Stocks to Watch · Thu 06 April 2017 01:39 PM

Four quality stocks

QBE:ASX
DMP:ASX
GXL:ASX
XIP:ASX

By Tony Featherstone

It does not take much to unleash the bulls these days. We’re supposedly in the bull market’s third phase or the investment clock’s final quarter – the part where prices zoom.

Never mind that the perma-bulls have been positive for years, misread the bear market and destroyed capital. Even a broken clock is eventually correct, as they say.

For the record, I too am more positive on the market this year – a position I outlined for the Switzer Super Report earlier this year. Not enough to believe the market will take off, but more confident in what remains a long, grinding recovery.

Still, I’ve written on markets long enough to know that second-guessing sentiment is a mug’s game. Far better is focusing on companies, valuing them and thinking like an investor rather than a speculator, and blocking out as much market noise as possible.

The goal should be to buy exceptional companies when they trade below their intrinsic (fair) value. For many investors, that means buying high-quality companies during bouts of irrational market or company-specific selling.

Below are four stocks that fit the bill. For interest, I’ve chosen a large-cap, mid-cap, small-cap and micro-cap stock. Each is a quality company trading well below its share-price high, and starting to pick up again after heavy bouts of selling.

1. Large-cap: QBE Insurance Group (QBE)

I nominated QBE for this report last year as part of a feature on stocks that benefit from rising United States interest rates. QBE has rallied from $10.22 (since that mid-October column) to $12.85 – a 25% gain in less than six months.

The market is focusing mostly on QBE’s “macro” story. The insurer benefits from US rate rises because most of its investment portfolio is in long-duration assets, such as bonds. QBE’s share price is historically correlated to the yield on US 10-year Treasuries. If one believes US bond yields are turning higher, as I do, QBE has further to run.

QBE’s “micro” story also appeals. As I wrote in February, QBE delivered one of the market’s better interim profit reports, relative to market expectation. The decline in global insurance pricing is starting to ease, margins are modestly improving and QBE is becoming more efficient. Some big headwinds for QBE are slowly becoming tailwinds.

The market is underestimating QBE’s turnaround. An average share-price target of $10.92, based on the consensus of 13 analysts, looks too conservative.  QBE is due for a pullback or consolidation after its rally in the past six months, but the three-year outlook is improving.

Takeover speculation and revelations about the personal relationship between QBE CEO John Neal and his assistant have overshadowed the operational gains. That’s an opportunity.

Chart 1: QBE

Source: ASX website

2. Mid-Cap: Domino’s Pizza Enterprises (DMP)

The market for years underestimated the pizza franchise’s earning growth. One fund manager after another said Domino’s was badly overvalued, yet it kept rallying, becoming one of Australia’s great companies in the process.

Now the market is overestimating Domino’s problems. Revelations about some Domino’s franchisees underpaying staff hurt confidence in the company’s operating model, cash flow, and brand. It coincided with the fourth-quarter correction in mid- and small-caps.

Domino’s fell from a 52-week high of $80.69 to $52.18, wiping billions of its market capitalisation. It is the market’s twelfth most shorted stock based on Australian Securities and Investments Commission data. Sentiment has turned sharply against Domino’s.

Make no mistake: Domino’s was overdue for a correction. I would not buy the stock anywhere near $80. Talk about Domino’s being valued like a technology stock and its plans for drone-deliveries seemed like hype, to justify an inflated valuation. I nominated Domino’s as a stock to sell for this report in December 2016 when it traded just below $70.

Beneath the gloom, Domino’s issued a record profit in its FY17 interim report and upgraded full-year guidance. Operationally, Domino’s is flying.

The company’s offshore divisions, particularly in Europe, are significant growth engines. Locally, Domino’s ordering and delivery technology is a valuable competitive advantage that provides pricing power. Look at how Domino’s disrupted the pizza market with cheap pizza.

I visited a store recently to buy half a dozen pizzas for a kid’s birthday party. The value was undeniable ($5.95 pizza that tasted okay), the service was quick and Domino’s menu has expanded into higher-margin desserts and drinks. Like or loathe its pizzas, Domino’s has a formidable fast-food offering, providing it can improve franchisee governance.

After heavy falls, Domino’s has risen to $57.87. Do not expect Domino’s to retest previous price highs anytime soon: it has much work ahead to restore market confidence. But the stock is finally offering glimmers of value after its correction.

Chart 2: Domino’s

Source: ASX website

3. Small-Cap: Greencross (GXL)

The integrated vet clinic and pet products retailer was one of best floats in years, its shares soaring from a $1 issue price in the May 2007 Initial Public Offering to $10.78 in 2014. Investors loved the company’s strategy to consolidate the fragmented vet industry.

But fears of rising competition for vet clinics and thus higher prices, and Greencross’s big acquisition in pet retailing (through Petbarn) eventually weighed on the stock. The market needs time to digest Greencross’ acquisition spree. The stock fell to $5.75 last year.

Greencross has since rallied to $7.29 but the market appears to be hesitant, waiting for more evidence that the company’s integration strategy is working. The potential is cross-selling veterinary services and pet accessories to a growing customer group.

I like Greencross on three fronts. First, the vet industry remains highly fragmented with more than 2,200 practices in Australia, many run by baby boomers who will look to exit their practice in the next five to 10 years by selling to a corporate owner.

The ASX-listed National Veterinary Clinic, making good headway (it too looks undervalued), is small in the scheme of the industry. There’s some talk of US companies entering the Australian vet market and the industry conditions look good for now.

Second, pet retailing has good long-term growth prospects as consumers spend more on companion animals and pet insurance. The $12-billion industry has grown 42% since 2013 and shows no signs of slowing as consumers spend more on their ‘fur babies’.

Third, Greencross’ FY17 interim result was slightly better than expected and further confirmation that its integration strategy across vet clinics and pet retailing is working. Revenue and cost synergies from its acquisitions are becoming more apparent.

A forecast Price Earnings (PE) multiple of about 15 times FY18 earnings is not overly demanding given Greencross’s dominant position in a growth industry and cross-selling prospects as it encourages Petbarn consumers to use its vet clinics.

Chart 3: Greencross

Source: ASX website

4. Micro-cap: Xenith IP Group (XIP)

My preferred micro-cap, Catapult Group International, was covered in last week’s Switzer Super Report. So this week I’ve included Xenith IP Group, the intellectual property services group that listed on ASX through a November 2015 Initial Public Offering.

Xenith raised $55 million at $2.72 and followed in the footsteps of IPH, a larger intellectual property firm that was one the market’s star floats, before its sharp falls in 2016. QANTM Intellectual Property was another IP float last year.

IPH had a rollercoaster ride, soaring from $2.10 a share in November 2014 to $9.26 in early January, before tumbling to $4.76. Weaker-than-expected earnings and some senior partners selling stock as escrow provisions were lifted crunched IPH’s share price and hurt sentiment towards intellectual property stocks.

Xenith was caught in the downdraft, falling from a 52-week high of $3.94 to $2.07.

Intellectual property services is an attractive industry. Clients pay upfront for service, unlike in ‘no-win, no-fee’ law firms, and the customer base tends to be sticky. That’s why some IP firm have more than a century of history: it’s a steady sector with lower client turnover.

At $2.07, Xenith trades on a forecast PE of about 10 times FY18 earnings. Care is needed given the small number of forecasts on which this is based. But the company looks undervalued given its prospects for organic growth and through acquisitions, and its estimated 4 per yield.

I’ll cover Xenith and QANTM in greater detail in coming issues, but suffice to say it looks like one of the better-value micro-caps, for experienced, risk-tolerant investors.

Chart 4: Xenith

Source: ASX website

 

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By Tony Featherstone

Tony Featherstone is a former managing editor of BRW and Shares magazines. All prices and analysis at 30 March 2017. The information in this article should not be considered personal advice. This content, provided by Switzer Super Report, 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. This article does not reflect the views of nabtrade.

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