It’s been a very interesting Australian full-year reporting season already, with stock prices reacting to results in a similar way American stocks do to quarterly earnings. Quite simply, good results have been rewarded and weak results punished. That may sound obvious but it’s really about results versus what market expectations were. If the result leads to consensus FY17 upgrades, the stock tends to re-rate, and vice versa. This again confirms the old adage “it’s a market of stocks, not a stock market”.
Thankfully, the vast majority of Australian stocks the AIM Global High Conviction Fund owns have passed the earnings test. We have also had a takeover bid for Vitaco (VIT) – a stock I have recommended in these reports.
We have also had strong results from Baby Bunting (BBN) and Class (CL1), reminding that growth is never cheap on P/E’s, but if you buy the right price to growth multiples (PEG ratio) in structural growth sectors, and the company delivers, the share price rewards can be strong.
BBN has been a good one for us and hopefully you too. We have owned BBN since the IPO and first recommended it to Switzer readers in November 2015 at $250m market cap. The market cap today is $375m which equates to a +50% share price gain.
I must inform you that we have lowered our BBN exposure above $3.00 a share feeling the share price and forward P/E of 28x now reflects most of the positive attributes of the company. No doubt BBN has been “discovered” by the market and we wouldn’t be surprised to see the stock trade in a $2.75 to $3.30 trading range for the next 12 months. Most broker analysts also have 12-month BBN share price targets in that range and some downgraded recommendations from “buy” to “hold”, which is entirely appropriate after the huge share price gains and in line with our thinking.
Don’t get me wrong, BBN has delivered exactly as we had hoped/forecast, but we do think it’s time for the share price to have a period of consolidation. My long-term view of this debt-free category killer company is unchanged.
As you know, I only invest where I see structural growth. I need to see sectorial tailwinds in a sector and then own one of two stocks with the best earnings leverage to that structural growth theme.
Superannuation Services is a genuine structural growth theme in Australia. The legislated growth in compulsory superannuation contributions, combined with the structural change towards self-managed superannuation, is driving exponential growth in companies who provide services to the SMSF Army and their financial planner advisers.
One such company is Class (CL1), which provides cloud-based software services to an increasing number of SMSF investors and their advisers. From our conversations with financial planners, Class’ product is best in “class” and that is evidenced in the full-year results which confirmed strong growth on all fronts.
Class is Australia’s major provider of cloud-based software for SMSF administration. Class has over 112,000 billable portfolios amongst its client base, with over 110,000 portfolios using the “Class Super” product. Class also has a non-SMSF product, Class Portfolio, launched last year, which has 1,827 funds on its platform.
We believe Class’ core market has plenty of scope for further growth and market share gains. According to Class, their core market is accountants with between 25 and 500 funds. Class estimates that this accounts for around 57% of the total SMSF market. Of this, around 20% are class users, which gives significant scope for further penetration by Class.
Class currently has 20% market share in the SMSF administration market in Australia. The cloud currently represents around a quarter of the total SMSF administration market, and Class has about 2/3rds of the cloud-based SMSF administration market. Current growth in Class’ billable portfolios is over 15,000 per half, representing around 30-35%pa growth. Analysts estimate strong growth in market share continuing with Class achieving 45% market share by 2025.
Class added 30,600 billable portfolios in FY16 which drove underlying EPS +64%. That FY16 result was around +4% ahead of analyst estimates and has led to analysts revising up their FY17 forecasts.
In reality, Class is growing its share of a structurally growing market. That leads to growth on growth, if management continues to execute well, and that is why this stock commands high forward multiples.
The five drivers of growth are:
- Growth in billable portfolios on the Class Super platform
- Growth in the number of SMSF’s in Australia
- Continuing shift towards cloud-based SMSF administration
- Growing the ‘Partner fee’ revenue channel
- Growth in funds using the Class Portfolio Product
Even better, this is a debt free company ($15m net cash) that is funding its growth organically.
Let’s have a look at a few slides from CL1’s FY16 results presentation.
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The Class investment idea is one of those classic ideas you can check yourself. As myself and my investment team have done, ask your financial planner or accountant if they use the Class Super product and what do they think of it? I’ll be very surprised if you don’t get the same glowing feedback we got that did and continues to drive us to own CL1 shares.
As with Peter Lynch theory, the best investment ideas you can see with your own eyes in everyday life. It is likely that a high percentage of you are actually using the Class Super product. If you are, either directly or indirectly, my view is it also makes sense to own CL1 shares and share in the growth of the company as others discover this excellent product.
Of course, when I type the investment arithmetic below many of you will scream ‘expensive’. Sure, if you think all companies are created equal and should therefore trade on the same P/E you are right, but that is absolutely NOT the way to approach equity market investing as all companies were certainly not created equal and those demonstrating structural growth in structurally high ROE’s command structurally higher P/E’s.
I invest on price to growth ratios (PEG). Any stock where the prospective EPS growth is higher than the prospective P/E is potentially “cheap” on the way I look at things. This approach is serving our investors well in a world where structural growth is hard to find, and value traps easy to find.
Similarly, you want to invest in the industry disruptors, not the disrupted. This is why I own so few top-20 Australian stocks (in fact I am short a few). Most have significantly higher P/E’s than their prospective EPS growth, and most are at risk of being disrupted at the margin by new competition. Incumbency breeds arrogance (e.g. WOW, Australian banks) and arrogance breeds susceptibility to being disrupted. It’s also worth remembering that high-dividend yield usually means low growth. You also need to consider whether those high dividend yields are supported by sustainable payout ratios.
Broadly, I believe the outperformance of Australian small/mid-caps over top 20 stocks will continue because it’s all about who is growing and who isn’t.
That is why at AIM, our Australian investments are all small/mid-cap industrial growth companies who we think will continue to be in consensus earnings upgrades cycles.
CL1 trades on 41x FY17 consensus EPS forecasts which expect +46% EPS growth. That’s a PEG ratio of .89x, and on that basis, I continue to believe there’s significant upside in CL1 shares in the next 18 to 24 months.
I must remind you however, that CL1 is a small-cap stock with associated low liquidity. The market cap is $400m and any investment in CL1 must be sized appropriately inside an equity portfolio.
In summary, the reporting season in Australia is differentiating where growth is and isn’t. We have taken some profits in Baby Bunting (BBN) and increased our exposure to Class (CL1).
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.