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One of the best loved small cap shares just got hit with a “sell” recommendation

The share price of Lovisa Holdings Ltd (ASX: LOV) is going gangbusters ahead of its profit results but one broker is urging investors to cash out of one of the best loved small cap stocks on our market.

Everything has a price and Canaccord Genuity believes investors are overpaying as it downgraded Lovisa to “sell” from “hold”.

But that hasn’t dampened sentiment towards the jewellery retailer as its shares jumped 2.6% to $11.70 in lunch time trade. This takes its one-year gain to 190% compared to the 10% rise by the All Ordinaries (Index:^AORD) (ASX:XAO) and S&P/ASX 200 (Index:^AXJO) (ASX:XJO).

You’d be hard pressed to find another retailer with such stellar gains given the challenging operating environment with weak wages growth, high household debt, and the arrival of online shopping rivals like Amazon.com and Kogan.com Ltd (ASX: KGN).

Lovisa has managed to overcome these challenges and deliver growth thanks to its capable management team and offshore expansion, but the stock is now trading on a FY19 consensus price-earnings (P/E) of 30 times, which by the way, is a 31% premium over Kogan.

What’s alarming is that there are a number of things that can trigger a painful de-rating in the stock over the next 12 months, according to Canaccord.

“We see the potential for Lovisa to have a much larger overseas footprint in time, but we believe the current $11.40/share price already captures ~330 stores from pilot/ non-forecast regions longer-term (~750 total network) – compared to an estimated 16 stores presently operating or planned across Spain, France and the US,” said the broker, who has a price target of $9.11 on the stock.

“In the near-term, Lovisa needs to navigate tough comps at home, currency headwinds and rollout expectations in the market that we feel are incongruent with management’s discipline around store economics.”

The “tough comps” refers to the high bar management has set itself when it delivered better-than-expected same store sales growth figures over the last four years. Canaccord doesn’t think it can pull another rabbit out of its earnings hat this time as the tailwinds that helped it deliver strong growth are waning or have disappeared.

These include the closure of a number of its competitors, price increases and the launch of its very popular range of new designs in FY17 and FY18.

There’s also the issue of the weakening Australian dollar. While Lovisa’s offshore expansion will help ease margin pressure (it buys its products in US dollars), the company makes most of its sales in the domestic market.

I am expecting the exchange rate to feature in the earnings commentary for a number of other retailers as well, including Reject Shop Ltd (ASX: TRS) and Nick Scali Limited (ASX: NCK), as they directly source products from overseas suppliers, but at least these retailers are not trading on lofty premiums to the market.

I can’t help but to agree that it might be wise to take some money off the table when it comes to Lovisa.

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Motley Fool contributor Brendon Lau owns shares of The Reject Shop Limited. The Motley Fool Australia has recommended Kogan.com ltd and The Reject Shop Limited. 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 Scott Phillips.

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