Price-earnings (PE) multiples have a habit of trapping unwary investors. A stock with a low PE that looks cheap keeps falling because it is poor quality. Another with a high PE seems expensive but the price keeps rising because of the company’s outstanding earnings growth.
Investors who base decisions on simple rules of thumb learn a painful lesson: the numerator in the PE multiple (price) is an imperfect market signal and often wrong; and the denominator (earnings per share) is hard to forecast accurately with high-growth companies.
Seek, REA Group and Carsales.com are good examples. All are high-growth stocks and high PE stocks, and all have looked expensive for years. I recall some small-cap fund managers years ago saying they could not buy the online advertising stocks given 40-plus PE multiples.
One of my favoured investment strategies over the past five years has been buying Seek, REA and Carsales.com on price dips during market corrections and pullbacks. That is usually the best hope of buying outstanding growth stocks at cheaper prices.
Moreover, there is a good case that investors should ignore PE ratios or any financial metric that uses market price as an input. The market is often wrong in the short term, yet we use its signals to create financial metrics such as PE ratios or dividend yields.
Instead, look at the PE multiple as one of several metrics when judging a stock. Others such as return on equity, which shows how hard the company sweats each dollar of shareholder funds, give great insight. Companies with high, rising ROE are ones to watch.
Caveats aside, do not be put off with high-PE stocks. Yes, extra care is needed buying stocks on a PE of 30 times that are priced to perfection. The key is understanding their quality and whether future earnings stream warrants paying a multiple of more than twice the market average.
Pacific Smiles Group is an example. The dentistry group listed on ASX through a $42-million IPO in November 2014. Its $1.30 issued shares leapt to $1.70 on debut and by March 2015 Pacific Smiles was $2.50. At its peak, the forecast PE multiple was about 38 times 2014-15 earnings, based on consensus analyst forecasts.
Chart 1: Pacific Smiles Group
Source: Yahoo Finance
On paper, that looked rich for a company with five months history as a listed entity and for one in dentistry, a steady growth industry but hardly the next boom market.
Investors could have taken profits or given up Pacific Smiles after such strong gains and it looks like many did with the share price hitting $2.14 this month. That is a mistake: Pacific Smiles has excellent growth prospects and the dental industry is more attractive than many realise.
This column has had a favourable view on the other ASX-listed dentistry group, 1300 SMILES, for several years. I wrote about 1300 for The Bull in July 2014, in ‘Dentistry star filling the value gap‘. It has risen from $6.20 to $6.55 since then.
Chart 2: 1300 Smiles
Source: Yahoo Finance
1300 has a more conservative growth strategy than Pacific Smiles, much to the chagrin of some small-cap fund managers who would like 1300 to expand faster. But it is hard to fault 1300’s long-term record and careful approach to value-adding acquisitions.
Pacific Smiles is more aggressive. It is opening dental practices in shopping centres, an unusual approach given most are usually found in suburban shopping strips.
Founded in 2003, Pacific Smiles has 47 dental centres, 220 dentists and will have about 500,000 patient appointments this year. But even that only gives 2 per cent market share of an estimated $8.7-billion dentistry market, where the largest competitor has a 5 per cent share.
Like 1300, Pacific Smiles is benefiting from an incredibly fragmented market: lots of one-dentist clinics with baby-boomer owners looking to retire, work part-time, or sell to a corporate owner and work in the practice, free from admin and other complications.
Pacific Smiles wants to open six to 10 practices each year and has identified more than 200 potential areas. Its return on invested capital is more than 50 per cent and underlying earnings have grown around 24 per cent annually over six years.
I like aggregators that have surplus cash flow and can fund organic growth internally; the outstanding veterinary clinic, Greencross, is an example. They can open or acquire more practices without taking on large debt or through excessive share issuance that dilutes shareholders. When growth slows, they can ease back on the investment to maintain earnings.
About a third of Pacific Smiles clinics are less than three years old, meaning significant potential for faster growth as they build patient numbers and mature. Average fee growth was 7 per cent over the past five years; as Pacific Smiles earns more revenue from a larger number of practices, revenues and earnings will start to snowball.
I like its strategy to open clinics in shopping centres. As the population grows, more people are spending time in large centres that are becoming entertainment precincts rather than pure shopping outlets. Nobody would say a visit to the dentist is entertainment, but having your local dentist at the shopping centre is convenient for many people.
Also, high foot-traffic at shopping centres means Pacific Smiles might attract those who are lax with annual visits to the dentist and increase patient numbers. An oversupply of young dentists means there is scope to service a larger patient base.
I am always wary of buying stocks after they soar, and equally wary of giving up on them based on what has happened rather that what might. Pacific Smiles has an excellent record, has done everything right since listing on ASX, has a good position in a long-term growth industry, and has some hallmarks of exceptional companies. It clearly came to market too cheaply.
Its strong, reliable earnings growth justifies a high PE multiple and further share price gains, albeit at a slower pace from here, making it a high-growth stock to watch.
Tony Featherstone is a former managing editor of BRW and Shares magazines. The column does not imply any stock recommendations. Readers should do further research of their own or talk to their adviser before acting on themes in this article. All prices and analysis at May 21, 2015