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[SMALL CAPS] The magic pizza revisted

By Stephen Wood

The competitive advantages of our process are that it critically values the amount of capital required to achieve growth and that it looks beyond the 12-18 month gaze of the market. 12-18 months are not long enough to properly value the benefits of compound growth that the best companies and managements can achieve. 12-18 months are also not long enough to properly value a company that is very efficient with its use of capital, compared with a company that is not.

We believe that Dominos is a classic case in point. 'It’s always just a bit expensive'. 'There will always be a better opportunity to buy…on a dip'. It is rarely BUY rated by sellside analysts. You have to be a little sympathetic to their views given that the price has just jumped significantly and the 1 yr PE ratio is high at 50x FY16 consensus earnings. This does leave little room for error.

Dominos is extremely efficient with its capital. Not only is it predominantly a franchise model but even at the franchisee level, a store costs only a few hundred thousand dollars and the IT spend is now being spread across a footprint of 240m people. In addition the management only has to partially replicate what has been achieved in Australia and NZ in the key market of France to make the valuation stack up. Let alone the value of long term success in Japan.

The management team ticks all of our eight commandments. We have also caught up with management individually post the recent acquisition of 89 Sprint Pizza stores in Western France and always enjoy the discussions we have about long term planning in the fast food space. Dominos is a long way ahead of the competition in electronic and mobile ordering. So given this, should it be part of a diversified small cap portfolio at over $46 a share?

Dominos is a top 10 position in our portfolio, so we think so. We take profits when the position has repeatedly grown too close to our limit of a 5% active position. That risk control is also part of our process. But we also are very reluctant to sell down the position too far so long as our long term valuation continues to show that Dominos is fair value.

The ability of an exceptional management team to accelerate earnings growth is sometimes very hard to model. The fact that this note is virtually unchanged in eight months—but an apparently fully valued company share price has increased almost 50%—nicely makes the point.

Even at these levels. Its always good to eat part of the pizza and find out later on that it has re-appeared.

Stephen Wood is a Portfolio Manager for UBS.

DISCLAIMER: Whilst the information and statistics contained in this article are believed to be correct at the time of publishing, they are indicative only and do not constitute legal or financial advice. Investors should seek independent financial and legal advice before deciding whether any investment is right for them.

Published on: Wednesday, October 21, 2015

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