At any one time within the investing community, there are always the market darlings, unable to put a foot wrong, and the ugly ducklings, often discarded and unloved.
Contrast the current optimism toward health food providers with Chinese exposure, including Bellamy's Australia Ltd (ASX: BAL) and Blackmores Limited (ASX: BKL), to the doom and gloom of the beaten-down resources sector.
There are strong fundamental economic reasons for both of these views. However, investors can hurt their returns (1) when buying overpriced market darlings and (2) by avoiding currently unloved companies, sectors and industries in which a few hidden gems could be hiding.
This article looks at a few of the recent market darlings.
Chinese exposure
Bellamy's FY15 net profit after tax (NPAT) was $9.1 million and its current market cap is $930 million. Its trailing price to earnings (P/E) ratio is around 100.
If NPAT doubles in FY16 and again in FY17 to $36m, the company would have a price to earning (P/E) multiple of 25 which could be considered a crude approximation of fair value. This implies that around 2 years of 100% NPAT growth is factored into the current share price.
While it is possible that Bellamy's could achieve this growth, it increases the risk of an investment in the shares at current prices.
Blackmores reported FY15 NPAT was $46.6 million and has a current market cap of $2.9 billion. Its trailing PE ratio is 62.
The average analyst on Yahoo! Finance estimates that Blackmores will grow NPAT by 80% in FY16 and then again by 25% in FY17 to $100 million. At this point, the PE ratio would be 29 and again indicates that around 2 years of substantial earnings growth is factored into the price.
Technology startups
1-Page Ltd (ASX: 1PG) is trying to revolutionise the way in which companies source and hire new employees. This potential has clearly excited investors, pushing the stock up more than 1000% in the past year.
The business reported revenue of just $159,000 in FY15 and a loss after tax of $8.4 million, yet has a market capitalisation of $460 million.
Compare this to established company Seek Limited (ASX: SEK) which reported FY15 revenue and underlying NPAT of $859 million and $196 million, respectively, and has a market cap of $4.8 billion – only 10x that of 1-Page.
1-Page generates little revenue, burns a lot of cash and it is anyone's guess as to when it could become profitable – if it ever does.
Reffind Ltd (ASX: RFN) is another company aiming to secure a piece of the jobs market. Similar to 1-Page, Reffind produced little revenue during FY15 ($21,000) while burning through cash developing its products.
Again, investors buying Reffind today are speculating that its products will gain acceptance in the market and that the business will eventually become profitable.
Foolish Takeaway
Be careful and appreciate the risks involved with market darlings sporting sky-high share prices with expected massive future growth. Low-risk investors who value capital preservation might be advised to look elsewhere.
If you have a higher risk tolerance, these types of investments can provide huge returns – but conversely could also see a total wipeout of your capital. It also pays to remember that any miss of investor's lofty expectations will likely see the share prices hammered.
A suggestion for these investors is to buy incrementally into the company at three different times over the next 1 to 2 years as the business proves itself. You could miss out on some early returns, but you will also likely avoid some significant losses.
