Successful growth stocks are often worth buying at high prices. But when the wind changes, it often makes sense to make a sharp exit. Today I’m looking at two growth stocks where I believe the valuation has become dangerously stretched.
How did that happen?
Shares of stock market darling Hargreaves Lansdown (LSE: HL) fell by 3% this morning after the fund supermarket surprised investors with a dividend cut.
According to the firm, the group’s “growth in scale and complexity” has led the Financial Conduct Authority to review the amount of spare cash — known as regulatory capital — that Hargreaves must hold.
Market analysts had priced-in a special dividend for 2017, but the company now believes that this isn’t affordable. Hargreaves will only pay its ordinary dividend this year, without any extra.
Is this a profit warning?
Today’s news definitely isn’t a profit warning. The group said today that pre-tax profit is expected to have climbed by 21% to about £265m for the year ended 30 June, in line with forecasts.
I think today’s slide is a useful warning of what could go wrong with this highly rated stock. Although Hargreaves has plenty of cash, we now know that much of this is encumbered by regulatory restrictions.
A second risk is that much of the firm’s income comes from fees levied as a percentage of assets under management. This means that if the stock market falls, fees fall. A stock market correction could hit profits hard.
Hargreaves’ stock now trades on a forecast P/E of 30, with a prospective yield of 2.1%. I don’t think this is very attractive, given the risks. I’d consider investing elsewhere.
Predicting the future
Management at market research and data analytics company YouGov (LSE: YOU) made a prediction of their own today. They advised investors that full-year profits for the year which ended on 31 July are expected to be “ahead of expectations”.
Investors celebrated the good news by pushing the group’s share price up 5% to 271p. I’m afraid that this valuation is ringing alarm bells for me.
Adjusted earnings for the year just ended were expected to be 10.3p per share. After today’s announcement, this should rise. I’d estimate about 11.5p per share. This would put the stock on a forecast P/E of 23, which doesn’t seem too bad for a fast-growing small-cap.
However, this adjusted figure is likely to contain some very large adjustments. I think these flatter the true profitability of this business.
For example, the group’s adjusted earnings for the first half of last year were 4.2p per share, but its reported earnings were just 1.4p per share. I don’t have space here to analyse these adjustments in detail. But my view is that many of them represent recurring annual costs — such as software development — which should be included in a fair measure of profits.
For this reason I believe it’s more appropriate to value YouGov based on its reported earnings per share. On this basis, this stock has a trailing P/E of 77. I think that’s much too high, given that its profit margins are pretty average.
I expect a sharp correction at some point, and would consider selling some stock after today’s gains.
One growth stock I'd buy
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Roland Head has no position in any shares mentioned. The Motley Fool UK has recommended Hargreaves Lansdown. 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.