Picture this: an under-researched small-cap stock reports soaring earnings growth. The share price rallies and brokers issue buy recommendations and favourable reports.
Early investors tell everyone they know about the company. The financial media writes bullish stories on the stock, driving further price gains. Fund managers who have long stopped buying the stock on valuation grounds, comment favourably on it in the press.
The market and media laud company management and the board. The CEO’s profile rises. Emboldened by the gains, the company aggressively raises equity capital to fund overseas acquisitions. It needs a fresh story for the market and sees global growth as its ticket.
As hype builds, small investors buy near the share-price peak. Fund managers who bought earlier have scaled back their holdings or sold out. Small investors do not realise the stock is “priced for perfection” and requires unrealistic earnings growth to justify its valuation.
Inevitably, the company starts to miss market expectations with its profit growth. Investors, itching to take profits, dump its shares. More analysts question the valuation and the media hunts for bad news. The slightest problem is amplified and the price tanks.
Small investors give up on the stock, believing the best is behind it. Brokers switch their attention to the next big thing and the stock’s profile falls. Investment media write fewer stories about the company, even though price falls have brought it closer to value territory.
I’ve seen this scenario play out many times over the years. Seduced by hype, smaller investors chase market darlings higher and higher, only to give up on them when they disappoint. They focus too much on price and not enough on value, damaging portfolio returns.
Domino’s Pizza Enterprises shows what happens when star stocks lose favour. Shares in the pizza chain soared from about $5 in 2010 to $76 in 2016 – extraordinary growth for a retail business selling a highly commoditised product in an intensively competitive market.
Chart 1: Domino’s Pizza EnterprisesSource: The Bull
Domino’s could do no wrong. Some commentators argued Domino’s was becoming a technology company because of its superior food-ordering and delivery systems and should be valued as such. Investors loved Domino’s expansion strategy in Europe and Japan.
Then bad news struck. Domino’s missed earnings guidance for FY17; there were revelations about staff underpayment at some stores; and CEO Don Meij sold some shares this year when Domino’s was buying back stock, creating a perceived conflict of interest.
If that was not enough, the Parliamentary Inquiry in Franchising and the Financial Services Royal Commission’s recent focus on loans in the sector spooked investors on Domino’s and other franchising stocks. Investors fear greater government regulation in the sector.
This confluence of bad news drove Domino’s to $39 earlier this year, wiping billions off its market capitalisation from the price peak. The stock has since spiked to $51 and some good judges are upgrading their recommendations, amid the gloom.
Macquarie Equities this month lifted its recommendation to outperform, from neutral. The investment bank believes the outcome from the franchising inquiry will be negative for the sector, although manageable for Domino’s and its franchisee network.
Domino’s European growth outlook is another tailwind. Stores there earn less than half the profit of their Australian peers, creating scope for earnings gains. As Domino’s opens more stores in Europe, economies of scale will improve per-store performance.
Macquarie acknowledges that Domino’s requires a strong second half to meet full-year earnings guidance. It says the football World Cup in Russia from mid-June is a “potentially large positive” given that Domino’s has stores in Germany, France, Belgium and Australia.
With each country competing in the tournament, one can see football-loving fans eating more pizzas as they watch games on TV. The time difference is good for Europe, though not great for Australian football fans who must stay up to 1am on the East Coast to watch a live match in Russia at 6pm. Still, the World Cup should boost Domino’s FY18 result.
The key issue, as always, is valuation. Domino’s is on an estimated Price Earnings (PE) multiple of about 27 times in FY19, using Macquarie’s earnings-per-share growth forecasts and the latest share price. That does not seem excessive for a business that can grow at double-digit growth rates annually and make further earnings-accretive acquisitions offshore.
Macquarie wrote in early June: “Our upgraded recommendation is premised on near-term downside earnings risk … being less than previously thought and the medium- to longer-term earnings outlook skewed to the upside because of the Europe opportunity. Whilst (Domino’s) may no longer deliver us the growth rates of previous years, it arguably no longer needs to, following a meaningful de-rate in valuation.”
An average share-price target of $48.59, based on the consensus of 11 broking firms, suggests Domino’s remains overvalued. Macquarie’s 12-month target is $55.
I’ll stick with the bulls on this one. The market has priced in lower growth in Domino’s at the current share price and it has plenty of challenges.
Although I don’t see Domino’s getting close to its previous price peak anytime soon, this is still a quality company with an expanding global footprint and scope to beat market expectations in the next few years.
Also, plenty of short-sellers who bet Domino’s would fall further have been squeezed in recent week. If Domino’s recovery continues, short sellers will be forced to buy stock to cover their position, thus supporting further share price gains.
Domino’s clearly ran too far, too fast at its price peak. And fell too far when the market panicked. Investors who recognised the pattern of an overhyped market darling – and the value that is created when irrational selling erupts – can make money again on the pizza king.
But they will need at least a three-year outlook and tolerance of higher risk.
• Tony Featherstone is a former managing editor of BRW, Shares and Personal Investor magazines. The information in this article should not be considered personal advice. It has been prepared without considering your objectives, financial situation or needs. Before acting on information in this article you should consider the appropriateness and accuracy of the information, regarding your objectives, financial situation and needs. Do further research of your own and/or seek personal financial advice from a licensed adviser before making any financial or investment decisions based on this article. All prices and analysis at June 6 2018.