Buy Cheap, and Be Patient. Why stock picking is the key to solid returns.

Richard Hemming

Is it just me, or does it seem that this reporting season has been a wilder ride than usual at one end, and pretty boring (but profitable) at the other? The takeout is that value hunting or another way to describe it, stock picking, is the way to generate consistent strong returns. This is what happens when interest rates are on the rise.

Some unpopular ASX small caps that we’ve been backing for a while have been showing signs of life. I’m talking about manufacturers like Capral Aluminium (CAA) and Gale Pacific (GAP). And these sorts of stocks are still cheap, trading on low double-digit price earnings ratios and delivering 5 per cent plus dividend yields.


A group of trees growing from small to big
 

Cheap for a reason

They’ve both got big issues to deal with, for instance Capral has to deal with cheap aluminium products being dumped into Australia from offshore; while Gale has to deal with the difficulties of being a small company trying to tackle markets as diverse as providing covers for grain storage; to delivering shade cloth to the Middle East and the giant North American market.

These types of companies don’t always work out, but you’ve got a better chance of being successful when the PE is 10 times than when its 25 times.

You buy when it’s expensive and you take your chances; in some ways you’re playing the “greater fool” game. When you buy cheap, sentiment is not a huge part of the price, so it’s one form of insurance against a big market drop.

We are not in the GetSwift rich business.

This is important to state, because in the market overall, we’re getting to the stage where there are a lot of go-go stocks trading at eye watering valuations that make you wonder whether it’s possible they have any chance of meeting expectations. And it’s clear that some of these “go-go stocks” are unravelling.

The capitulation of the software company GetSwift’s share price (ASX GSW) has been spectacular.


Graph showing the share price of GetSwift from March 5 2017 to March 5 2018
 

Its stock has just come out of an ASX suspension and it’s trading at 15% of its previous high, which was only a few months ago. Other software/technology stocks have been hit hard too, which include corporate video platform Big Un and Buddy Platform, whose share prices have more than halved in recent weeks.

Why software is a dangerous space

Software companies are inherently risky from a financial standpoint because they tend to capitalise much of their research and development expenditure. The millions spent becomes an asset, rather than an expense. It is at management or the board’s discretion whether these funds are amortised or written off over one or two years. This allows a certain amount of manipulation.

Also, it’s easy for software to become stranded and to lose its efficacy or productive capacity because someone else comes along and does the same thing another way. The barriers to entry are low.

We have done well out of Reckon because we bought cheap and have been patient

The accounting software company Reckon (RKN) is a case in point. The company had reached the point where it could have spent a lot more money developing its cloud based desktop accountant practice software but MYOB was doing the same thing; and so was Xero. Reckon could have spent a great deal of money but ended up with an essentially useless asset. Luckily for Reckon shareholders MYOB stepped in to purchase this business for $180 million. Combining Reckon’s business with a competitor reduces the risk that money spent on software won’t be wasted.

The Demise of the Franchisor

Another big recent casualty in markets have been “glamour” growth stocks Domino’s Pizza and its little brother, Retail Food Group, which both rely on the franchisee model, which allows them to achieve seemingly bulletproof growth through the constant “rolling out” of stores. I’ve mentioned these two stocks in the past as being heavily vulnerable, but the recent shareholder notice disclosures by Domino’s Pizza CEO Don Meij underline that these are really momentum stocks. When an insider sells into a share buy-back, come on!

At a certain point these companies are achieving growth over everything. They might be great at managing 25 outlets that are wholly owned, but when it gets to 225, management can’t deal with it and stores start fighting between themselves for market share. You get dis-economies of scale.

Crust Pizza was a great business when it was on its own; but it turned into a very average business when RFG took over it and lost control over what made the business special in the first place.

Remember our philosophy

One of our principles is to buy cheap and be patient. When there is craziness in the market place, this is what we hold onto.

About the Author

Richard Hemming

Investment analyst and Editor of Under the Radar Report

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