My GARP Picks - Part I

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Includes: ADBE, AIABF, BBY, EVGGF, EVVTY, HESAF, HESAY, ING, LCHTF, LPSN, OTCM, PYPL, ROL, SEIC, ZEN
by: Steven Chen
Summary

Wonderful businesses rarely trade at discounts (or even fair prices).

In today's market, equity investors need to search harder for opportunities.

In this article, I list my first 4 picks from the GARP perspective.

Source: Online.

Background

As my frequent SA readers may have realized, I am extremely "loyal" to the investment approach of "buying wonderful businesses at fair prices." When it comes to stock picks, this approach limits me to only those with good business economics: e.g., consistently superior returns on capital, internal opportunities of reinvesting at attractive rates of return, durable competitive edge, able management, and good long-term prospects.

As you might imagine, such picks seldom trade at attractive valuations, especially in today's market hitting all-time highs. Just check my previous coverages on Hermes International (OTCPK:HESAY) (OTCPK:HESAF) and Rollins (ROL), and you will see why readers often "complained" that my stock ideas were not (immediately) actionable. While I would generally disagree and advocate that many of them are actually actionable in the long term with the necessary patience, I do see some existing opportunities out there for the so-called GARP candidates ("Growth At Reasonable Price").

Screening

As the starting point, I generate the list of top picks from my factor-based business quality model, which examines a company quantitatively and qualitatively from the following dimensions:

  • Capital efficiency
  • Profitability
  • Economic Moat
  • Financial strength
  • Cash flow
  • Shareholder-friendliness
  • Industry and competitive landscape
  • Growth and momentum
  • Capital intensity
  • Long-term prospect

As usual, no consideration of valuation is conducted at this stage of generating the so-called investable universe. Even as market prices go up or down dramatically, this investable universe should not expand or shrink much. Long-term buy-and-hold investors are supposed to follow wonderful businesses closely and patiently and to only swing at their most comfortable pitches. As the stock market keeps hitting all-time highs, comfortable pitches would get more and more scarce.

However, is this market out of opportunities? I doubt it. Investors would just need to search harder for comfortable pitches. Here, I would like to compare the price multiple to the respective growth rate, in order to find a reasonable price for growth.

Instead of the traditional PEG, which relies on earnings, I use P/FCF/G, which is price-to-free-cash-flow divided by my estimated long-term growth rate. In my opinion, free cash flow better represents equity owners' interests and is harder to manipulate.

Typically, GARP investors should look for stocks with PEG or P/FCF/G at below 1x. However, in light of the low-interest-rate environment around the globe, the expectation for even lower interest rates, and the high quality of the business, I would regard the P/FCF/G of around 1.5x as good value while trying to avoid any P/FCF/G at above 2x.

So below are my picks of good companies that I find are trading at reasonable prices given their respective growth prospects. Again, mentioning of any stock does not constitute investment recommendations. Investors should always conduct careful analysis themselves and/or consult with their investment advisors before the stock idea becomes really actionable for them.

SEI Investments (SEIC)

Source: SEI Official Website.

P/FCF: 18x

Projected growth rate: 12%

P/FCF/G: 1.5x

Headquartered in Pennsylvania, SEI Investments is a global provider of investment processing, investment management, and investment operations solutions to institutions, private banks, investment advisors, investment managers, and private clients.

As displayed below, the business has grown its FCF per share at high-teens CAGR.

Source: GuruFocus; data as of 6/24/2019.

Meanwhile, the return on tangible asset, although being cyclical, improved over time, from below 20% in 1990 to over 30% at the moment.

Source: GuruFocus; data as of 6/24/2019.

The business builds its competitive advantage through strong R&D capability. The management seems to have focused on and invested strategically for the long run. As you see below, SEI plans on expanding its service/product footprints with more markets and more verticals.

Source: Investor Presentation, June 2019.

The asset management industry has been providing both headwinds (e.g., increasing popularity of passive investing, fee pressure) and tailwinds (e.g., tighter regulations, ongoing and upcoming replacement of legacy systems and inefficient operations) for SEI Investments. Given the company's positioning in the FinTech ecosystem as well as track records of penetrating existing markets and discovering adjacent markets, I would at least assume a low-teens CAGR for the business going forward.

As you can see below, the P/FCF of the share has been flirting around the 20x level since the financial crisis, unlike the overall market valuation hitting new multi-year highs. I think that a 1.5x P/FCF/G should deliver attractive value to long-term buy-and-hold investors, assuming that the management executes the growth strategy well.

Source: GuruFocus; data as of 6/24/2019.

OTC Markets Group (OTCQX:OTCM)

Source: Online.

P/FCF: 21x

Projected growth rate: 12%

P/FCF/G: 1.75x

Headquartered in New York City, OTC Markets Group is a financial market providing price and liquidity information for almost 10,000 over-the-counter securities across three markets: OTCQX, OTCQB, and Pink.

As displayed below, the business has grown its FCF per share at high-teens CAGR for the recent few years.

Source: GuruFocus; data as of 6/24/2019.

Meanwhile, the company improved its return on tangible asset, from 22% back in 2010 to 42% now.

Source: GuruFocus; data as of 6/24/2019.

The network effect, the subscription model and recurring sales (88% of the total revenue) constitute the economic moat for the management to protect the superior profitability.

Geographic expansion and existing market penetration could be the mid-to-long-term growth engine. Moving forward, a low-teens CAGR is a conservative estimate in my opinion.

Although the price multiples of the share expanded for the past few years. A 21x P/FCF (or a 5% free cash flow yield) should provide some value for buy-and-hold investors, given the low-risk double-digit growth prospect of the business and compared to the near 2% 10-year treasury yield.

Source: GuruFocus; data as of 6/24/2019.

Evolution Gaming (OTCPK:EVVTY) (OTCPK:EVGGF)

Related image

Source: Online.

P/FCF: 38x

Projected growth rate: 25%

P/FCF/G: 1.52x

Having just gone public a few years ago, Evolution Gaming is the world leader in live dealer gaming. Although the stock is accessible through the US OTC market, investors are strongly recommended to buy (wherever conditions permit and for better liquidity) through the primarily-listed ticker EVO on the Stockholm Stock Exchange.

The growth of the company was quite explosive - almost 5x in terms of FCF per share for the past 5 years. The most recent year saw a 38% increase in the top line and a 61% in free cash flow.

Source: GuruFocus; data as of 6/24/2019.

Source: Morningstar; data as of 6/24/2019.

Of course, such phenomenal growth should not be sustainable, even in this fast-growing online casino market. Actually, it is already noticed that the annual growth rates are coming down at all levels (e.g., revenue, operating income, free cash flow) compared with the respective 3-year and 5-year averages.

Even with rapid growth, the business saw little deterioration in its returns on tangible asset (see below), implying some competitive edge to fend off competitions. I think that the main source of the economic moat comes from the B2B business model (i.e., switch cost) as well as the superior product quality.

Source: GuruFocus; data as of 6/24/2019.

In my view, it is appropriate to assume the growth rate to decay to 25% (which is more than a 50% discount off the previous rate) for the foreseeable future here, mostly driven by geographic expansion (and penetration), product innovation, and industry tailwind as well.

With a 25% annual increase in FCF, the current P/FCF of below 38x seems reasonable. We also notice that P/FCF has been trending down for the past couple of years and some other price multiples (see below) are lower or near their respective 3-year averages.

Source: Morningstar; data as of 6/24/2019.

Source: GuruFocus; data as of 6/24/2019.

LiveChat Software (OTCPK:LCHTF)

Source: LiveChat Software Official Website.

P/FCF: 14x

Projected growth rate: 12%

P/FCF/G: 1.17x

LiveChat Software is a customer service software company and developer of LiveChat - software as a service-based help desk software and online chat software for e-commerce sales, customer support, and lead generation. Although the stock is accessible through the US OTC market, investors are strongly recommended to buy (wherever conditions permit and for better liquidity) through the primarily-listed ticker LVC on the Warsaw Stock Exchange.

Based in Poland, the company is one of the key players in the market, alongside Zendesk (ZEN) and LivePerson (LPSN). Although it just IPO'ed a couple of years ago, LiveChat already serves more than 27,000 paid customers in over 150 countries, including Adobe (ADBE), AirAsia (OTCPK:AIABF), Best Buy (BBY), ING (ING), Huawei, and PayPal (PYPL).

LiveChat Software is in a highly scalable business, driven by industry tailwind - per Research N Report’s market research, the global live chat software market to expected to grow steadily at a CAGR of almost 7.2% by 2025.

Since its IPO, the company has grown its free cash flow per share by roughly 5x.

Source: GuruFocus; data as of 6/24/2019.

In the meantime, the management did a good job in allocating capital wisely, delivering extremely high returns (over 100% since 2015) on tangible assets.

Source: GuruFocus; data as of 6/24/2019.

Although the loss of one key customer acquisition channel may cause a material decline in the velocity of customer base expansion, the subscription model, which generates recurring revenue and is protected through high switch cost, should drive the business forward at a low-teens CAGR. The current churn rate is about 3%.

We also notice that P/FCF has been trending down for the last couple of years, standing at around 14x at the moment. Considering the P/FCF/G of below 1.2x for a SaaS business in a fast-growing industry, I believe that the current risk/reward ratio is favorable to long-term investors.

Source: GuruFocus; data as of 6/24/2019.

Summary

In this article, we went through 4 stock picks, which I think present attractive values from a GARP perspective. Although many of them are quite sensitive to economic cycles, all of the businesses generate recurring sales with strong balance sheets and good long-term growth prospects.

If you have any GARP pick, feel free to comment below. Otherwise, stay tuned for Part II.

Disclosure: I am/we are long EVVTY, SEIC, OTCM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Mentioning of any stock in the article does not constitute investment recommendations. Investors should always conduct careful analysis themselves and/or consult with their investment advisors before acting in the stock market.