Three ASX stocks with a 60% payoff upside

A 60% payoff upside from even one ASX-listed company might be a pipedream for many investors, but it’s simply par for the course for the highly experienced Monash Investors.

In fact, they will only invest in companies where they anticipate a 60% payoff upside, or 30% downside for companies they short. This forms part of their GIVE strategy, which uses growth, insight, value, and event to identify opportunities.

Simon Shields, co-founder at Monash Investors, views the market conditions as ripe for these opportunities.

“At the moment, and it doesn’t happen all the time, we’re actually seeing quite a decent economic cycle…There are other companies around now that have very solid growth because of their position in their industry, their pricing power.”

Monash Investors have recently added to their portfolio, with pricing power and market behaviour key among the rationale for some of the new additions.

Simon Shields recently joined us for a three-part series of Expert Insights. In the first edition of the series, he discusses the attributes Monash Investors use to select stocks, the three stocks Monash currently hold where they see a 60% payoff upside and the triggers that would lead them to sell a company.

Edited transcript

What are the four attributes you look for in stocks?

We have a mnemonic that we use called GIVE: growth, insight, value and event. 

We’re both growth and value at the same time, which sounds contradictory but the way we define value is how much payoff are we going to get from investing in a company. 

We can invest long or short. If we’re investing short, we’re selling a stock that we’ve borrowed but don’t own. If the share price goes down, we make money on it.

The way we assess value is generally by using DCFs (discounted cashflow). We’ll do a DCF on a company and if there’s at least a 60% payoff to the upside for a long stock, we’ll buy it. By that, I mean the stock has to be trading at a price today that we think is wrong and the right price is more than 60% above where the current share price is. That right price is the price we think the stock should be trading at today if the market agreed with us about the future of the business when it comes to its profit and loss statement, its cash flow statement and balance sheet. There’s a lot of detailed modelling and analytical work that goes into creating that valuation. So that’s the payoff we’re looking for.

To get the sort of value of that payoff, you need growth. It could be a step change up generally in terms of earnings, or a step change down if it’s a short. That’s where the growth comes in. Typically you’ll see some very high rates of growth in the companies we’re investing in, but that’s not always the case. If the PE or the valuation metric for some other reason is quite modest, you might not need much in the way of growth for the stock to have a 60% payoff.

There might be some other issue around the company that’s caused its price to come back and give us that 60% payoff. That’s the growth and value together. Then there’s the insight. Why is this company misunderstood? Why is the share price misbehaving? How is it going to be resolved? That really gets back to what is the business situation or behaviour that is causing the market to misprice this stock.

The last is the event. The event is a lesser part of our portfolio. It’s for stocks where we don’t get the 60% upside or 30% downside in the case of events. If they have a near-term event, we will invest in those stocks.

An example of a stock with at least the first three is Lovisa (ASX: LOV).

Lovisa is a very successful Australian jewellery retailer. It’s got over 150 stores in Australia and many stores around the world. It’s rolling its stores out at a rate of around 15% per annum. At the moment, this is a recurring business situation. This is our insight. We find the market habitually fails to properly price the effect of a global store rollout on a share price. When we model this increase in the store rollout into the future outlook for this business over a number of years, you’ve got a very good business with decent growth. We’re actually getting into the high teens, low twenties in terms of EPS growth over the next 5-7 years per annum for this company. That’s the growth, that step up in earnings. It’s that earnings driver that allows us to get a valuation on this company that’s close to 100% above where the stock price is trading.

Are there sectors where you typically find more stocks with these attributes?

We tend to find them more in the growth areas. Often you see that in retailers where it’s the penetration of a new concept or the rollout of stores. Sometimes you find businesses with a new product, for example, technology driven. Another situation is where you might get changes in government regulation that will help one area, hurt another or change the competitive dynamic within an industry.

At the moment, and it doesn’t happen all the time, we’re actually seeing quite a decent economic cycle. We’ve gone from growth to a bit of a recession. Perhaps in time, we’ll get the growth back again. The whole market pulls back. 

The cyclical companies in particular pull back more if the cycle is going down. There are other companies around now that have very solid growth because of their position in their industry, their pricing power. That’s throwing up all sorts of interesting opportunities at the moment.

Finally, I do think we’re seeing the medium-to-longer term price of oil being mispriced due to the lack of investment in the industry. That’s throwing up investment opportunities as well.

What triggers would lead you to remove a stock from the portfolio?

There’s a few different triggers.

If a stock price gets to what we want – the price we think it should be trading at – there’s no point hanging around in that stock anymore. We’ll exit the stock.

That wasn’t the case in City Chic (ASX: CCX). City Chic had an earnings result which fired off one of our early warning triggers. If a stock misses an earnings number, it’s an early warning trigger. If the short interest rate rises rapidly – that is an early warning trigger. We have near-term sign posts for stocks as well. City Chic actually made the number that was expected for the result but it had a blowout in inventory.

The immediate reaction to a early warning trigger is to cut a third of the weight. If we get two earning warning triggers in a row, we’ll exit the stock completely. We didn’t wait for that to happen. Following the result, we thought more about the company. The reason we’d been in City Chic was because we thought it was selling into an under served niche of the market. Plus-sized women being an under served niche in the market. It had extremely good growth over time serving that niche. However many mainstream clothing retailers started selling into that space and it’s no longer under served. Essentially it was an investment thesis violation that caused us to exit City Chic. It’s worked out quite well because the stock has only gone down since we’ve exited.

How does pricing power support resilient in terms of recent acquisitions James Hardie (ASX: JHX) and REA Group (ASX: REA)?

In the case of both those companies, they have extremely strong industry positions and as a result, quite a high degree of pricing power. REA Group (realestate.com) will just keep putting through price rises each year. It’s been a feature of the real estate industry. Many years ago, it was all about display advertising in local newspapers and classifieds in the big city dailies. There was enormous pricing power back then as well. That business model got totally destroyed by the internet. The internet started off free for advertising real estate. Over time, Realestate.com became the dominant player in Australia. It’s largely a natural monopoly in the same way that the ASX is to a large extent a natural monopoly. There is a place for the number two player, Domain Group (ASX: DHG). Really it’s a whole network effect. Everybody wants to go to the marketplace where they’ve got the most views, the best liquidity. So Realestate.com has been able to charge prices over time. Of course, it’s now in that pricing cycle where it puts up the price every year. The price is such a small percentage of the value of the asset that is being advertised, it’s essentially irrelevant. The good news for realestate.com is, of course, over time, house prices go up. It will always stay a very small percentage of the total value of the asset even as they put their prices up. Enormous pricing power.

In an inflationary environment, you want to have a company that has the ability to pass on cost increases.

In fact, the best situation is they’ve got very high operational leverage. While they get some cost increases, when they pass it on, they actually increase the difference between the revenues and their costs and increase that profit margin.

Now James Hardie is a similar situation. It is a bit more fragmented in the siding market in the United States but they are very dominant in fibre cement. They really do not have any competitors in that market segment. They do have some close substitutes but they’re not the same. They’re again able to put their prices up over time in the same way that REA Group does, not just with crude price increases but also by adding bells and whistles to the products.

James Hardie does that. Whether it’s Colour Plus or the next architectural style or whatever. It also has a change in the same way that REA Group has a chance to increase its price over time. Both these companies are very highly rated and it’s a great opportunity to be able to buy them once they’ve pulled back. Certainly that’s what we’ve seen in this cycle. We might not have got them at the lowest price, but we’ve got them at very good prices. We can certainly get our 60% upside based on the modelling we’ve done at the prices we’ve been able to buy them at.

Benefit at every stage of a cycle

Monash Investors Limited invest in a small number of compelling stocks that offer considerable upside and short expensive stocks that are at risk of falling. Want to learn more? Head to their website or visit the fund profile below for further information.

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