Spurred by fears on Wall Street about over-stretched stock valuations, global equity markets fell on Friday from Asia and Europe, as investors looked for safer havens. At least these were the headlines du jour.
The Nasdaq composite, which has been hit in recent days as investors bailed out of high-flying 
technology and biotech shares, slipped anew. The index on Thursday had recorded its biggest single-day percentage loss since November 2011. This should not come as a surprise.
With the strong gains on Canadian and U.S. over the past 24-months has come a rise in the level of broader valuations. In fact, in a few specific segments including tech (social media and new tech) and biotech, valuations have been driven to lofty levels with investors chasing growth as confidence has increased.
While there are a number of companies we are very interested in buying at present, quite frankly they are not cheap. As such, this year we included 8 such companies in our Cash Rich Report which we consider to check off most of the boxes we look for in an investment including excellent balance sheets with strong net cash positions, strong cash flow generation and good to great growth in solid businesses.
The rub however, is in the fact that the valuations both individually and collectively are currently premium – and the markets are beginning to take notice. At present, we are not able to currently purchase these attractive companies on the cheap. The type of selection criteria that has led us to companies like Enghouse Systems Limited (TSX:ESL) and C-COM Satellite Systems Inc. (TSX-V:CMI) in recent years. Both technology (software and hardware) related companies that possessed strong growth and were bought at reasonable to very cheap prices. In other words, they embodied GARP.
In fact, we can reference about 15 stocks from the past 2 years that, at the recommendation date, traded at 3-10 times earnings with strong growth, great balance sheets and positive outlooks. Contrast this with the 8 companies we included in our “Cash Rich, But Not Cheap” research note to our clients where we see price earnings multiples from 50-200 times and price to cash flow which average in the range of 40, and there is reason to be wary when investing at such levels.
At times investors can be wise to “pay up” or pay a fair to premium price to purchase great companies. Many pundits will say you get what you pay for. To a point we agree, but as we have shown over time, it is possible to buy great companies at good to great value. But we do not believe in buying growth at any price or GAAP stocks. For all the Amazon’s and Twitter’s there are countless companies (tech or otherwise) who initially posted or promised growth only to fall off the proverbial investment cliff when it slowed or was not delivered. This is what unrealistic growth expectations can lead to – it is a rare company that lives up to or leaps this type of high bar long-term.
In an investment, there are often two components we are looking for to achieve price appreciation – 1) Above average annual earnings growth. 2) Multiple expansion.
You can achieve the above average earnings growth component if the company continues to grow net income at 25-100% (for example). Indeed, in recent times, the majority of the companies on this list have continued to do so which has been positive for their share prices. However, as we will noted, this can be a difficult level to sustain and when a stock trades at premium valuations, the market expectations are high and any misstep can lead to severe corrections.
For example, company A has growth of 35% and trades at 8 times earnings. Company B has growth of 35% and trades at 30 times earnings. Both could theoretically maintain the same earnings multiple and see their share prices rise by 35% (the growth in their earnings). It is far more likely that the Company A could see a doubling in the PE multiple the market awards it from 8-16 (given its growth and the fact the average stock on the market trades at 18-19 times earnings) than Company B moving from 30-60 times earnings. Remember Company B already trades at a premium to the average stock which is tough to sustain at the best of times for great companies.
We favour investing in Small-Cap Growth stocks which have the potential for both above average annual earnings growth and multiple expansion. This is difficult to do when you are paying prices that are a significant premium to the market average. While several of the 8 quality companies on our list will likely continue to grow and continue to be long-term winners. Our margin of safety on each company is less.
To give you an example of what can happen to a premium priced, albeit good company when it reports a stumble in earnings we reference the Q3 results of Lonestar West Inc. (LSI:TSX-V), which were reported at the end of November in 2013 with the stock trading at $4.00. While revenues increased smartly by 34.8% to $8.3 million in the previous year equivalent quarter, net income declined sharply to $91,981 from $664,585 in the previous year equivalent quarter. The stock subsequently lost over 32% of its market value in a few months since. When valuations are premium (PE or price to cash flow ratios are high), expectations are high. If they are not met we can see a sharp correction. Of course, when stocks with lower premiums miss expectations, they can drop as well, but there can be a floor, book or break of value at times which has the potential to hold the stock.
Another example from the list is Kelso Technologies Inc. (KLS:TSX-V), a railroad equipment supplier that designs, produces and sells proprietary tank car service equipment used in the safe loading, unloading and containment of hazardous materials during transport. This is a solid market at present and the company has posted strong revenue, cash flow and earnings growth this past year. The balance sheet is strong as well. We like the business and the growth, but in the $5.00 range at present it trades at over 100 times last year’s earnings. This multiple can shrink with further growth as we expect, but with the average stock on the TSX trading somewhere in the range of 20 times earnings the premium we are asked to pay for this growth is high. Good company, but it might not be at a price which gives us both the growth or margin of safety we are looking for long-term.
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Sincere regards,
Ryan Irvine,
President & CEO
Web: www.keystocks.com
Email: rirvine@keystocks.com
Phone: 6 0 4 – 2 7 3 – 1 1 1 8
