Trading the Trend - Stage 2 Kings

There are many ways to skin a cat in the stock market, but one of the best ways to do so has been to find an early stage 2 stock and ride it upwards. 

If you’re an investor – it doesn’t matter how undervalued your stock is – to realise a gain on that investment the market needs to notice and then narrow the value disconnect.

This is often one of the complaints of the value investor. There is comfort in the margin of safety, but it can be a lonely wait. 

In the recent decade, momentum has trumped everything. And more than momentum – a good story.

This is why companies like ITM Power have a market cap of over £1 billion. Total income in its half-year report was £3.8 million, of which only £2.4 was revenue, and £1.4 million was grant income!

I’m no great investor but it doesn’t take a Warren Buffett to see that the share price may be rich and much of its potential success could well be priced in.

But as much as anyone wants to crow about how it can’t last – the real winners have been ITM Power’s shareholders.

Here’s a chart of ITM Power since 2019. It’s surged from 25p to a high of 240p. This chart alone explains why trading stocks that are in stage 2 is a great strategy. It’s one that has been employed by Weinstein, O’Neill, Minervini, and countless others. 

Identifying stage 2 stocks early is a key ingredient to stock market trading success, as these stocks offer plenty of breakout opportunities to trade or even average up. 

Nearly three years ago now, I bought my first shares in Future Group. I believed it had a scalable business model, and it had nearly trebled from the lows and so the stock was clearly in a stage 2 uptrend.

I was sadly stopped out of my last lot when some chap across the pond had a pop at Future and derailed the price, and the stock has gone one to post even bigger gains. 

There may be a lot left in the business, but it’s certainly better to be buying closer to the start of the move than after the move is well-documented. It’s fine to be late to the party – the price was up nearly 200% before I bought my first share – but don’t overstay your welcome.

I like to nail down profits into strength, and my stops take care of the rest. When the fish are biting – keep feeding.

No longer Majestic

One stock I bought recently that I did not think I’d ever own is Naked Wine. It’s the old Majestic Wine that I believed to appear to be a bunch of boring wine warehouses that struggled to actually make any money.
As it turns out – it did struggle to make money, and Majestic Wine has now been sold off with management going all in on its small online subscription brand of Naked Wines.

Majestic Wine started as a disruptor to the industry. Management now intend to do it again with Naked Wines.

Recurring revenue model

One of the benefits of a focus on Naked Wines is that it is a scalable online business model; a pure play retailer. Instead of carrying the burden of large fixed costs, Naked Wines has the biggest potential to deliver value to shareholders on account of larger addressable markets and by virtue of its rapid growth in the US. 

 Success is measured in various factors. Sales to new customers (naturally), the investment in new customers, the life time return of this investment, repeat customer sales, repeat customer sales retention, and the repeat customer contribution. 

 Is the model defendable? Anyone can create an online wine subscription, right? 

They can. But Naked Wines funds independent winemakers, who produce exclusive wins at preferential prices. The company then uses economies of scale to pass on the savings to customers. 

The competitive advantage here is that the model (in theory) delivers better wines for cheaper prices. For wine lovers, there’s a story – support winemakers to produce great wines. 

Key drivers of growth in the business

Naked Wines intends to grow its customer base, but already it is seeing customers spending more each year. 

Customer investment is now being hiked up by £5 million from £14.1 million to £19.1 million in order to drive future growth. The company says that its investments are generating a payback of 4x showing an attractive return. However, the company thinks it can go even faster. It wants to continuously increase investment in order to dramatically increase future contribution and value. 

This is because the customers have high loyalty value to Naked. The business also tests everything, and lets data lead the way. Every quarter the best performing investments are doubled up on and the worst performers are cancelled. 

Strength in stock price

In recent weeks WINE’s stock price has surged and nearly doubled. 

I am now long from 380p having bought the breakout of the recent high. I’m running a wider stop on this position and would exit around 315p. The reason for this is because the stock is strong, and I realise a large run up is likely to have a volatile pull back at some point, and also because my position size is small for now. 

Ideally, I want to scale it up. There is a clear fundamental reason for the drive in the share price as the business has shed the Majestic brand, and is now a fully focused machine intent on creating value by scaling up Naked Wines. I want to add to this position if the opportunity presents itself.

It is my opinion (although I am prepared to be wrong and cut my losses as this is a trade for me only) that there is significant upside in the business if:

• Naked Wines can continue to generate 4x payback on investment

• Loyal customers remain loyal and average spend stays high

Update on recent trading

Covid-19 does not appear to have impacted WINE negatively at all.

“Since restrictions on social gathering began, we have seen higher levels of demand from both new and repeat customers in all of our markets, particularly in the US, and as a result we are finishing the year with good momentum and expect revenue for FY20 to be in excess of £200m, which is slightly ahead of current consensus1. We have continued to invest aggressively in new customer recruitment and now expect our total investment for FY20 to be towards the middle of the £20-25m range we indicated with our interim results, with our key payback measure being above our 4x target.”

Revenue is growing better than forecasted, and more importantly the payback measure is above the company’s 4x target.

Valuation

In fairness, the valuation here leaves a lot to be desired. In FY20 Naked Wines is projected to make £0.9 million in post-tax profit.

At the current market cap, that means a PE ratio of over 300.
Granted, those expectations can always be beaten, but one could argue that the valuation for the business is richer than the wines that it produces.

But when has valuation ever mattered?

You can download your free copy of Ten Habits of Highly Profitable Traders from Michael’s website at www.shiftingshares.com 

Twitter: @shiftingshares