Wednesday, 25 February 2015

AO World and today's short side profit

I don't talk too much about the short side explicitly however, in my hedge fund portfolio, I am running at any one moment in time between five and ten specific stock shorts.  The whole ethos of this particular portfolio is to achieve absolute returns and that means - due to the inevitable fluctuations of global equity markets - a good sized short book at all times.

One group of short side opportunities history and experience have taught me to be careful about is the 'valuation short' where a company trades a a premium to its peer group and it is hard at face value to work out why.  Whilst irrationality, high sentiment and other such anomalies are perfectly usual occurrences in the markets, I have found that more often than not Mr Market has spotted something.  For years, for example, I had people telling me that Randgold Resources was expensive versus its peer group.  They were statistically absolutely correct but Randgold's multi-year outperformance of any other reasonable cap gold company indicates that their fundamental business positioning on high grade gold projects has paid off.

Which brings me to AO World.  As regular readers of my ShareProphets articles will know I have written a couple of articles over the last few months pointing out what I regard as a fundamental overvaluation.  As I noted in the last of these in January:

'I looked at the self-styled ‘leading European online retailer of electrical products’ a few weeks ago and concluded that it would ultimately prove to be a car crash for investors based on an excitable valuation today in a sector with growth but ultimately wafer-thin margins and a high level of competition'

The rationale for that article was a trading update from the company which appeared to show good progress at a revenue growth level.  As the old retail saying goes 'sales are vanity, profits are sanity'  and that proved to be the case today with a regulatory update which noted:

“it is now apparent that some of the revenue growth in the second half of FY14 and going into FY15 was due to the extra publicity surrounding the company at that time...(hence) profits will be slightly below market expectations'

With a x100+ P/E ratio there is never any room for disappointment and unsurprisingly the share has dumped today and is currently down over 30%.  

So a nice short-side profit today and given the still material rating applied to the share I for one am remaining on the short side until a fuller set of numbers - with more precise earnings/cash flow guidance - is published.  

As I said in the linked piece above in January, AO World will survive given they have a good balance sheet and their chosen area of business is not ex-growth but the conclusion investors should draw must surely be to exercise caution in high valuation stories and really check if it is likely the fundamentals are of the highest quality.  Any slippage here and it will not prove a happy investment.  

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