASX. Chart shows end-of-day closing prices

The emergence of global micro-job platforms that connect employers and freelancers is a fascinating trend. These platforms facilitate labour-market arbitrage, as western companies hire freelancers in developing markets for a fraction of the price, and workers in those markets earn a higher fee than they would from local companies.

Freelancer’s platform has almost 15 million freelancers and employers bidding on more than seven million projects. As it acquires smaller platforms in other countries, those numbers should balloon. There is plenty of room to grow; the market has estimated annual revenue opportunity of US$16 billion and Freelancer’s FY14 revenue was US$23 million.

Canaccord Equities has a buy recommendation and a $1.46 12-month price target. The broker says Freelancer is expected to deliver more than 30% compound annual revenue growth over the next five years, while sustaining 87% gross profit margins.

Using the valuation metric of Enterprise Value to Earnings Before Interest and Tax, Freelancer trades at an EV/EBIT of 9 times in FY17, falling to 3.2 times in FY20. Canaccord says: “We estimate this is a discount to the ASX Industrials index despite Freelancer experiencing a significantly stronger revenue growth profile and higher marginal return on invested capital (the two drivers of value creation).”

Xero on the way back

An industry disruptor with even greater potential, Xero, is also on the way back after heavy share-price falls. The cloud-based accounting software provider soared sixfold in 2013 to peak at $37.45, before slumping to a 52-week low of $13.76. It has great prospects, but was overhyped by some brokers.

Chart 2: Xero

^[2]Source: ASX

I could not get interested in Xero at those heady prices and wrote as much for the Switzer Super Report in November 2013 ^[3]. I commented: “Xero’s long-term potential and management execution so far impress. But its valuation, relative to other software providers, has run too far, too fast.”

Xero rallied in February 2015 after announcing large investments from a leading Silicon Valley venture capitalist, Accel Partners, and from the company’s largest institutional investor, Matrix Capital Management. These blue-chip investors bring a lot more than just money to the table and are a serious validation of Xero’s quality and prospects.

Moreover, the looming MYOB listing on ASX, worth up to $2.25 billion, creates valuation perspective for Xero, which is worth $3.17 billion but has much stronger growth prospects overseas.

Brokers seem to love or avoid Xero on valuation grounds. Macquarie Wealth Management has a $12-month target of A$24.30 and downgraded its recommendation to underperform in late March. Macquarie wrote: “In our view, at the current share price the risk/return balance is unattractive. This is not a reflection of our view on the operating momentum of the company or quality of management. The reverse is true, and we concede that if Xero can maintain 80% growth rates its valuation metrics improve.”

Understandably, the market struggles to value companies like Freelancer and Xero that rack up large losses in the pursuit of market-share growth and the eventual monetisation of large audiences. Or recognise the latent strategic value of a dominant industry position online.

Both stocks have higher risks at current valuations. They were more attractive three months ago. But both are trading well below their peak historic valuation, look reasonable on projected valuation, and have attracted some strategic investors to their register.

Even so, SMSFs need care with disruptors such as Xero, Freelancer, OzForex Group, iSentia Group, 3P Learning or other tech-based companies with a growing global footprint. Allocating a small proportion of the portfolio equity to such stocks is critical. If they fail, portfolio damage is minimised; if they succeed, long-term returns can be spectacular.

– Tony Featherstone is a former managing editor of BRW and Shares magazines. All prices and analysis at March 31, 2015.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.