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Why I’d still buy ‘overvalued’ multi-baggers Gear4music Holdings plc and Keywords Studios plc

Online musical instrument retailer Gear4music (LSE: G4M) and technical services provider Keywords Studios (LSE: KWS) have rewarded investors handsomely over the last year with share price rises of 494% and 235% respectively before today.  

Despite this wonderful performance — and the massive valuations now attached to both stocks — I think there could be further upside ahead. 

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Still in tune

While fairly light on detail, today’s AGM trading update from Gear4music saw CEO and founder Andrew Wass confirm that the business was trading in line with expectations with revenue growth in both in the UK and its international markets continuing to be “strong relative to a very strong H1 FY17“. Recently opened European distribution centres in Sweden and Germany are “materially improving” Gear4music’s presence in Northern Europe and further sales momentum is predicted in H2.

As previously announced, the company expects the current financial year to follow a “more typical seasonal trading pattern” with sales and profits weighted towards H2. First-half numbers — due in October — will also take into account costs relating to the aforementioned distribution hubs and the firm’s new premises in York. 

As updates go, today’s statement was hardly doom-laden. In keeping with investors’ tendency to wildly overreact when anything less than perfect is announced by a market darling however, shares fell over 12% in early trading.

Today’s sell-off is surely overdone. The company’s plan to become one of the largest musical instrument retailers in Europe still feels both realistic and achievable given the quality of its online offering, hugely positive customer feedback and growing presence in a highly fragmented industry. The oversubscribed £4.2m fundraise back in May was also a huge indication of how confident institutional investors are in the company’s long term prospects. 

It’s never pleasant to see a holding plummet so far in one day but my belief in Gear4music remains as solid as ever. Indeed, although a forecast 31% rise in earnings per share in 2018/19 will still leave the company trading at a heady 60 times earnings, I regard today’s fall as an excellent opportunity for growth focused investors to build a position.

Game on

Although a degree of profit-taking appears to have already commenced following yesterday’s superlative 19% rise, I simply can’t see shares in Keywords going anywhere but up over the medium-to-long-term, such is the potential for companies operating in the hugely lucrative gaming industry.

Yesterday’s ahead of expectations half-year update made for very pleasant reading. In the six months to the end of June, revenues grew by 50% to €63.7m and adjusted pre-tax profits by 60% to €9.6m. With one exception due to tough prior year comparables, all of the company’s service lines registered organic growth on a like-for-like basis.

Much of my bullishness on Keywords is due to its acquisition-friendly nature. The Dublin-based business has made four purchases since the beginning of 2017 alone, including one that allows it to enter the market for video games-related software engineering services. Given the €35m credit facility agreed with Barclays back in April, I suspect this spree will continue over the remainder of the financial year, such is the firm’s goal of becoming the go-to company in its niche.

The valuation of 45 times forecast earnings may look seriously high but given the potential growth that lies ahead, it may still be a price worth paying.

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Paul Summers owns shares in Gear4music and Keywords Studios. The Motley Fool UK has recommended Keywords Studios. 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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