We would like to introduce you to a stock that we find very interesting, having just added it to our portfolio, Investors Cloud (1435.T). We’d also like to run you through the process for stock selection, and what we look for in these stocks.
We have a phrase at Morphic, “Change creates opportunity”. We look for places in the world where change is taking place that hasn’t been fully recognised. This could be good change where we will go long, or bad change where we might want to go short.
How would we define these types of changes? What are some of the characteristics we look for that define this change?
Firstly, we look for price momentum or price trends. What this means is that underlying in the marketplace, there’s already a movement taking place towards pricing some of these outcomes, so as an investor you’re not catching what’s called ‘a falling knife’, where you have gone into a situation where the change is not being recognised, and you might be the one that’s on the outer.
Secondly, we look for earnings revisions, where the sell side is coming around to the idea that change is taking place.
Thirdly, we look for valuation, because at the end of the day, buying a stock where change is taking place but is incredibly overvalued, can equal dot-com bubble problems.
Investors Cloud is a $1 billion market cap, Japanese-listed real estate business. What makes it so interesting is not only is it a property developer, it’s a property developer that focusses on working with small and individual investors. They have an incredible database and background knowledge, and focus on the feedback from their investors about what type of new property they are looking to buy.
One of the biggest costs for a property developer is developing a building where you have been unable to pre-sell a large amount of your property. Focussing on investors’ feedback reduces the risk associated for Investor Cloud. They focus on small investors in Japan who earn between US$80,000 and US$200,000 a year, capturing a population of around 4 million people.
They work with them to find a development site, often outside Tokyo, build it and then, this is the key here for this stock, they operate it on behalf of the investors. Now why is that so important? Consider buying an investment property out in Bankstown or somewhere like this. You tend to be the owner/manager, or you might have a real estate agent who takes over the management of the whole building for you. This creates an incredible revenue stream for the business as well.
What’s so interesting about the rental stream that comes from these properties and the ability to leverage this is it creates what’s called a razor-razorblade model. In this case, what they’re doing is they’re profiting from building, operating and selling these properties and they’re able to get a lot of repeat business out of these customers.
Firstly, this is a brand new business model and it is relatively untried in Japan. It might turn out that small and medium-sized wealthy people are not interested in owning a yield on property. We find this somewhat unbelievable in the sense that Japanese bond yields are negative and there’s a great demand both in Australia and Japan for people who are approaching retirement to have a steady stream of income. We’ve seen it in their signup rates that they’re on track, but there is still a risk that this business model doesn’t play out.
Secondly, the Japanese recovery, which is currently underway, falters and Japan goes back into one of their many recessions over the last few years. This would mean people would become risk averse and stop spending money in this area, so the business is at risk there from a) losing customers and b) from inability to finance some of its new developments.
The third risk is valuation. The stock is valued at 18 to 20 times. Now, for a great business growing at the rate that this business is growing at, we don’t consider this a particularly expensive valuation for a growth business, particularly given the opportunity set, but nonetheless, if the market wants to decide they didn’t think the growth prospects were what we think they are, you could expect a de-rating in the earnings. Now at this stage, we’ve seen none of these things occur, but they are some of the risks.
Why should you invest in this stock now? Every good investor should ask themselves this question, every good investor should say, “I don’t really know.” Now leave that funny bit aside, what I mean by that is all great investments have multiple catalysts and you usually get one of them right. It’s often not the one that you think you’re going to get right. One way of overcoming that risk is to use the process of price momentum that I described at the start. If people around you are already looking at the stock and starting to invest in it, it gives you an indication that you’re not early, that some of your risks that you may have worried about are not there.
The other key thing there is the analyst coverage on the stock. It’s just passed through $1 billion of market cap and now at this stage, there’s only two analysts covering the business. Hopefully as it grows in market cap, more analysts come on board, then they’re able to increase coverage. One of the interesting things about Japan is the complete lack of coverage of smaller stocks. We do know that when coverage goes up, analysts then introduce it to a larger opportunity set of clients. We’re looking for more increased coverage in the business to keep operating the way it is this year and hopefully, more upside for our investors.
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