US Edition
Investing in growth stocks is fraught with danger. Their high valuations tend to give investors little or no margin of safety. Should they fail to meet the market’s expectations, share price declines can be dramatic.
And since their profitability is often highly dependent on the performance of the economy, growth stocks habitually underperform the wider stock market during periods of economic difficulty.
Equally, high-quality growth shares frequently deliver stunning capital returns in more sanguine economic environments.
Investors must therefore be prepared to stick with them, as this column intends to do with the beverages company Fever‑Tree, through periods of decline to benefit from their potential to outperform the wider stock market when more buoyant conditions return.
Fever-Tree is being affected by a combination of high inflation and rising interest rates. The company, a producer of soft drinks such as tonic water and ginger ale, reported a paltry 1pc rise in UK revenues in its latest half-year results, while rampant inflation was partly to blame for a 6.7 percentage point reduction in its gross profit margin. This resulted in an 11pc decline in gross profits (ie before overheads) relative to the same period the previous year.
It also announced a profits warning alongside its interim results.
It now expects profits of about £33m for the 2023 financial year, which would represent a 17pc fall relative to the previous year. Its shares have slumped by 26pc following the release of its half-year results, which means they are now down by 61pc since Questor first tipped them in March 2021.
Crucially, though, the company was able to increase its market share in Britain to a record high of 45pc. This is more than half as much again as the market share of its nearest competitor and means the business is well placed to benefit from an improving consumer outlook, which should translate into higher demand for its products.
Indeed, consumer confidence in Britain has dramatically strengthened over the past year, while inflation is forecast to fall to 2pc within 18 months and interest rates look unlikely to move significantly higher.
Furthermore, Fever-Tree’s sales in America increased by 40pc during the first half of its current financial year.
The US is now its largest region by revenue and is likely to deliver further sales growth as product innovation continues. The US economy should benefit from a more dovish monetary policy. The Federal Reserve, America’s central bank, seems unlikely to raise interest rates substantially before it starts to cut them during 2025.
Fever-Tree’s first-half performance was also hampered by exceptional events.
For example, profitability in Australia was hit by a one-off inventory buyback conducted as part of a change in distribution model. As a result, its underlying performance is stronger than the reported results suggest. And as unseasonably poor weather in Britain affected demand during the key summer period, the prospects for the company’s bottom line are very likely to improve.
In fact, it expects to report a significant margin improvement in 2024. In the meantime, its net cash of £60m shows that it has the financial strength to overcome a challenging operating environment. It also benefits from a clear competitive advantage over rivals as a result of the strong loyalty of its customers. Evidence of this can be seen in its return on equity figure, which has averaged 15pc over the past three years in spite of its aversion to borrowing.
Given our upbeat assessment of the company’s long-term prospects, as well as the fact that its shares are quoted on Aim, Fever-Tree is a natural fit for our Inheritance Tax Portfolio following Breedon’s recent move to the main market.
Certainly, Fever-Tree’s valuation remains extremely high. It trades at 42.7 times earnings even after its share price slump. And it undoubtedly faces a tough near-term outlook as economic uncertainty lingers.
On a long-term view, though, the company’s clear competitive advantage, solid financial position and growth prospects across several major markets mean it has recovery potential. It is also well placed to capitalise on an improving operating environment thanks to its increasing market share.
While risky, as all growth stocks are, its significant potential creates a favourable risk-to-reward trade-off for new investors.
Questor says: buy
Ticker: FEVR
Share price at close: 964.5p
Read the latest Questor column on telegraph.co.uk every Monday, Tuesday, Wednesday, Thursday and Friday from 6am
Read Questor’s rules of investment before you follow our tips