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Here’s why one fund manager is steering clear of A2 Milk shares

The a2 Milk Company Ltd (ASX: A2M) is a business that continues to the divide bulls and bears as some believe its a2-only-protein milk products are a disruptor in huge consumer-facing dairy markets, while others think it’s heading for a fall as competition catches up with it.

The stock is up over 2,200% in the past 5 years to suggest betting against it is a dangerous game, but the professional investors at Melbourne’s Yarra Capital Management are not buying shares on valuation grounds among other factors.

According to the fundie’s end of February 2018 investor update, a2 Milk is a “key active underweight” because “we believe the stock’s valuation – trading at a forecast P/E of 31.1 times – fully captures the company’s growth opportunity at this time but doesn’t factor in potential distribution risks….the market’s expectations for future growth rely on A2M sustaining its current market share growth and the brand maintaining its appeal to the Chinese consumer, which may become increasingly challenged as competitors launch comparable products.

At $14.05 today near a record high a2 Milk shares certainly have plenty of growth baked into their valuation, but just today the company updated the market that it continued to see market share growth in China through the quarter ending March 2019.

a2 expects its revenue growth rate for the six months ending June 30 2019 to at least match the 41% growth rate delivered over the first half.

It is correct that EBITDA margins in the second half are expected to be lower than the first half, although full year EBTIDA margins are still expected to be a strong 31%-32%.

The group is also flush with cash, with NZ$287.9 million cash on hand and last week I wrote that I thought it was a good stock to buy this April, admittedly when the shares were about 70 cents cheaper than today.

As Yarra Funds Management rightly points out a2 comes with a lot of risks around valuation and competition, so it wouldn’t be suitable for investors with a low risk tolerance.

However, it looks one of the better growth businesses on the local market in my opinion.

I’d definitely prefer it to baby formula manufacturing rivals such as Bellamy’s Australia Ltd (ASX: BAL), Bubs Australia Ltd (ASX: BUB) and Wattle Health Ltd (ASX: WHA).

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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. The Motley Fool Australia has recommended Bellamy's Australia and BUBS AUST FPO. 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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