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Why Appen shares aren’t on my buy list in 2019

The Appen Ltd  (ASX: APX) share price has surged higher this year, with yesterday’s closing price of $16 per share representing a 25% increase since the start of January. I’m a big fan of Appen, but I’ve listed a few key points that are making me reconsider the stock at its current valuation in 2019.

The Product Works…

Appen describes itself as a “global leader in the development of high-quality, human annotated datasets for machine learning and artificial intelligence”. Behind the buzzwords, Appen essentially provides data that improves the functionality of its clients’ existing machine learning algorithms, adding value through improved insights for business purposes.

The company has grown rapidly in recent years with offices in Australia, China, the Philippines, United Kingdom and the USA. With this international expansion has come a meteoric rise for the company’s share price as Appen’s market cap has swelled tenfold from $165.2 million in January 2016 to $1.71 billion today.

For those doing the maths, that works out to be a 932% increase in share price over those three years – not a bad return in anyone’s books.

And the Opportunity is Huge…

The use of data science and data analytics in business is growing. Now that we’ve well and truly entered the “Information Age”, the applications for artificial intelligence and machine learning are growing and investment is booming. The largest companies in the world rely on huge volumes of data processing and insights gathered, and Appen’s offering leaves it well-placed to capitalise on this boom.

But There are Some Headwinds…

While I fully expect Appen to ride the data analytics boom right to the top, unfortunately so does the market. Appen is trading on a P/E ratio of 82, which by anyone’s standards, is pretty lofty. While the market is expecting big things, a positive earnings surprise in February could revise expectations upwards and boost share price upside for investors.

My other concern with Appen is sector-specific – the Information Technology can be highly cyclical. The main threat to Appen’s growth from my perspective is an economic downturn, with companies tightening spending amidst corporate profits and cutting down on discretionary services such as Appen’s AI and machine learning training.

Foolish Takeaway

In my books, Appen appears to be a well-run company with a bright future. The biggest factors making me steer clear for now are its high P/E ratio and its vulnerability to an economic downturn. In the meantime, I’d be looking to put my money in a more defensive stock such as AGL Energy Limited (ASX: AGL) or Wesfarmers Limited (ASX: WES).

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Motley Fool contributor Lachlan Hall has no position in any of the stocks mentioned. The Motley Fool Australia owns shares of and has recommended Wesfarmers Limited. The Motley Fool Australia owns shares of Appen Ltd. 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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