When Growth Stalls

In today’s Money Morning…the real reason Domino’s fell so hard…the danger of high expectations…real life is messier and more complicated than academic models…and more…

The big story for Aussie investors yesterday was the Domino’s Pizza [ASX:DMP] results. And the share price plunge that followed. It’s a good example of the risks of investing in growth stocks. But Domino’s is as risky as a walk in the park compared to some stocks I’m going to tell you about today.

And I’m not talking about ‘speccy’ microcap stocks.

I’m talking about big name companies you know all about. Every Australian investor — or super fund holder — probably owns some of these shares. And they probably don’t realise that they’re loaded to the brim with risk. Just one whiff of bad news away from making Domino’s falls yesterday look pretty sedate.

I’ll get to that shortly. But first, let’s briefly recap the fallout from yesterday, and the real reasons behind it…

Domino’s finished the day 18.6% down, and was more than 20% down at one stage.

So, what was the cause?  Was it falling revenues, reduced profits, or increasing costs?

No, none of them.

In fact, the company produced a stellar set of numbers. Group revenue topped $1 billion for the first time, up 15.4%. Underlying net profits grew 28.8% to $118.5 million.

And it certainly wasn’t some issues with their online platform in France, as the company tried to claim.

The problem was simply that the markets expected more. And the company expected more.

Domino’s issued earnings guidance figures just six months ago, that have already failed to be met.

Figures were down across the board, from Australia, to Japan and Europe.

Now here’s the thing…

Domino’s was trading at a price-earnings (PE) ratio of 37 before the results were out. That ratio says investors were willing to pay 37 times the current earnings figure for the company.

That’s an expensive valuation.

Compare that for example to the US listed Yum Brands [NYSE:YUM]. This company owns big name brands such as Pizza Hut, KFC and Taco Bell. It has stores around the world, including India and China.

Yum is trading at a PE ratio of just 19 and is valued at US$26 billion.

At face value, which company would you rather own?

A single product pizza chain with an ‘app’? Or a multi brand company with a global footprint, including in two of the world’s fastest growing economies?

This is the risk with high PE stocks.

Any signs that the growth rate is stalling can result in falls that seem out of proportion with the results. With Domino’s the results weren’t that bad, but they already had a high valuation, based on these growth rates continuing.

It’s the equivalent of coming third when you were expected to win. Compared to coming second when people thought you would come last.

Disappointment and happiness are relative to previous expectations.

But if you thought Domino’s had a high PE ratio, wait until you hear about these stocks. These are great companies, but are they great shares to invest in?

They certainly have high expectations driving them — for now.

Look out below

The US Nasdaq has companies with some of the highest PE ratios on any market.

That makes sense for a technology index. The companies here are creating products that — if they succeed — can grow at super-fast rates.

But exponential growth rates can’t last forever.

There are only so many markets, so many customers and so much shelf life a company can have. And unless you are Google [NASDAQ:GOOG], most companies will have to compete with newcomers and competitors constantly.

That means PE ratios have to fall, eventually.

And if they fall in this market, the falls could be spectacular.

Take a look at Amazon [NASDAQ:AMZN] for instance. It’s trading at a PE ratio of 185. Or what about Netflix [NASDAQ:NFLX]? It’s at a whopping PE ratio of 221!

Tesla [NASDAQ:TSLA] and Snapchat [NASDAQ:SNAP] aren’t even making any earnings to have PE ratios. At least, not positive ones…

Yet Amazon is valued at US$60 billion and Snapchat at US$14.6 billion.

Though in Snapchat’s case, the share price is coming down hard for the same reason that Domino’s share price fell. Optimistic expectations are not being met.

With no profits, the falls can be even more dramatic when investors lose faith in the growth story.

Risk and reward

A high PE ratio is not always bad. And a low one is not always good.

They are simply reminders that the market factors in future expectations, both good and bad. You should always look into the assumptions behind them.

They are often wrong.

There are academic theories that markets are efficient and will price information fairly accurately as it comes to hand.

But my experience suggests otherwise. Real life is more complex than financial modelling. And you only need to look at the share price volatility yesterday in Domino’s to see how wrong the market can be.

Investors in growth stocks need to develop models that factor in changes to growth rates. If a stock is too sensitive to a slight drop in growth it may be too high risk, regardless of the progress and popularity of the actual business itself.

Price is what you pay, value is what you get. What’s the upside if you’re right? What’s the downside if you’re wrong?

Remember, the point of investing is to make profits, not to support your favourite brands. Occasionally you can do both. But only if the figures stack up first.

Good investing,

Ryan Dinse,
Editor, Money Morning

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Ryan Dinse is an Editor at Money Morning.

He has worked in finance and investing for the past two decades as a financial planner, senior credit analyst, equity trader and fintech entrepreneur.

With an academic background in economics, he believes that the key to making good investments is investing appropriately at each stage of the economic cycle.

Different market conditions provide different opportunities. Ryan combines fundamental, technical and economic analysis with the goal of making sure you are in the right investments at the right time.

Ryan's premium publications include:

Money Morning Australia