The latest ructions in the market mean that investors will be heavily focused on the outlook statements contained in this reporting season. Increasing volatility means that each investor's interpretation of valuation is a crucial determinant to making money. It really is a stock picker's world now.
You need to be brave and not follow the herd. Under the Radar puts a great deal of effort into the analysis of financials so that you can make the best decision possible for your portfolio.
The reporting season is more important at the Small end of the market than for their much bigger brothers and sisters. Why? Because Small Caps don’t give much away. Few report much detail outside of their interim and final results. There is not much, if any coverage, from the media. For example, the number of companies covered by the AFR has dwindled to less than a third of what it was even five years ago.
The results season is the one occasion when management has to give you an indication of current market conditions; and you get to see under the hood under the company’s financials.
Even after the recent volatility, the ASX Emerging Companies Index has climbed almost 20% in six months, while the ASX200 hasn’t even increased 3%. So expectations are more important than ever.
The market PE is about 16 times for forecast earnings (14x for resources; 20 times for industrials). Expectations are for flat or low single digit earnings growth from industrials; 30% rising in resources.
The results season is really where the rubber hits the road; lots of sector commentary but you can’t hide from the numbers. Whether it’s the Christmas effect for retailers. Or whether it’s buoyant commodities for the mining services.
A key trend has been for “underlying” profits at earnings before interest tax, depreciation and amortisation (EBITDA). We don’t rely on their version, however. We do our own work! These “underlying” figures are notoriously unreliable. Along these lines, “exceptional items” are important. The devil is always in the detail.
The quality of cash flow is important. When markets get skittish there is always more focus on cash. Under the Radar will be doing the ground work to enable that you are looking at the real picture picture.
What is the trend in small caps?
Small caps have run hard in the past five or six months as investors go looking for growth with a back drop of low interest rates.
There have also been takeovers. In the past week Sirtex (SRX) was made an offer and before that AWE (AWE).
Since we commenced over six years ago, we’ve recommended just over 130 different companies, of which 21 have been taken over; a strike rate of over 15 per cent. In 2017 this percentage has climbed to almost 30%. You just have to look at Australia’s sluggish economic growth to see that mergers and acquisitions of Small Caps is not going to fade any time soon.
If you’re a big company you can borrow at 3% and your earnings return ought to be a lot more than that; easy to have an earnings enhancing takeover.
What does this mean for small caps?
We think that it’s important to be looking to take advantage of this momentum and take some profits!
We’ve had some big winners, and we always put as much effort into when to sell these stocks as when to buy them.
A lot of stocks that have been quiet performers have been climbing fast in recent months, as you can imagine. These ones come quickly to mind, but there have been quite a few more:
IMF Bentham (IMF)
Alliance Aviation (AQZ)
Medical Developments (MVP)
Another that has climbed is the services group Hills (HIL), which continues to go through a transformation. We update the progress of this company in this week's issue.
What is the difference between sell and take profits?
You don’t wait until you have a reason to sell. Put another way, selling to raise cash is something you should be doing all the time, rather than simply when you have to.
In many small caps we can see signs of stocks where a lot of buying, looking around and wondering who the next buyer is. The spreads are widening; volumes are thinning.
We’re you’re eyes and ears on the ground.
So what does "Take profits" mean compared with "Sell"? If we say Sell, it means get out no matter what your level of holding. A Take profits rating is more nuanced. It very much depends how many you have. It might mean selling the whole lot to bank profits if you don't own many; or it might be a question of just selling a few because the market isn’t liquid in that stock. You take profits on a few where you can get the cash. It may be that you take your costs out and you let the market run the rest of your holding for free.
What have you been looking at lately?
Next week we begin coverage on a company in transformation because it’s doing a big merger which is a case of one plus one equals three. The group looks very cheap and has a great deal of financial flexibility.
We've also been looking at solar and battery technology because it is becoming increasingly economic.
It seems likely over time that fossil fuel forms a less important part of society's core energy requirements and that there are increasing renewable options. This range will become increasingly available because of lower costs. Both storage costs and capture costs are going down at a fast rate, which is the nature of manufacturing when increasing volumes are required.
We disentangle this fascinating sector for our subscribers and look at some investment options.