High growth is how I like it

Sometimes I’m tempted to choose shares with slower growth and a higher dividend yield. However, this isn’t my usual preference. Instead, I’m searching for the highest returns I can find. Almost always, this comes in the form of a sturdy growth stock.

Alfa is a business focused on providing software solutions to the asset management industry. This is a high-barrier-to-entry field with specialised requirements. Particularly at the moment, financial institutions are investing heavily in tech to become more efficient. Therefore, the shares are well-positioned to continue growing.

While its position in the market is formidable, it does face heavy competition. This includes FIS, which is a much larger firm with a broader portfolio. Its international presence could be a significant inhibition of Alfa’s potential for expansion as it already dominates the market share.

A rich valuation

Strong growth always comes at a price. With a price-to-earnings ratio of 28, Alfa is not cheap. Its valuation has also been rising over time, meaning that the market is fully aware of the impressive expansion on offer here.

The valuation is a reason for me to be cautious. In my opinion, it opens up a significant chance of volatility if the company fails to meet its high growth expectations.

Therefore, it’s important that I diversify my portfolio thoroughly. This will help to protect me if the stock price falls because the company has a bad quarter or year.

Taking risks is worth it

Just because a company has a high valuation, doesn’t have to mean the stock is too expensive for me. On the contrary, a rich valuation can often mean the firm is well worth investing in. If many people think fondly of a business and buy its shares, a rising price is a good signal that management is operating well.

Therefore, I’m quite comfortable taking on the valuation risk with Alfa shares. With a strong annual revenue growth rate of 7.5% estimated by analysts for the next three years, the company isn’t showing any signs of slowing down soon.

One thing to bear in mind is that this investment only comes with a small dividend yield of 0.6%. Therefore, if I do decide to invest in it, I’ll really be investing in its growth prospects, not its income potential.

Patience, selection and prudence

I always take my time when choosing businesses to add to my portfolio. Warren Buffett taught that it’s not the number of investments we make that matters but the quality of those we choose. Considering his company, Berkshire Hathaway, is nearly at $1trn in market cap, I’d be wise to take his advice.

For me, Alfa is a strong company, but it’s not the best I’ve found. Therefore, I’m going to keep looking. There are plenty of even stronger investments that The Motley Fool frequently identifies.

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Investors are cheering Alfa’s latest financial results, which show underlying profits up 22% during the first half of the year. I’ve been taking a look to see if I’d like to add this very profitable business to my portfolio.

A strong performance

Alfa makes software that’s used by large automotive companies and other customers for asset finance, such as car loans. A key selling point is that Alfa’s software can replace multiple third-party systems, providing a single platform to track loans, funding, and repayments.

Today’s results show that revenue rose by 12% to £41.1m during the first half of the year, excluding the impact of currency rates. Operating profit for the period was 22% higher, at £11.4m.

The group continued to win new business and the total value of its current order book rose by 30% to £125m. Alfa’s net cash balance also rose by 35% to £50m during the half year. This is more than needed, so the company plans to return £30m to shareholders through a special dividend of 10p per share.

Expensive but good?

I think Alfa has many of the characteristics I look for in a high-quality business.

Like many software businesses, Alfa is gradually switching its customers from standalone licensed products to subscription services. The company’s latest platform — version 5 — is cloud-based and management say that a growing number of customers are signing up for this upgrade.

Subscription revenue now accounts for 28% of revenue, up from 20% one year ago. I expect this to continue rising, providing reliable, predictable cash flow. 

Another attraction for me is that profit margins are very high. Alfa’s latest numbers show an operating profit margin of 28%. That’s in line with the group’s historical performance. High margins generally drive strong cash generation. This allows a business to fund internal growth without needing much debt — that’s good for shareholder returns.

Where next for this growth stock?

I can see a lot to like about Alfa. But even the best company is only a good buy at the right price. Are Alfa shares still cheap enough to buy? I’ve been crunching the numbers.

Management now expects full-year revenue to be around 4% higher than previously expected. My sums suggest that this still leaves the stock trading on around 26 times forecast earnings.

In addition, shareholders are set to receive a 10p special dividend in addition to the company’s regular 1p annual payout. With the stock at 178p, that gives Alfa a useful dividend yield of 6% for the current year.

The main risk that concerns me is that the company is heavily dependent on contract renewals and new customer wins. If work is delayed or cancelled — as we saw in 2019 — profits can fall well below expectations. Failure to convert enough customers to subscription services could also hit profitability.

I’d like to do more research on this business. But if everything checks out as I expect, I would consider buying Alfa shares for my portfolio at current levels.

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I try to make the most of my ISA allowance every year. I focus on growth companies and income stocks to try and maximise the benefits of these wrappers. 

UK shares to buy

A couple of companies on the market stand out to me right now as being tremendous ISA investments. The first stock is Alfa Financial Software (LSE: ALFA).

As its name suggests, this enterprise designs and develops software for the asset finance industry. This is an incredibly defensive market because organisations buying the company’s software are unlikely to change their providers regularly. 

The group is currently chasing some significant new contracts, with 10 prospects in its late-stage pipeline. Even without these new prospects, the company expects to report revenue growth of 5% for the year. 

Despite the sticky nature of its product, Alfa’s growth shouldn’t be taken for granted. If the company underspends on research and development, or suffers a significant cyber attack, customers may move elsewhere. 

This risk aside, I’d buy Alfa for its growth potential as an ISA investing champion. 

Technological change 

Another company I’d acquire is RM (LSE: RM). This education software business recently reported a 21% increase in revenues for the six months ended 31 May. Statutory profit before tax increased 213% in the period. This allowed the group to reinstate its interim dividend at 1.7p. 

RM’s education business has benefited from the ongoing digitisation of school infrastructure. This has accelerated during the pandemic, and I think it will continue. Technology adoption has accelerated in many sectors over the past year. I believe it’s improbable the world will ever go back to the methods used before the pandemic. 

Based on this view, I think RM’s profits and sales will continue to grow, and the company may be able to increase its dividend further in the years ahead. Those are the reasons why I’d buy the stock for my ISA today. 

Key challenges the group will face are competition and higher costs. The software sector is incredibly competitive, and if the group doesn’t keep up with its competitors, it may lose market share. 

ISA investing for income 

The final company I’d buy for my basket of UK shares in a Stocks and Shares ISA is Ferrexpo (LSE: FXPO). This iron ore miner is an income champion. Unfortunately, it may not be suitable for many investors for environmental and governance reasons. Iron ore mining is an environmentally damaging process, and the enterprise is majority-owned by just a few shareholders. 

These risks aside, it’s been able to capitalise on rising iron ore prices over the past 12 months. According to the company’s 2020 financial results, earnings before interest, tax, depreciation and amortisation increased 46%.

Strong earnings allowed the group to eliminate its debt and announce a special dividend for 2020. Total dividends for the year amounted to 52p, giving a dividend yield of 11% on the current share price. 

This income potential is why I’d buy the stock for my ISA today. 

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Though customer numbers rose by 18%, the firm’s loan book was up 9% and revenue came in 12% ahead, adjusted profit after tax fell by 24% and adjusted EPS was down 31%. But the company said its “full-year guidance for key operating metrics remains unchanged,” and the interim dividend was hiked by a big 66% to reach 3.1p per share.

On today’s share price, we’re looking at a prospective P/E of only 4.1. That’s a very low valuation, but we need to understand the nature of the business.

Guarantor loans

Amigo offers guarantor loans to people with poor credit ratings who can’t borrow from conventional lenders, and it charges an APR of 49.9% for the privilege. That makes me twitch, but it’s at least a lot better than short-term payday loans that can come with an APR of more than 1,000%.

Is that risky? Amigo reported an impairment-to-revenue ratio of 31%, up from 23% a year previously, and that, along with a provision for complaints, is behind the fall in profit. The firm reckons it’s in line with guidance, but it does concern me.

Do I think the shares are a buy? There has to be regulatory risk associated with Amigo, and we’ve seen a number of sub-prime lenders struggling and going under. But I do think the low valuation overplays the risk, and if it wasn’t for personal ethical issues, I think I’d be buying.

Finance techie

Another morning riser that’s caught my eye is Alfa Financial Software (LSE: ALFA), whose shares gained 7.7% approaching noon.

Like Amigo Holdings, the Alfa share price has slumped badly since flotation, currently down 68%. But it’s been edging up gradually in recent months, and since August’s low, we’ve seen a 56% gain.

Alfa is a bit of a blue-sky growth prospect with only modest profits so far, billing itself as “a leading developer of mission-critical software for the asset finance industry,” and that instantly screams caution to me.

Alfa failed to convert early sales through to the profit levels it was expecting, and the crash is exactly what happens when a hot growth stock turns ex-darling.

EPS fell 31% in 2018, and analysts have a further 60% collapse on the cards for this year before things are predicted to level off in 2020. That still puts the shares on a forward P/E of around 36, but new contract wins suggest a turnaround in fortunes might come sooner than expected.

Contracts

On 8 November, Alfa won what chief executive Andrew Denton described as a “high-profile contract with one of the UK’s most ambitious challenger banks.” That was followed on 19 November by another new contract win, this time from “the German subsidiary of a major international bank,” with the bank said to be “one of the largest automotive finance providers in Germany.”

With £53m cash and no debt at the halfway stage at 30 June, Alfa Financial looks in good shape and could be set for a growth rebound. But the valuation is still too rich for my low-risk tastes.

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Take Experian (LSE: EXPN) for example. This is one of the world’s largest and most experienced data management companies, best known for its credit-rating services, although this is just one part of the group. 

The company also uses data to help other businesses and brands connect with customers as well as offering services to help enterprises streamline their operations with the use of data.

Fat profit margins 

The great thing about data is that, unlike other commodities, it’s relatively easy and cheap to collect, especially for companies like Experian which dominate certain parts of the market. 

Because data is relatively cheap to collect, but customers are willing to pay a premium to get hold of the information, Experian books an impressive operating profit margin of 24%, putting it in the top 25% of the most profitable companies listed in London today.

Experian is also highly cash generative. For the financial year ending 31 March 2018, the company reported a free cash flow of $769m. Management is returning virtually all of this free cash flow to investors. Last year, for example, Experian paid out a total of $392m in dividends and $565m in share buybacks.

Growth continues

I think this trend will not only continue, but cash returns will increase. Thanks to the world’s ever-increasing demand for data and data services, Experian’s earnings per share have grown at a compound annual rate of 29% over the past six years. 

With this being the case, it’s no surprise that shares in Experian have returned 19.5% per annum for investors over the past 15 years, turning every £1,000 invested into £16,300.

So, even though its shares trade at a forward P/E of 26.5, I think they have the potential to make you rich as Experian continues to build on its leading position the global market for data collection and data management.

Complex product 

As well as Experian, I’m also interested in Alfa Financial Software (LSE: ALFA). In some respects, this is another data play. The company develops mission-critical software for the asset finance industry, a highly valuable and regulated market.

Unfortunately, shares in Alfa dived last year after it warned on trading due to the slower than expected conversion of its sales pipeline. This extra friction caused the group’s revenue to fall by 19% for the year, and operating profit declined 34%. However, like Experian, the company is highly cash generative and its net cash balance increased 43% to £45m during the year, even though growth slowed.

Management is optimistic the headwinds that held it back in 2018 won’t be repeated. Alfa is currently progressing contractual discussions with a new sizeable European customer. It’s also entered the second phase of implementation for an existing multinational customer, which should produce a positive outcome this year, according to Alfa’s 2018 results release.

City analysts think the company will return to growth in 2019, and I’m inclined to believe them. They’re expecting the group to report earnings per share of 6.3p for 2019, up 16% year-on-year and giving a forward P/E of 19.7. This multiple might seem expensive at first glance, but when you factor in the business’s operating margin of 38%, I think it’s a premium worth paying.

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However, while some growth stocks have made their investors rich, others have struggled lately. Here are the three worst growth stocks of 2018 so far. 

Rising costs

Growth star Asos (LSE: ASC) has fallen from grace this year as investors have baulked at the group’s escalating capex spending. 

Even though the company announced a 27% increase in sales for the six months ending in February, the firm is having to spend more to keep its edge over competitors. For the next two years, Asos is planning to spend £230m-£250m on logistics and distribution facilities, up from initial guidance of £200m-£220m.

Compared to current City forecasts for net profit of £81m for fiscal 2018, this figure is significant. With shares in Asos trading at 52 times forward earnings, management can’t afford to disappoint investors. 

Unfortunately, it looks as if this is what it has done. After rising 13% during the first quarter of 2018, it slumped following results. The stock is now down 13% for the year, a decline of 26% from the peak. 

To rebuild investor confidence, Asos needs to prove that it remains ahead of the competition, and the only way to show this is with profit growth. But I believe there could be further declines ahead.

Bust IPO 

Last year, Alfa Financial Software (LSE: ALFA) made a splash as the biggest IPO in London. The company has not lived up to the hype. Year-to-date the stock has cratered 70%.

Earlier this year, the company issued a profit warning announcing that a major customer had paused its implementation of Alfa’s software, following data migration issues. As well as this headwind, the group also warned that contract completions with two other companies were taking longer than expected.

As a result, City analysts believe the group will miss revenue expectations for the year by around £20m, which is a big deal. Analysts have slashed EPS expectations for the year from 11.4p to 5.5p. Even at this lower level, the stock looks expensive, trading at 26 times forward earnings. 

I like to avoid companies where the loss of just one client can make or break a year of performance and Alfa is no different. In my view, the risk here far outweighs the reward. 

Failed acquisition 

In 2017, Animalcare Group (LSE: ANCR) completed what management initially described as a transformative acquisition with Belgian veterinary business Ecuphar.

The deal has been transformative, but not in the way management or shareholders might have hoped. Integration is proving tricky. Full-year results for 2017 showed a decline in EBITDA margins from 13% to 11% as difficult trading conditions forced the enlarged enterprise to slash prices. Cash profit fell 9%.

Investors have lost trust in the highly-rated company. The shares are down 50% year-to-date and nearly 60% since the merger. The valuation has fallen from a forward P/E of 31 in September 2017 to just 11.7 today. The one good thing about the decline is the stock now looks cheap, but I would wait for further evidence that the business is back on track before buying.

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This is why I believe Alfa Financial Software (LSE: ALFA) and Microgen (LSE: MCGN) are perfect buy-and-forget growth stocks to hold for the next 10 years.

Profits double 

Today Alfa reported its first annual results since its IPO last year, showcasing its strengths. The company, which provides “mission critical software for the asset finance industry,” announced today that revenue for 2017 rose 20% to £88m, or 9% year-on-year to £86m at constant currency. Pre-tax profit surged to £34m, double last year’s reported figure of £17m.

However, it seems that the market is displeased with management’s growth outlook. Due to currency fluctuations, growth is expected to slow in 2018. Specifically, alongside today’s numbers, CEO Andrew Denton said a backdrop of a weakening dollar means the board expects to report low double-digit top line growth on a budget rate, or mid double-digit growth on a constant currency basis. It seems investors have also been disappointed by the lack of a dividend announcement for the year.

Still, despite this downbeat outlook, the long-term opportunity ahead of Alfa, and its peer Microgen, is tremendous. For example, Alfa estimates its addressable software market is over $3bn, compared to its current revenue run-rate of £88m ($123m).

City analysts are expecting the firm’s earnings per share to jump 15% for 2018 after last year’s surge in profitability. And as long as Alfa continues to provide a professional service to clients, I believe earnings can continue to grow at a double-digit rate for the foreseeable future.

Growth through acquisitions 

Bolt-on acquisitions are another tactic Alfa can use to boost growth. Microgen has chosen this route, using organic cash flow to buy up growth. In August of last year, the firm announced the acquisition of RevStream Inc, a California-based provider of revenue management enterprise software expanding its portfolio of mission-critical software businesses.

Following this deal, and others like it, the firm’s adjusted earnings per share increased by 39% to 17.1p for 2017, smashing City estimates of 15.2p. After this strong performance, it looks as if analysts are behind the curve with the company as they were expecting earnings per share of 18.3p for 2018. Considering 2017’s outperformance, I wouldn’t be surprised if analysts revised their forecasts for future growth substantially higher in the months ahead.

Unfortunately, the one problem with both Microgen and Alfa is that the shares currently command a high valuation. Shares in Microgen are trading at a forward P/E of 27.8 and Alfa is trading at a forward P/E of just under 40. While high, these valuations reflect the bespoke and sticky nature of these businesses’ revenue streams and future growth potential.

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Whether you view short sellers as an integral part of a healthy capital market or opportunistic parasites, the accusations have likely done interested investors on the outside looking in a favour. IQE’s once astronomical valuation has now come down to a more palatable 38 times forward earnings. But this valuation still prices in several years of expected growth, which is always risky with fast-moving tech firms.

An additional worry is that the short sellers’ reports do raise valid questions about the group’s corporate governance structure. Now these could be nothing more than growing pains of a previously tiny and obscure company that is now unexpectedly in the limelight. But I’ve seen too many AIM-listed stocks wilt under poor corporate governance standards to invest in IQE right now due to questions surrounding its relationship with joint ventures and accounting practices.

Another issue giving me pause is the group’s rapid expansion. In November, it issued shares representing 9.9% of its previously issued capital to raise £95m for expansion purposes including a significant increase in the volume of machinery at its new foundry. While the group’s sales are currently rising at a brisk pace and it’s good to see management investing to meet demand anticipated several years out, there’s always the risk that changes in the industry could see the company saddled with excess capacity.  

Likewise, while IQE supplies a series of chip makers rather than just one or two, its sales are still fairly concentrated. The industry is also undergoing rapid changes with a series of acquisitions, business model shakeups and customers squeezing suppliers’ margins. As a small player in the wider industry, these changes risk buffeting IQE’s fortunes, which together with short sellers’ concerns make the company’s valuation too high for me to invest in the stock right now.

This recent market entrant makes a splash 

I’m much more interested in Alfa Financial Software (LSE: ALFA), which designs and supplies software for the asset financing sector. Like IQE, Alfa trades at a lofty valuation of 38 times forward earnings. But I believe the sticky nature of its product — which is used by financial institutions such as RBS and carmakers such as Mercedes-Benz North America — and rapid growth warrant such a premium.

In the half year to June, the group’s sales leapt 29% year-on-year in constant currency terms to £45.1m as it landed two new contracts, completed three software implementation programmes, and increased recurring revenue streams from existing clients. Looking forward, there’s still plenty of room to grow as its software is in high demand from a range of lenders looking for an easy-to-use, unified programme to keep track of and service loans.

With the founder-led management team investing in building up the company’s developer ranks, the group’s large sales pipeline should be quickly converted into cold hard cash. And with a large net cash position, high profitability and plenty of room to grow, I think Alfa could be a great long-term holding. 

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Well, sort of. Management isn’t targeting its first annual profit since 2007 until next year and qualifies that this target is based on the still-to-be-decided size of its expected multi-billion-pound settlement with the US Department of Justice over the mis-selling of mortgage backed securities in the dark days of the financial crisis.

There’s still no concrete timeframe for when this settlement will conclude, but some analysts expect it to be twice the £4.2bn payout agreed with the Federal Housing Finance Agency earlier this year. The bank has already stashed £2.8bn for the expected fine, but if it’s substantially over this mark, expect that first annual profit to be pushed back yet another year.

That said, management is doing well in fixing the issues it actually has agency over. In the first nine months of the year, its heavily adjusted cost-to-income ratio fell from 65.9% to 53.9%, while its statutory return on tangible equity (RoE) flipped from a substantial negative to 5.2%. This means the bank’s 2020 target of a sub 50% cost-to-income ratio and RoE over 12% remain achievable.

However, there is still a lot of heavy lifting to be done. With the mega-fine threatening to wipe out several years’ worth of underlying profits, plenty of costly restructuring still ahead, and the prize at the end of the road a highly competitive retail banking market with low interest rates equalling low profitability, I see many better places to invest my money than RBS, even if it is finally, possibly, back on the right track.    

An already profitable alternative 

Much more attractive to me is a supplier of RBS, Alfa Financial Software (LSE: ALFA). The tech firm provides software to the asset finance sector, which covers everything from consumer auto loans to firms purchasing machinery on credit.

As the regularly shambolic performance of big banks’ IT systems illustrates, the finance industry does not have a great track record of designing its own software. That’s where Alfa comes in, with a cloud and computer-based platform that is tailored to a customer’s specific needs and often comes with a price tag much lower than doing it in-house.

Unsurprisingly, this offer has been a hit with car companies, banks and even Uber. In the half year to June, its first reporting period as a public company, revenue was up 29% in constant currency terms to £43.9m while adjusted operating profits were up 20% to £20.2m.

More than half of the firm’s revenue comes from the early years of a contract as it works to embed its software in clients’ systems and train their personnel in using it. However, over the long term, there is considerable potential for Alfa to increase its percentage of recurring revenue, which brought in £10m in H1 compared to only £2.4m in the year prior.

Alfa’s shares aren’t cheap at 45 times forward earnings but with no debt, high profitability and huge growth potential, I see plenty to like.  

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Founded in 1990, Alfa specialises in asset financing software, and develops IT systems that are used by companies to manage loans for the purchase of assets such as cars, planes and office equipment. Customers include Barclays, Mercedez-Benz and Nordea. Having released just a few news announcements since listing in May, investors will no doubt be eager to examine today’s half-year results. 

Strong results  

The numbers look impressive, with revenues rising 57% to £45.1m and operating profit increasing 15% to £14m. Adjusted diluted earnings per share surged 128% to 5.7p. The group gave an upbeat outlook, stating that it “continues to see a strong and diverse pipeline of opportunities which underpin the Board’s confidence into 2018 and beyond.”

The market appears to be pleased with the results, and the shares are up 8% as I write. So is now the time to buy?

While Alfa certainly appears to have strong momentum, I’d personally be a little hesitant about jumping into the stock right now.

Its market capitalisation currently stands at over £1.3bn, which seems quite high for a company that is forecast to generate revenue of £86m this year. Furthermore, on forecast FY2017 earnings of 10.5p per share, the forward P/E ratio is a high 43.8, which doesn’t leave much room for error. Alfa looks to be an exciting software company, however, I’d be inclined to watch the stock from the sidelines for now.

Micro Focus International

One stock that does look interesting at present, in my view, is FTSE 100 listed Micro Focus International (LSE: MCRO). Micro Focus is a global software company that helps customers merge new technology solutions with existing IT infrastructure systems, in order to meet complex business demands.

The stock has been a brilliant performer over the last five years, rising from around 550p to 2,270p today, a gain of over 300%. However the share price has declined in recent months, ahead of the company’s acquisition of Hewlett Packard Enterprise (HPE), which is set to complete tomorrow.

It’s no surprise that the merger has knocked sentiment, as the $9bn purchase of HPE’s software business is set to add a significant pile of debt to the balance sheet, which clearly adds risk to the investment thesis.

However, for long-term investors, I believe the share price fall may have created an opportunity. The merger with HPE is set to create one of the largest tech firms in the UK, and one of the world’s “largest pureplay infrastructure software companies”, with combined revenues of around $4.5bn. Furthermore, management believes it will give the company “considerable scope to improve profitability through the application of Micro Focus’ disciplined operating model.”

City analysts estimate that the combined entity will generate earnings per share of $1.81 for FY2018, which places the stock on a forward P/E ratio of a reasonable 16.2. The company also looks to have dividend appeal, having increased its dividend for 11 consecutive years and currently yielding 3.1%. For those looking for UK tech exposure, Micro Focus could be a solid long-term investment, in my opinion. 

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