Winter is coming

Winter normally means good news for share prices. There seems to be an element of this expectation around this year, but at the same time there is quite a bit of talk of overvaluation and the possibility of an imminent correction. I’ve seen several articles warning investors to look out for the signs of euphoria that would indicate the bull market is coming to a close. This is easier said than done! While the mood is probably a bit ‘more euphoric’ than last year, I think there still seems to be a healthy enough degree of scepticism about (and cash on the sidelines) to support another leg in the rally.

Most of the stocks I sold last week have bounced back to some extent, leaving me feeling a little foolish. As mentioned in my portfolio review, I think my strategy needs some tweaking around the timing of scaling up and then selling positions, so I don’t give up my smaller gains so easily. It seems pretty clear that scaling up as the price rises is something I should do more selectively. I’m also planning to have a closer look in a future post at how to identify situations when it might be a good idea to take profits on my winners before the momentum reverses.

This week I’ve bought three new positions. I’ve bought back into Micro Focus, a long time favourite of mine, at near its all time highs. I’ve written about it quite a bit before so won’t again here. I’ve also bought new positions in Avon Rubber and Facebook, completing my set of the US tech giants: Apple, Amazon, Google and Facebook. Long term these all seem to have pretty great prospects to me and surprisingly, with the exception of Amazon, aren’t even really all that highly valued.

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Avon Rubber

Avon Rubber makes specialised rubber products, mostly importantly respiratory protection equipment. It is an international business selling mainly to governments through framework contracts and the like.

Quality

  • Business economics: it is a profitable business with decent margins (13%) and returns on capital (18%). It generates a lot of free cash flow and has net cash on the balance sheet.
  • Track record: Avon has an excellent track record. Since the financial crisis in 2008, it has had consistently growing revenues and profits. The rate of growth has been pretty fast too – over 20% CAGR for the last five years. The share price has steadily risen too for the most part but has failed to make much progress for the past two years.
  • Competitive advantage: in its annual report, Avon Rubber describes itself as the global leader in advanced respiratory protection systems for a number of markets. A quick bit of online digging seems to support this and identifies only a few other small specialised competitors for its respiratory masks. This niche has some competitive benefits for Avon – customers care a lot about quality and are probably reluctant to switch to unproven but cheaper alternatives. This probably creates some barriers to entry. However, while it appears to have some competitive advantage, Avon has to sell its products through competitive tenders to large public sector customers who sometimes face budget constraints and become more price sensitive. I think this limits the scale of any economic moat it might have. From my (somewhat limited) research, the strength of Avon’s competitive advantage appears sufficient for me to consider it as a investment candidate, but only just.
  • Growth prospects: Avon is optimistic about its prospects for continued growth and given its track record I’m inclined to believe this optimism. It is able to sell its products globally and I believe this means there is a large addressable market still to play for. The demand for respiratory protection systems seems unlikely to be very cyclical, suggesting Avon may also have some defensive characteristics. However, I note that profits and the share price fell very substantially in 2008.

Price

Avon recently announced results ahead of expectations and the share price is on the cusp of breaking out to new highs after a two year period of consolidation. The valuation seems very cheap relative to the prospects for continued growth, given Avon’s successful track record. Current forecasts don’t seem to reflect management’s current optimism. It feels that the market is perennially pessimistic in its expectations for Avon Rubber. I think there is a good chance that Avon can continue to confound these overly pessimistic expectations and if it does so there is scope for a substantial rerating to bring the valuation more in line with other businesses of its calibre.

 

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Facebook

As measured by adoption and usage, Facebook is the most successful thing in history. It operates a social network used by almost a quarter of the world’s population and monetises it through offering the capability to carry out incredibly targeted advertising.

Quality

  • Business economics: Facebook’s business model is extremely profitable and scalable with fairly fixed costs and, in some senses, little additional investment required to support growing revenues. I say in some senses as it does need to invest to keep innovating. Facebook has very high margins, returns on capital and cash flows.
  • Track record: the track record is pretty impressive. Facebook has recent track record of extremely rapid growth in revenues and profits. Since listing at an at the time seemingly expensive valuation in 2013, the share price has risen steadily increasing in value six times.
  • Competitive advantage: I think Facebook has one of the strongest competitive advantages of any company I can think of. Its platform benefits from huge network effects ie that users benefit from all the other users on it. These network effects would make it very hard for a similar sort of platform to compete. In addition to the network effects, the large amounts of personal information stored on the platform makes it hard to see many of its users ever switching to something else. This personal information also means Facebook can offer an unrivalled ability for advertisers to carry out targeted brand advertising. The biggest threat to Facebook may actually come from regulation but I’m not overly concerned about this either.
  • Growth prospects: growth in adoption and usage of Facebook looks set to continue at quite a pace for a little while yet. In the longer term I think Facebook’s platform could give it an advantage in providing all sorts of services.

Price

The share price is in an uptrend near all time highs. Facebook recently massively beat its earnings expectations, but warned that it could face increased costs from improving security. I don’t think the latter is something to worry about too much in the long term. The valuation seems cheap given the quality and growth prospects.

 

2 thoughts on “Winter is coming

  1. Avon: You haven’t mentioned that it has a £300m pension scheme, with a £33 – 44m deficit (depending on which measure). Cash contribution to the deficit was £1m this year, rising to £1.5m next, reviewed in 2019. I hold, but to me the valuation seems more reasonable and less cheap with the pension issues accounted for.

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  2. You’re right – I hadn’t considered the pension deficit, which is relevant for the valuation. Thanks for flagging.

    There’s also some net cash on the balance sheet that I haven’t really accounted for in thinking about valuation. While these factors are relevant, I think they are much less significant than the growth prospects in determining how cheap Avon is. I don’t think it makes sense worry about them too much in the bigger picture, though I will mentally adjust my valuation accordingly.

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