SEEKING QUALITY BUSINESSES WITH FAVOURABLE PROSPECTS

Another profit reporting season has come and gone. As Ian Anderson from Jethro Tull sang in Dharma For One “Seek and you will find, truth within your mind”. If he was a stock analyst maybe he would have sung about finding truth or better yet profit within our share portfolios. Putting aside the change in tone from spirituality to materiality did all, most, some or few of your stocks live up to expectations? Like always across the market as wholesome stocks did and some did not. And over the last twelve months, there have been a lot of poorly performed stocks which perhaps isn’t totally surprising given that the market itself is still down about 15% from its peak earlier last year.

Still as we know it’s not what happens with the market that matters but what happens with the specific shares that you hold in your portfolio that are important over time. Many of the higher quality shares with favourable prospects have either not fallen significantly in price during this time or better yet have increased in price and increased dividends. So to improve the probabilities of sound returns we want to stack our portfolios with stocks that are high-quality businesses, have favourable longer term prospects and have been bought at a rational or undervalued price. And ignore those that don’t meet these criteria.

One of the better profit results came from Seek (SEK). Revenue was up 22%, profits were up 9% and the dividend was up 11%. Just the sort of truth that we like to see but does SEK stack up against the holy mantra (quality, prospects and rational price) that we want to see in our stocks?

SEK has a high-quality rating, a low gearing (debt) ratio of just 6%, a successful track record and, more importantly, still appears to have favourable prospects. Whether the current price of $15.68 results in SEK being under or overvalued is another question. So why do SEK’s prospects appear favourable? The initial phase of SEK’s growth was where it provided online the main job advertising board thus replacing traditional print media. By focusing on being the website with the largest number of job seekers it has attracted employers looking for the largest pool of talent. This along with the scale advantages from having a relatively fixed cost base has created entry barriers that have allowed SEK to generate high Return on Equity or profitability and plenty of free cash flow. Still that is the past and that success does appear to be reflected in the current share price. The cash flow has allowed SEK to invest for the future in its domestic business, in Seek Learning (where things haven’t so far gone totally smoothly) and by investing in leading online job websites in Asia, Africa and Central and South America.

In Australia SEK is now moving into its second stage of growth by creating new products to create value-added services that leverage its core competencies and strategic advantages rather than just defending its job board business from new business models that seek to disrupt SEK’s business model just like SEK disrupted the traditional print media business of job ads.

Where SEK’s business model differs from print media is the data capture. Online is more interactive and engaging and lends itself to learning about both job seekers and employers. This data can be used to identify opportunities and produce products that can meet demand and supply in a way that was previously unavailable with one-dimensional job ads in print media. It does this by identifying and prompting people that might be interested in a new job but are not actively looking i.e. passive job seekers. Historically employers have had to access the passive job seeker market by using recruitment firms that would manually search their database of past applicants. SEK’s rapidly growing database is potentially much broader than that of any individual recruitment company and SEK’s search technology and systems are also faster and more efficient when searching a database for potential candidates. An example of the possibilities is SEK’s recent announcement that Hays Recruitment will use SEK’s search technology to filter both its own and SEK’s database. This sees SEK starting to integrate its technology into a recruiter’s business to improve their efficiency and capabilities directly. This process still has a fair way to go and will require further investment (which reduces shorter term profits) so while there will be hurdles and hiccups it does mean that SEK still potentially has favourable longer term prospects. SEK can further leverage its potential by incorporating its Australian product development into its overseas businesses.

So SEK appears high quality and appears to have favourable prospects. Is the price rational or undervalued? At the current price of $15.68 SEK does not appear to be undervalued. Forecast earnings, dividends, ROE and future values are as follows:

So while SEK has an attractive growth profile to invest in SEK at current prices you would need to have an expectation that future earnings per share (profits) are going to be higher than current forecasts. This is certainly possible (it is also possible that profits will be lower than forecast) however there is little room for disappointment in the current price. It can’t be said that buying SEK at its current price results in the probabilities of receiving returns sufficiently high to justify the risk being strongly in your favour.

However at a lower price SEK could well be an attractive investment. And while this is not a forecast that is by no means impossible. The share price of SEK has ranged between $11.95 and $18.73 in the last three years. High-quality businesses with favourable prospects like SEK are often not available for extended periods of time at undervalued prices. However, one never knows (and this is where stock market volatility can work in our favour) when there may be a temporary price fall that provides the opportunity to invest in SEK at a rational price.

As disciplined value investors what we want to know (and this is where the research effort should be directed) are which businesses on the stock market are potentially high quality and have favourable prospects. And also, what is a rational price to pay. If we know this in advance we then patiently monitor these stocks for any opportunities that may arise. It may be that a stock like SEK does briefly become available at a rational price (remember from the November 2015 blog) how obliging Mr Market can be sometimes. If a high-quality business with favourable prospects does become available at a rational price we need to already have done our research so that we can act promptly before the opportunity is missed.

Ok that’s enough of seeking stockmarket holy grails for today. Previous blogs can be read at www.lifestylefstas.com.au.