Here some common examples of what an investor would say when passing on a company by looking only at today’s valuation:
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“It’s a cyclical at low P/E, therefore the cycle is likely peaking or has peaked.”
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“They are dealing with something potentially temporary; I’ll wait until we get some clarity before buying.”
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“That is way too expensive, I don’t care how good of a business it is.”
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“That’s too cheap. Something is up and the market knows.”
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“It’s cheap, but the industry is in decline.”
This is by no means an exhaustive list. I’ll go through my own experience with each of the above.
The obvious examples of looking at the current or trailing valuation is cyclicals. These businesses will trade at a dirt-cheap price to earnings or cash flow usually as the cycle turns against them. Then they trade at infinite earnings (or negative earnings) as the cycle turns. We all know this. There are some different ways to look at the business, so we don’t fall for buying a cyclical at 3x P/E right before they start bleeding cash.
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Using forward earnings estimates. This is probably the easiest if you own a company with many analysts following. Having said that, my experience is that analysts tend to overestimate what the market will pay for a business with low certainty and declining fundamentals.
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Taking full cycle earnings and attempt to value the business based on “smoothed” earnings. This can be done, but I am not great at it. Nothing operates in a vacuum, so what worked one cycle may not work in another. They tend to rhyme but not repeat.
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Valuing based on assets. This could be book value, tangible book value or replacement cost. All of them have their pros and cons. I tend to favor a multiple of tangible book for cyclicals. I look at prior cycles for the business and peers. If the business is dramatically different than last cycle, then this will be too noisy to use as an indicator.
For this example I will use VMD. The business was affected by the shutdowns during the pandemic. They managed to pivot and provide contact tracing in several locations. During this time the OIG announced the findings to an audit they performed on VMD. The report was released in May 2021, but the audits where from cases submitted to 2016/17. OIG claimed that VMD used incorrect coding and was overpaid by Medicare. They claimed that VMD was not meeting Medicare requirements for 98 of the 100 cases audited.
The company responded shortly after claiming no wrongdoing. Of course, the stock got hard hit. VMD traded at nearly $9 in May 2021 and was down to $7.50 shortly thereafter. As well, the business was transitioning off the contact tracing contracts faster than the legacy business was ramping back up after reopening. The shares went all the way down to under $4.
I remember reading the OIG report a few times as well as going through some other reports to see if they had merit and what the consequences would be for VMD. The transition off covid based revenue back to the base business was a bit cloudy. The largest unknown was the OIG finding, but even if they had to repay all the amount, the stock was still cheap in my opinion. Eventually the claims were overruled, and the base business resumed its growth rate. Both the issues turned out to be temporary in nature.
When a business that has been growing gangbusters goes to just growing fast, the market may struggle to find an appropriate valuation. Many businesses grow at an insanely fast rate due to a low base and being at the front end of the demand curve.
An example of when I overpaid was Biosyent (RX.to). I took a position in early 2017. The top line had grown from 3 million in 2011 to almost 21 million in 2017 due to the launch of their iron supplement (Feramax). The market took the stock from well under $1 to over $10 in 2014. Since then, the stock was down about 40% as the market was grappling with a slower growth rate. I was not expecting the hyper growth from 2011 to 2014 but was still expecting north of 20% per year. After a couple of quarters, it was clear that I overestimated the growth rate. I sold my shares at a hair above break even. Revenue has still grown from 21 million to 31 million in the last 5 years which is impressive. But my initial entry point of over 14x EV/EBITDA was too expensive given the growth rate and reliance on a single product.
I am a sucker for a dirt-cheap valuation. That’s why it was so hard to hold XPEL as it become more and more expensive. XPEL right before the pandemic was trading around 20x EV/EBITDA. Today it’s around 16x. EBITDA went from 19 million to 75 million over that time. So even with the high initial valuation, the stock is up from $15 to $50. Of course, if you did the work on XPEL like many investors (or just piggybacked when others did the work like I did) you would have seen how much white space was available for XPEL in the next 5 years. They managed to outgrow the valuation compression, which is no easy task.
I don’t want to minimize this specific example as many times the market can sniff out a bad quarter or a rough year ahead of time. Shares will trade down without any news and then the bad quarter hits. I had a couple of examples of when the market was right and when it wasn’t.
CPH is probably the best example of this when the market isn’t correct. A couple years ago CPH was trading at a FCF multiple of 3-4x without removing the cash (and 2-3x removing excess cash). They had a new CEO and taken out a ton of expenses. There is/was risk with the isotretinoin portfolio, but the Canadian market looked stable which would easily justify more than the market cap at the time.
Another example the market (and me) missed was ADF Group (DRX.to). Shares were available for under $2 al the way until the end of 2022 and for under $1 during the pandemic. The business is lumpy, but trailing revenues were growing fairly consistently since early 2021. The business has a highish fixed cost structure so it doesn’t take a genius to see how they could grow earnings much faster than revenues. Trailing revenues went from 175 million to nearly 300 million, while EBIT went from 12 million to over 40 million. I was asleep at the wheel on that one.
The businesses may be losing money today or barely breaking even. They are likely investing heavily for growth and not looking to show a ton of IFRS earnings. Many early-stage businesses look like this.
You could put many of the covid winners here. The example that immediately comes to mind for me is MTLO. I bought the stock in late 2020 based on high growth, low capital requirements at scale, heavy insider ownership and a valuation based on ARR. My expectations failed to materialize, and the business never really scaled. MTLO has since needed capital (a few times). I was bailed out by the frothy market in 2021 around technology companies and managed to keep my loss at 10% or so. The company is down over 80% since I sold.
Another example is OneSoft (OSS.v). I was quite early on this one. I took an initial position way back in mid 2017. They didn’t have a ton of revenue and were losing money. They were introducing a solution that would be downright disruptive. The sales cycles is very long. Over the years they have grown revenue by having more miles ingested from current customers, additional add on modules and winning new logos. They are now a bit above break even. When I bought the company was at something like 20-22x price to sales. Today it’s around 9x trailing and 6x forward.
What I learned from my experiences is that one needs to take a deeper look at the underlying assumptions before passing on an opportunity. Yes, there are many immediate negative qualifiers, but if it’s a business that I would own then spending some time looking at the bet makes sense. The market may be “fairly” efficient but it does offer up opportunities all the time if you are willing to look (and hold of course).
Feel free to leave some of your own examples in the comments.
Thanks for reading.
Dean