Quick Bites | Soufflé stocks of the ASX

Individual share investing is humbling. Investors observe that for most of the time, rising earnings go hand in hand with a rising share price (and vice versa). But not all the time. Sometimes share prices rise and fall beyond the direction of earnings by a surprising order of magnitude. That is, fluctuations in a stock’s valuation multiple can explain more of the share price change than do changes in sales, earnings or cash flow.

The most prominent current example of share price change being dominated by rating change have been the software and platform stocks. The table below shows the toll the AI-disruption narrative has taken recently, despite still healthy earnings progress (except Xero, which has had EPS downgrades following the Melio acquisition).

Can the above stocks recover recent losses? If the growth forecasts in the following table are to be believed, then you would think these stocks are now a reasonable bet given they are trading below the levels seen in prior moments of risk-off across markets.

What about a full recovery to prior peak levels (as shown, the above group in late 2021 averaged an EV/EBITDA of almost 50x)? That seems unlikely. Why? Not because we know more about AI than the market. And not because we can better forecast than the market. Instead, because of the saying: soufflés don’t rise twice. The ASX is littered with examples of stocks that, for reasons of liquidity and sentiment, enjoyed a period of being rated well beyond what could be rationalised via fundamentals. Once the individual stock bubble pops, it rarely, if ever, reflates.

Soufflé stocks can happen in any sector. Here are five stocks, all different, that enjoyed a chapter of price appreciation that went well beyond what could be observed in the fundamentals at the time. To provide context, each stock is shown against a peer business in terms of either history, industry, strategy (e.g., organic vs. acquisitive growth) or level of profitability.

Example 1 – IDP Education (IEL.ASX)

Let’s compare IEL to Seek (SEK.ASX). Seek once owned 50% of IDP Education but sold the business via an IPO in late 2015. As you will see in the left chart below, in the period from IPO to immediately before COVID-19, IEL grew strongly, and the share market rewarded its growth with a rise in valuation (in absolute terms and relative to SEK, shown in orange). COVID-19 lockdowns and border restrictions then followed, which created an initial down-cycle in earnings followed by a strong up-cycle (for both companies). However, in the recovery period in mid-to-late 2021, what stood out was IEL reaching a market valuation of $10bn vs $13bn for SEK, despite the former being not even half as profitable. A multiple of 50x EBIT for IEL was a head-scratcher for the fundamentals-based investor, as it likely also was for SEK management, having sold the business for a little over $300m just 6 years earlier.

Example 2 – Pro Medicus (PME.ASX)

Mid-last year, PME rose to a valuation of $30bn, equalling online classifieds company REA Group. As shown in the left chart below, while PME has grown its earnings strongly over time, it generates only ~25% of the earnings of REA. Thus, for a fundamental investor to embrace a valuation of $30bn involved needing to embrace a step-change in PME’s profitability (noting REA isn’t without an ongoing solid growth outlook thanks to being a very strong business). Is that probable? Not when you consider how new revenue is written for PME (via tenders, contracts and installations that require people and hence is graduated), and especially not when you probe the financial accounts to see negligible (i.e., <$10m p.a.) spending on R&D (an outlay all investors look at to gauge the level of intent by a company to create future sources of revenue and earnings).

Example 3 – Domino’s Pizza (DMP.ASX)

The below chart compares Domino’s to Premier Investments (PMV.ASX). They are different businesses. Why I’ve put these two next to each other is to show what was broadly similar levels and trends in profitability but vastly different valuation treatment. Compare the left chart to the right chart. Who would have thought for those earnings trends that DMP would at one stage hit a valuation of $15bn? The reason seemingly was hype that Domino’s wasn’t in the business of franchising and pizzas; it was in the business of technology (apps, online ordering, and last-mile logistics).

Example 4 – Temple and Webster (TPW.ASX)

Let’s compare TPW with Nick Scali (NCK.ASX). Two Australian discretionary retailers of furniture, with TPW prospering via the online channel vs NCK also growing but via its traditional bricks-and-mortar stores. Notice, on the left chart, the consistent superiority of NCK from an earnings perspective. Yet on the right chart you see comparable market valuation over much of the last decade, and only belatedly in November last year did TPW suffer a material de-rating to reflect a changed opinion of how well this business can translate sales into profit for shareholders.

Example 5 – Reece (REH.ASX)

Reece was an ASX market darling for many years, driven by the company’s strong track record in its core Australian wholesale plumbing distribution business. In 2018, Reece acquired Morsco (also a plumbing products distributor) in the USA with the goal of doing it all over again in a market much larger than Australia. As per the left chart below, following the addition of the US acquisition, earnings for REH have progressed and interestingly tracked a similar path to US-listed peer and market leader, Ferguson Enterprises (FERG-US). Yet valuation differed markedly, with REH surging to a multiple of 30x EBIT vs 15x for FERG in late 2021. To the fundamental investor at the time, given Australia was recognised as a strong but reasonably mature business, the price being implied for Morsco didn’t make sense given FERG, at 9x the size, had obvious advantages (scale, distribution infrastructure, own brands). Incredibly, the love affair for REH continued until the FY25 result, when the CEO delivered a confronting assessment of the challenges facing the business, not just due to macro headwinds but also evolving competitive dynamics.

What’s the key lesson from the above?

Narrative-driven valuation bubbles, aka “soufflé” stocks, rarely reflate once the speculative air escapes and the market refocuses on fundamentals. Investors need to be careful not to anchor to prior peaks. Of course, the above has all been said with the benefit of hindsight. Much harder is picking overvaluation (or undervaluation) in the moment. The key is to remain grounded in process while accepting that markets can and will detach from fundamentals—sometimes for longer than expected. To quote Morgan Housel from The Psychology of Money: “different investors play different games – know what game you are playing”.