On Wednesday, ASOS (LSE: ASC) reported a 68% crash in pre-tax profit and a 70% slump in earnings per share. Yet its share price climbed 20% on the day of the announcement. Welcome to the upside-down world of growth investing.
For years, I’ve been warning readers against the dangers of buying into soaring stocks when they’re on super-high valuations as, time and time again, I’ve seen such growth stories inflate and then burst.
ASOS has been a textbook example, with the shares soaring to almost £78 in March 2018, since when they’ve crashed back to current levels of around £30. The shares, incidentally, were on a P/E of 79 at their peak, based on that year’s eventual EPS figure.
How many shares have I seen that I’ve ever thought were worth such a high valuation? I really can’t think of a single one I’ve ever bought at anything close to that level.
You might point out that ASOS’s current woes are down to unpredictable warehouse problems, with the company saying it had “underestimated the impacts of large scale operational change being executed on two continents simultaneously” and that “with the benefit of hindsight, we were not adequately prepared for the additional complexities.”
But yes, that’s exactly it. Every new company will experience unanticipated problems. That simple fact is possibly about the only reliably predictable thing we can say about growth stocks. Oh, and that when such problems crop up, the share price will be hammered.
In the case of ASOS, the problems were known and the crash happened long before its full-year results were out. But could the same happen to online fashion rival Boohoo (LSE: BOO) now?
Well, Boohoo has the distinct advantage of not being a first mover and not testing untrodden ground — it’s often not the first movers in a new direction who have all the success. So Boohoo can, in theory at least, learn from the mistakes ASOS has made and endeavour not to make the same ones. But there are other mistakes.
Boohoo is also performing exceptionally well this year too, with first-half revenue up 43% and adjusted EPS up 46%. Global expansion is going well, with international trade now accounting for 44% of total revenues. Sentiment is very much in the company’s favour and keeping its name trending on social media can only help draw attention to it as an investment proposition.
But the problem I see is that share price valuation, with the stock on a P/E of 52 based on full-year forecasts. If those predictions prove accurate, Boohoo would need to see earnings per share multiply 3.7-fold in the coming years for the P/E to drop to around the FTSE 100 average — and that’s only if the share price doesn’t rise any further.
Now, that might well happen, and current brokers’ price targets for up to 350p (around 25% higher than current levels) might come good. But I think I’m seeing a lot of optimism already in the share price, and against that possible 25% upside I’m seeing no safety margin to offset the downside risk.
And when something goes wrong, which it inevitably will (even if it’s not of the same order of magnitude as ASOS’s problems this year), I think we could see a share price crunch.
Alan Oscroft has no position in any of the shares mentioned. The Motley Fool UK owns shares of and has recommended ASOS. The Motley Fool UK has recommended boohoo group. 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.