Too good to be true for some ASX winners?

The rush to growth stocks is bidding up everything from regional airlines to furniture retailers, but it might not last.

Nick Scali looks reasonably priced, but you have to question how many sofas Australian consumers can own and for how long they will keep buying them.

The legendary investor Warren Buffett announced in early May that he had got it wrong on airlines during the pandemic.

In a reversal of former strategy, Buffett had sold his entire holding in four US carriers - we will have to assume he hadn’t heard of Alliance Aviation.

The stock is Australia’s least recognised listed airline, but it is trading at around $3.30, more than triple its level of just over $1 in late March.

In business, it’s not always the big that take advantage of the small. In the case of Brisbane based Alliance, it’s a niche operator taking advantage of a global pandemic that has severely wounded the aviation industry.

The airline is benefiting from Australia’s big mines remaining open and social distancing, which has increased the number of flights to move the same number of workers, increasing revenue despite the loss of some charter and commercial passenger business.

On top of announcing a 29 per cent increase in FY20 profit before tax, Alliance has recently purchased 14 Embraer E190 medium bodied 100-seat aircraft for just under $US80m ($110m), putting the airline in the frame to compete with the newly reconstructed and private equity backed Virgin Australia.

Of course Alliance has risk attached to it, but as we all know, due to loose monetary policy, investors are embracing risk assets such as small caps that have growth potential.

The big question this reporting season is how much do you pay for growth?

As numbers come through from companies as well as management statements on the outlook for next year, we’re finding out that not all growth stocks are the same.

Let’s look at some examples.

Investors propelled furniture retailers Nick Scali’s stock up 15 per cent in recent weeks, largely on the assumption that consumers have been diverting travel-related spending to home furnishing.

What’s more this well established retailer has been strengthening its online proposition.

Nick Scali looks reasonably priced, but you have to question how many sofas Australian consumers can own and for how long they will keep buying them.

In my house we still own the same sofa we purchased 10 years ago. Maybe I’m a hard ass!

Then there is the high flying online retailer Kogan.

The company’s growth was slowing, and then COVID-19 came along. The pandemic has supercharged its customer numbers, but its shares have appreciated five fold since March.

It now trades on a forecast PE of over 45 times. It is inevitable the growth rate will start to slow off the higher base and forward multiples will be hard to justify. There is only one Amazon; there are many Kogans.

Another very strong performer in the current climate is the data centre owner and IT services group Macquarie Telecom where shares have more than doubled from $20 in late March to $45 as the market starts to work out the implications of its growth strategy (another datacentre is planned for Canberra).

The thing is, the money won’t start rolling in for some time. As an investor, you don’t want to overstay your welcome.

At the big end of town we’ve seen investors unimpressed, at least initially, with results from the likes of ResMed and Seek, which were both sold off after indicating that profitability was being impacted to the point that dividends will be under pressure for some time.

ResMed might be making sales from ventilators, but investors focused on slowing annuity revenues from its core CPAP product that treats sleep apnoea.

It seems investors are looking beyond COVID-19 and when you have finely tuned valuation models that are based on future earnings and dividend growth, that can impact on the share price ... and not in a good way.

Back to Alliance, which is trading on a 12-month forward PE of 19 times on our numbers.

At current levels, a new investor is certainly paying for growth potential. While management deserves the benefit of the doubt, the economic uncertainty is so great that not taking profits when you are making big returns is sometimes a bigger risk than holding on.

Richard Hemming is an independent analyst who edits www.undertheradarreport.com.au

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