The most important number for penny share investors

Letting your small-cap stocks run on can make you a fortune, says David Thornton. The hard part is knowing which of your winners to back.

In one of my first Penny Sleuths, I related the sorry tale of Asos. It's not often that I would describe an investment where I'd trebled my money as a tragedy. But in this case, I think it's fair.

Ten years ago, I bought a few Asos shares at 24p. I took a very nice turn on them and moved on, which was the biggest mistake of my investing career.

As we know, Asos became a phenomenon. It hit an incredible high of just over £70, which was a gain of a mere 29,900% on my purchase price, so let's just say I'm two or three million quid worse off than I might have been.

Needless to say, I drew a few lessons from this! The most important and positive one is that there is a lot of money to be made by investing in small companies.

Aim gets a bad press at times, but Asos shows that there are some priceless gems trading there. Stocks which can really transform your investment performance. So it's certainly worthwhile to keep looking for them.

Another is to run your winners and be patient with them. This can be extremely hard to do, and requires discipline and nerve. But in those rare cases where you have landed on a great long-term story, it can literally make you a fortune.

It's all about the multiple

This year's fall from grace in Asos throws up some other lessons. One of these is to remember that trees don't grow to the sky.

Of course, the really difficult bit is knowing exactly what sort of tree it is you've bought. I must have thought Asos was a bonsai or some sort of dwarf conifer! I was happy to chop it down when it was only a couple of feet high. It might still go on to become a giant redwood, but for now it has paused.

This 'pause' happened because Asos's spectacular run of earnings growth came to an end. Earnings at the company are expected to fall by around 16% this year. The market then expects a healthy rebound next year, so it's not a disaster. But the spell has been broken.

The end of Asos's run of 30% plus earnings growth has resulted in a devastating 70% drop in the company's share price.

Why was the fall in the share price so severe? It's simply down to a 'de-rating' of the shares. Before the profit warning, Asos was expected to earn 64.5p this year. So, at £70, Asos was trading on a prospective price/earnings (p/e) ratio of 108, which is pretty rich in anybody's language!

After the profit warning, the prospective p/e is 39. Now, this is still getting on for three times the average UK company's rating but it's a lot lower than 108.

Earnings matter but the multiple matters more

A super-high p/e is not that rare in very small stocks that are growing really fast. But it's hard for a company to maintain very high growth rates as it gets bigger. Remember trees don't grow to the sky. At some point the market will cotton on to the fact that things are going to slow down, and the inevitable de-rating happens.

Sometimes it happens rapidly, as with Asos. Other stocks see a slower de-rating the shares will begin underperforming despite prospects looking good. As an investor this can be quite hard to recognise at first.

There isn't a shock profit warning. It's just that the market adjusts its idea of the long-term growth rate downwards. The earnings forecasts for next year might not have budged - but the p/e falls, to reflect a more cautious view of the long term.

A current example of this might be Easyjet (LSE: EZJ). The shares have been a great investment, but have pulled back from £18 in April to £13 today a drop of almost a quarter. Yet, earnings forecasts have been stable around 113p for this year. The market has just decided to move the shares from a p/e of 16 to a p/e of 11.5.

There are a lot of factors that influence a p/e ratio; but they can all be boiled down to two things in my view:

the long term growth rate of a stock,

and the level of confidence that the market has in that growth.

At a p/e of 108, the market thought Asos had a bullet-proof business model and a long period of superior growth ahead of it. It was happy to look a long way out and place a low discount rate on those future earnings in other words, it was happy to take an optimistic view about Asos's future earnings.

When you do the arithmetic, this a bigger factor than the earnings forecasts themselves in determining the share price.

Which is why investing in growth stock is really tricky as well as potentially very rewarding. We can all have a stab at what profits a company might make. But guessing what p/e the market will put those profits on is a lot harder to get right. Asos soared to £70 driven by a p/e which went far higher than anyone would have predicted it could.

The really interesting thing about Asos is that it was able to grow its earnings at a 30% rate for so long. It did that by embracing new technology, like the way it made big investments in its mobile and tablet platforms.

It's another small example of how mobile money is changing banking and commerce, which I think it's one of the hottest trends in small cap investing today.

When it came to investing in Asos shares, I totally misjudged the company's multiple. It costs me a few million quid that's one mistake you don't want to make, so by all means try and run your winners.

But keep doing a 'reality check'. Ask yourself if the high p/e on your favourite stock requires it to 'grow to the sky'. And if you think it does, it's best to be safe and take at least some profits as it heads for the clouds!

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