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3 stocks to take profits on in the new financial year

Here are three market darlings due for a pullback or pause

When commentators talk of contrarian investing they usually mean buying unloved stocks, preferably when they scream value. Owning stocks the market detests takes guts.

Another form of contrarian investing is harder: selling stocks the market loves. Having bought the stock early and been rewarded many times over, you can’t let go. Greed takes over and you forget that every stock has its price.

I know this first-hand. Whenever I identify ‘sell’ ideas, criticism follows. Some readers detest the idea of media “talking down” a company they own. Others are so blinded by the company’s success they do not recognise that its future growth is priced into the stock.

I have also encountered readers who misinterpret the notion of sell. They equate it to dumping all their stock in the company immediately and avoiding it. Or they believe a sell recommendation implies something is wrong, when the idea might be purely on valuation grounds; that is, a great company is overvalued because the market is too optimistic.

Professional investors take a different approach. They look to buy high-quality companies when they are undervalued, add to their position and lighten it as the price rises. They might exit their position if the price runs too high, but typically do not buy or sell in one swoop.

This observation is not meant to blunt the ‘sell’ ideas below. Or fence-sit. Rather, it is to provide context that each idea below is for a high-quality company that looks overvalued after recent price gains.

Each warrants profit-taking at the current price, not a wholesale dumping. Early investors in these companies could lighten their position to protect capital gains and reinvest in cheaper stocks. True believers, who are willing to take higher valuation risk, might maintain a smaller position to share in any further upside.

Always seek financial advice, or do further research of your own, before acting on such ideas. Selling stocks has tax and portfolio implications. It’s one thing to identify attractive stocks for all readers, and another to identify stocks to sell, because that narrows it to investors who own the companies or short-sellers who punt on share prices heading lower.

Caveats aside, here are three overvalued stocks that warrant profit-taking. I’ll add three more next week.
 

1. Kogan.com (KGN)

Kudos to Kogan.com and founder Ruslan Kogan. The online retailer has starred in an ailing sector. Amid hype about Amazon’s entry into Australia, and how that will crush retailers, Kogan.com has soared from a $1.80 issue price in its 2016 float to $7.20, after peaking at $10.

Kogan.com has not missed a beat. Earnings have exceeded market expectation, customer numbers have leapt, the service is popular and the company is well run. Kogan.com is superbly leveraged to the boom in online retailing and has a first-mover advantage in its key categories.

Kogan.com initially welcomed Amazon’s entry into Australia, saying it would quicken the move to online retailing. Amazon’s impact here has been somewhat lacklustre, but it would be crazy to write off one of the greatest companies in history.

Also, Kogan founders have been selling shares, a move that sent the price lower this quarter. Founders, like everyone, have bills to pay, but selling big parcels of shares is never a good look because it implies management believes the stock is overpriced.

Further price weakness is likely as the market uncertainty in Kogan.com, at the current valuation and with Amazon ramping up operations, grows.

At $7.20, Kogan.com is on a trailing price-earnings (PE) multiple of 42 times. The stock is not widely covered among broking firms, making consensus forecasts unreliable. Suffice to say the market believes Kogan.com’s rapid earnings trajectory will continue well into the future, despite rising competition from Amazon and traditional retailers in e-commerce.

Chart 1. Kogan.com (KGN)

Source: nabtrade

 

2. Reliance Worldwide Corporation (RWC)

Reliance is hard to include on this list. I have highly rated the plumbing products innovator since it listed on the ASX at $2.50 and commented on it favourably several times for this Report and on Peter Switzer’s Money Talks program on Sky. Reliance is now $5.34.

I still rate Reliance’s market position, management and capacity to expand overseas. It is one of the best mid-cap floats in years. But the $1.22-billion acquisition in May of John Guest, a global leader in push-to-connect plumbing fittings, strengthens the case for profit-taking.

The UK-based John Guest looks like a good deal: it makes strategic sense, given the product crossover between the two companies. The market liked the news, driving Reliance sharply higher.

The John Guest acquisition cost, reasonable given the deal’s valuation metrics, was about half of Reliance’s market capitalisation before the deal. That’s a huge bite for any company to swallow. Too many Australian firms over the years have come unstuck with overly aggressive acquisitions offshore that failed to deliver and weighed on the core business.

I do not think that will be the case with Reliance but its valuation, after soaring gains over 12 months (a 67% total return), leaves little room for error. Early investors in Reliance should take some profits and maintain a smaller holding to benefit from any further upside.

It is hard to see Reliance soaring in the next few months as the market digests the deal. Morningstar values Reliance at $3.40. I’m not that bearish but am wary of small and mid-cap companies that bet the farm on big overseas acquisitions. Too many have burned investors.

An average price target of $4.46, based on the consensus of five broking firms (too small to rely on) suggests Reliance is overvalued at the current price.

Chart 2: Reliance Worldwide Corporation (RWC)

Source: nabtrade

 

3. Afterpay Touch Group (APT)

The financial technology (fintech) company has rocketed from $3 in early 2017 to $8.47. Afterpay’s lay-by concept, where products are paid for in four instalments, has caught on with young consumers and retailers eager to reach them.

Afterpay has a valuable first-mover advantage in retail and terrific potential to expand in the US, having signed up the giant Urban Outfitters there as a partner in the concept.

The company will be several times larger if it replicates its Australian success in the US and early signs are encouraging.

However, I have four main concerns, given Afterpay’s valuation. First, the market is already factoring in strong growth in the US and any disappointment could crunch the share price. Goldman Sachs this year reportedly attributed $1.50 of its $6.30 price target for Afterpay to the US operations. The market believes the US business is worth a lot more at Afterpay’s current price.

Second, Afterpay’s form of lending (lay-by) is hardly new or unique. That’s not to downplay Afterpay’s innovation in finding a form of lay-by that appeals to the psyche of young consumers, or its first-mover advantage as it quickly signs up more retailers to the service. Having a larger network of retailers using the service can be a “barrier to entry” in itself.

But Afterpay’s moat (its competitive advantage) is not as defendable as other tech companies with sky-high valuations. I’ve noticed rival lenders increasing their presence in this market, and Afterpay’s success will surely attract extra attention in the US.

Third, some good judges I know are concerned by Afterpay’s bad-debt provisions. They think it’s too low given this form of lending and Afterpay’s target market of younger consumers (who don’t always pay their debts). I’m not as concerned, but it’s something to watch, if levels of bad debt climb.

Fourth, Afterpay founders sold some shares recently, a move that did not seem to concern the market. Regulatory risk is another issue, if greater disclosure is required in late fees and other compliance issues. The market might be underplaying this risk at Afterpay’s valuation.

In fairness, Afterpay is one of the best floats in years and deserves its status as a fintech poster company. But a forward PE multiple of more than 70 times, based on consensus estimates, is high even by tech standards. The valuation, based on earnings-per-share growth of about 100%, leaves no room for error and makes Afterpay susceptible to heavy price falls.

As with others on this list, early investors in Afterpay could take some profits and maintain a smaller holding to share in any further upside. Should a correction occur, they will have cash to buy back in at lower prices in a stock that has excellent long-term prospects but has run too far and fast for now as the market embraces fintech.

Chart 3. Afterpay Touch Group (APT)

Source: nabtrade