Invest in the unloved: 4 out-of-favour stock opportunities

Many successful investors believe that taking the path less travelled is the most lucrative investment approach. But avoiding crowded trades is exceedingly difficult – perhaps even more so in the age of the 24/7, always-on news and social media cycle.

There are a few things to watch for, as outlined by Forager’s Steve Johnson and ECP Asset Management's Sam Byrnes. For individual companies, Johnson watches how the share price is tracking against earnings growth. And as he has told us in the past, he constantly asks the following questions:

• How much is a company going to make?
• When am I going to see the cash?
• What is that cash worth to me in today’s dollars?

As Johnson describes it, that means they can find companies with compelling stories but, more importantly, that offer good value.

In the following Q&A, both Byrnes and Johnson share their views on where they see opportunities. This includes a couple of sectors they believe are unloved and some specific ASX company examples.

Which parts of the market are overcrowded now?

When we spoke with Johnson on this topic six months ago, Resmed and CSL were two companies he cited as crowded trades that were at that point selling off.

“It’s been a strong six months for equities and especially the better “quality” part of the market. The better value I mentioned six months ago was short-lived,” he says now.

“Resmed and CSL are up substantially since November. So, we have rapidly returned to a world where investors are crowded into the “best” businesses and that brings a commensurate price tag.”

It’s been a similar story in what Johnson regards as “better quality” technology companies, citing ASX-listed energy and infrastructure software firm Gentrack (ASX: GTK) as one that has been a big return driver for Forager.

“But from today’s prices I find it hard to see these companies generating above market returns over the long term,” Johnson says.

Byrnes doesn’t see any obvious overcrowded parts of the market currently. While many commentators point to US technology as an example, he disagrees.

“It is worth remembering part of this is a recovery from 2022 lows. Add to that the significant margin optimisation that’s been broadly delivered upon in the sector, and the emergence of AI as a potentially significant structural driver, and the sector’s performance is understandable,” Byrnes says.

How an investment process helps steer around sentiment

Byrnes refers to “hype cycles” where stock valuations “become detached from reality, commentators unanimously preach the same bullish narrative and risks are de-emphasised.” He argues there is an element of truth in most narratives, typically driven by the success of a particular company or part of the value chain.

“A good way to spot hype cycles is to look at the lower quality peers and adjacent stocks that “touch” a given theme,” Byrnes says.

“The market doesn’t differentiate the quality of the business model, and the copy-cats get the same rich valuations as the market leaders. The BNPL craze was a good example, driven by the success of Afterpay.”

The second important piece of ECP’s process is valuation. ECP’s portfolio construction process reacts without bias to this market dynamic by systematically allocating more capital to its most undervalued companies. It also removes capital from stocks that are becoming progressively more expensive.

“While we may have equal conviction in all businesses in our portfolio, the reality is at any one point in time, they are valued differently due to varying investor sentiment,” Byrnes says.

“In that sense, we are acting inversely to short-term investor sentiment.”

What are some of the most unloved parts of the market currently?

At Forager, Johnson argues the most unloved companies currently are ASX-listed tourism stocks. The Forager Australian Shares Fund owns both Tourism Holdings (ASX: THL) and Experience Co (ASX: EXP).

“Both have been whacked by the market. Even the big players like Corporate Travel (ASX: CTD) and Flight Centre (ASX: FLT) have underperformed the market by a significant margin over the past six months,” Johnson says.

No longer unloved

Johnson highlighted mining services and European financials when we spoke six months ago, the stocks he mentioned having performed well during this period.

“So, no, I wouldn’t see they remain the most unloved. Still cheap (the starting point was 5 times earnings for most of these companies) but not as cheap as they were,” he says.

“Virgin Money UK (ASX: VUK) is under takeover offer, banks in general have been the best performing sector in Europe this calendar year,” says Johnson.

“Even mining services companies are seeing some love, Macmahon (ASX: MAH) is up 75% since November."

Asked what catalysts he sees ahead for the tourism stocks he mentioned, Johnson doesn’t generally pay much heed.

“Stocks are usually cheapest when the catalyst is hardest to see – those European banks were paying cash returns to shareholders of 15% per annum but nobody cared because they hadn’t “worked” for 16 years. But I don’t think tourism investors will have to wait too long.”

He notes the “frustratingly slow recovery from COVID for inbound tourism companies” including those mentioned above.

“But airfares are finally falling, the Australian dollar is at a relatively attractive level for foreigners and we have all had enough of visiting our families. I think we will see a really good summer for international arrivals into Australia and both of these companies return to historical earnings levels,” Johnson says.

“Experience Co has also put itself up for sale. So, a takeover offer is a distinct possibility”

“Unloved” companies on ECP’s radar

“Block Inc (ASX: SQ2) remains an unloved pick with investor debate about the length of its growth runway, leadership changes, and a P&L which is currently transitioning from loss making to profitability,” says Byrnes.

ECP has written previously about Block here, but to sum up:

“In addition to the structural growth opportunities in both Square (going up-market, and deeper into vertical niches) and Cash App (banking its user base), we believe the convergence of its ecosystems – the intersection of commerce and money management – inside of Cash App presents a significant opportunity to create economic value,” Byrnes says.

"A political dog-fight"

He also nominates international student company IDP Education (ASX: IEL), despite the “political dog-fight on immigration” that will hurt the business in the short-term.

Byrnes believes IDP’s business model is increasingly resilient to changes in any one destination.

“The crack-down to improve the quality of the industry is likely to substantially reduce competition for IDP and International Student demand is not going away,” Byrnes says.

“As students look to other destinations to study, IDP is best positioned to serve those customers.”

What do you think?

If you own any of these companies or have your eye on others you think are being unjustly written off by the market, please let us know in the comments below.

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