These high-flying growth stocks could be hazardous to your wealth

Roland Head explains why he’s steering clear of these growth stocks.

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Shares of nearly-new used car specialist Motorpoint Group (LSE: MOTR) motored 6% higher to 155p when markets opened today, after the firm said sales had accelerated 12.7% to £822m last year.

But these early gains soon stalled, perhaps because pre-tax profit fell by 30.7% to £11.7m last year. This pushed adjusted earnings down by 13.6% to 12.7p per share. One bright spot for shareholders was that a final dividend of 2.9p per share means the full-year payout has risen to 4.23p per share, giving a yield of 2.8%.

Why have profits fallen?

These figures seem to suggest that profit margins collapsed last year. That’s not entirely true. Despite a slow period following the EU referendum last year, Motorpoint’s gross profit margin on each car sold was almost unchanged, at about 7.6%.

Profits fell because of costs relating to site openings, and rising administrative costs. The value of the firm’s inventory of used cars rose by £23.5m to £98.4m last year, as it increased stock levels to support a higher number of sites.

That seems reasonable enough, but I’m concerned about the increase in overheads. Administrative costs rose by 50% last year, from £24m to £32m. Does an increase from 10 to 12 sites really require such a hefty increase in overheads? I’m not convinced.

While trading appears to remain strong, my view is that Motorpoint may not be very well positioned to deal with a slowdown. The group has increased stock levels, opened new branches and scaled up its central overheads. A slowdown could cause profits to collapse. It currently trades on 12 times trailing earnings with a yield of 2.8%. I wouldn’t chase this one any higher.

Is the market turning on this stock?

FTSE 100 newcomer ConvaTec Group (LSE: CTEC) makes medical supplies such as colostomy bags. Sales rose by 2.3% to $1,688m last year, which is the kind of pedestrian growth I’d expect from a business like this.

However, recent acquisitions and restructuring appear to be driving a big improvement in profit margins. ConvaTec’s adjusted operating margin rose from 26.5% to 28% last year. Adjusted earnings per share rose by 30% to $0.13 in 2016, and are expected to rise by a whopping 46% to $0.19 per share in 2017.

Given all of this, you may think that the shares deserve their lofty forecast P/E rating of 22. That may be so, but I’m concerned that investors face several risks that could limit further gains.

My first concern is that net debt is high, at $1,722.9m. ConvaTec’s ratio of net debt to adjusted EBITDA was three times at the end of 2017, well above my preferred limit of two times. Interest costs are also high — the group spent $270.6m on cash interest payments in 2016. That’s equivalent to more than half its adjusted operating profit of $472m.

It’s also worth noting that this rapid earnings growth isn’t expected to continue. Analysts have pencilled-in forecast earnings per share growth of 9.9% for 2018, leaving the stock on a 2018 P/E of 20.

The shares have already fallen by nearly 10% from their peak of 349p. In my view, further falls are likely as the stock’s valuation adjusts to reflect ConvaTec’s high debt levels and likely slower future growth.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

Roland Head has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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