How to spot when share prices have too much froth

Our stocks this week have enjoyed strong recent gains, but their dynamics are beginning to look less supportive. One, a UK automotive retailer, is facing weaker pricing and a tighter regulatory environment that recently drove a profit warning, yet the shares are trading at the top of their historic PE range. The other company, a major US software player, is enjoying a sector-wide rally based on hopes that the rate cycle and inflation swing back to being favourable. Lifting the hood, however, we see a business that looks to be struggling to add value to what has been a strong market undertow - and one that is now beginning to slow down. In both cases there are important learnings for stock-pickers.

Vertu Motors (VTU)  – the UK’s No. 5 automotive retailer/distributor, this Aim-traded stock recently issued a profit warning due to changing dynamics in the new and used car markets. There are a number of issues: used car prices, used car supply, fleet sale demand compression at the end of 2023, potential new car discounting from the manufacturers and the beginnings of the zero emissions regulatory changes (the ZEV Mandate) that could see some manufacturers struggle to deliver enough compliant new cards. Add in the consumer scheme and higher interest rates impacting finance and leasing costs, 2024 could be a tougher than expected year for the car industry. Add that Vertu is trading towards the top of its historic PE ratio range and today the balance of risk and rewards is more skewed towards risk. The shares may look cheap of a PE of 8.5x, but this reflects more a lower quality of earnings than absolute value. After bumper performance in the preceding 15 months, the shares could mark time. 

SalesForce (US:CRM) – this is a world leader in the software-as-a-service (SaaS) sector offering a growing suite of tools to track sales, service and staff interactions and extract value from large flows of information internally and externally. Growth has been high (around 25 per cent CAGR), but despite a large number of acquisitions and the issuing of a lot of new equity, that growth has been little better than the market undertow: it is not entirely clear that management has added a great deal of value. In addition, the very large gap between standard or GAAP reporting of profitability and the alternative presentation used by management could be a cause for concern. Taking a more prudent approach to accounting for costs, net margins are pretty slim. Going forward, the SaaS market is expected to slow materially meaning that a lot more growth will need to be driven internally: on the record to date, that could be harder to deliver.