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Why it might be time to sell your a2 Milk Company Ltd (Australia) shares

Don’t stand in front of a freight train is a common investment aphorism used to warn of the dangers in betting against fast-rising stocks.

Thanks to the popularity of momentum trading on the local share market it’s wise to heed this warning as inbetween trading updates popular stocks can generate incredible upward momentum.

Recently shares in the a2 Milk Company (Australia) Ltd (ASX: A2M) have rocketed thanks to some positive broker ratings and a surge in retail investor interest in the stock.

In fact it has climbed around 50% since its last trading update and is up 237% over the past year.

There’s no doubt its a2-only-protein infant formula and supermarket milk is soaring in popularity in Australia and China, but the group’s valuation may have gotten ahead of itself given its growth rates.

In FY 2017 it grew revenues 56% to NZ$549.5 million and earnings per share 186% to NZ12.7 cents per share thanks to the operating leverage in the business and fast-rising profit margins.

Its blockbuster FY 2017 put it on the radar of powerful analysts from the big end of town and the business media, while the rising share price in itself added to the hype .

Analysts are forecasting an FX-adjusted A$20 cents per share in financial year 2018 which would represent earnings per share growth of around 66% this year.

The company will need to deliver some very strong revenue growth while lifting margins to meet these forecasts and given the unpredictability of the baby formula market top-line growth may not deliver as expected over the full year.

Much of the demand for baby formula comes from China or Chinese daigou shoppers in Australia and relying too much on the strength of Chinese demand may be a mistake.

Infant formula (even of the a2-only-protein variety) is just a commodity at the end of the day, with low barriers to entry and potential for plenty of price-based competition flooding the market.

If the business were to meet analysts’ sales growth forecasts shares at $6.90 would be changing hands for 34x estimates of forward earnings. Given the anticipated growth rates this would probably be a fair valuation, however, if sales don’t grow as anticipated the share price could be in for a substantial fall.

The group is due to deliver its next trading update at its November 21 AGM which may prove a reality check. I have taken profits on the stock myself over the last month, as I expect its best growth days may be behind it despite the hype.

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Motley Fool contributor Tom Richardson owns shares of A2 Milk.

You can find Tom on Twitter @tommyr345

The Motley Fool Australia owns shares of A2 Milk. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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