INCREASING VOLATILITY PROVIDES OPPORTUNITIES TO PROFIT

Profit making opportunities occur more often in results season for Small Caps because these companies don’t give much away outside of their interim and final results and there is little media or broker coverage. It is one of the few occasions when management has to give you an indication of current market conditions; and you get to see under the hood of the company’s financials.

More to the point, selling to realise gains and taking risk off the table is something you should be thinking about all the time.

This is why Under the Radar always emphasises taking profits when opportunities occur, especially in the current market, which overall has been on a tear. In the past few issues we have advocated taking profits on some big share price runs in Under the Radar stocks, including Gentrack (GTK), Karoon Energy (KAR), Capitol Health (CAJ) and Mayne Pharma (MYX).

This reporting season is interesting because earnings estimates are under pressure, owing to a weakening economy after months of rising inflation and consequent increases in interest rates. Balance sheets will be more closely scrutinised and companies may reduce dividends as a result.

The evidence in recent months is that “growth” stocks are vulnerable to anything that doesn’t indicate strong future earnings. This reporting season is essential for investors to know what to look for in order to protect your portfolio and to take advantage of any over-reactions.

Not only will we be looking to continue to profit from share market euphoria, but potentially more profit opportunities can arise when investors take the sword unnecessarily to a Small Cap that has good long-term prospects.

WHY FOCUSING ON VALUE PROTECTS YOUR PORTFOLIO

A QUICK OVERVIEW OF THE FINANCIAL STATEMENTS

A company’s accounts consist of the holy trinity of the profit & loss (P&L); balance sheet; and cash flow statements.

The P&L is a summary of the revenues and expenses over the period, which culminates in the bottom line profit or loss after tax. The balance sheet is a snapshot (at the balance date) of the assets the company owns and the liabilities and equity used to fund them. Finally, the cash flow statement is the actual money received and paid by the company and is sort of like truth serum.

We look for mis-matches, which can highlight fundamental differences between the story a company is selling to investors, versus what is actually happening.  We will also look for internal anomalies like increasing inventories or debtors.

THE CHECKLIST

What Under the Radar Report looks for in a company’s profit result:

1.         Cash is King

·      How much cash/debt compared to last year?

·      Changes to working capital?

·      Net investment expenditure?

·      What is the company doing with its excess cash?

The first question is whether the company has more, or less, cash or net debt than the previous year and half year.  While this is a simple question to answer, the reasons behind changes in the cash position can be extremely complicated.  We will not go into all of the factors here, but emphasise that we will be expecting cash from operations approximately in line with profit before tax and interest (EBIT).  You may need to think about changes in working capital (inventories, debtors and creditors), as well as in net investment in PP&E (Property Plant and Equipment).  Where there is debt, what are its terms, when does it need to be renewed?  If free cash flow is not going towards debt reduction, something will have to give.  Whether a request for more funds from shareholders is done on good terms or bad will largely depend on the reason given for those funds, which in turn relies on underlying fundamentals – the interaction between the profit and loss; the cash flow statement and the balance sheet.  

2.         Sales Growth

·      Is the company growing sales?

·      Why are those sales growing – volume or price rises?

·      If it isn’t, what is driving earnings growth?

In most cases we are expecting sales growth from our companies.  If your company is in transition or restructuring; if it cannot grow sales; then bottom line progress will be much harder to achieve, and your patience as an investor will be tested.  If you don’t like the prospect of hanging in there, reduce your position.  If your company does report revenue growth, the key is whether you can identify and approximately quantify the factors behind the sales growth.  In a service business, this may be achieved through more efficient operation, or by an increase in staff or infrastructure.  In a manufacturing business revenue increases should be achieved from either increased volumes or higher selling prices.  Management's commentary on the sources of growth should be clear and unambiguous. 

3.         Margins Matter

·      How have costs changed over the period?

·      What are the company’s input costs?

·      What is the proportion of fixed costs to overall costs?

The factors behind sales growth, and the cost structures associated with achieving sales outcomes should be reflected in both gross profit margins and net profit margins.  Gross margins should expand when prices are rising faster than the input costs that go into creating the products and services.

Underpinning this is our eternal search for operating leverage, as a company's sales and margins should be growing, and the fixed operating costs of the infrastructure and corporate assets necessary to deliver the outcomes should reduce as a proportion of sales over time, increasing net margins.  So margins matter, and again the goal should be to understand what are the factors behind changes in margins and whether these are likely to be sustained or increased.

4.         Be wary of what’s “Underlying”

·      What are the headline profits versus the so-called underlying?

·      What has the company declared to be exceptional or one off in prior periods verus in the current period?

Some red flags are hidden in the exceptional items, which the company considers not part of its normal operations, or one-off in nature. Examples include gains and losses on asset sales, restructuring costs, as well as write-offs of intangible items when a board has reviewed the cash flows from those assets and decided that they are insufficient to support the assets’ carrying values in the accounts.

Companies exclude these items to come up with their “underlying earnings”, which is meant to reflect the performance of their ongoing operations. This is an issue when these one offs recur from one result to the next. Outside of us ignoring management’s definition, this becomes an issue of its credibility.

5.         Outlook Comments

·      What is the tone of the outlook comments?

·      Is the company looking to make acquisitions?

·      Does the company have a track record of underestimating or overestimating future profit growth?

Management's outlook is important not only for the specific numbers that the company is expecting to deliver or report, but also the tone and information about investment plans and strategic direction which the outlook should deliver.  If a company uses language which suggests that it is thinking of making acquisitions to increase its market strength, do not be surprised if a future equity issue is going to help fulfil that intention.

In most cases, management's outlook will be as positive as legally possible, but as a private investor you can be as suspicious as you feel is appropriate.  It is very easy to fall in love with a company, perhaps because it has performed so well and delivered all of its promise and more, and has made you lots of money already.  Or it seems so cheap that you cannot understand why you are the only buyer in the market, but the stock keeps going down.  Company reports need to be read with a healthy dose of scepticism.  The annual report should be read.  This can be somewhat tedious, but as an audited document, this is an important constraint on management’s ability to delude itself and investors.

5.         Share price reactions

·      Has the share price been trending up or down prior to the announcement?

·      Was there a sharp reaction on the day of the announcement?

Subscribers are sometimes surprised by the reaction of share prices to market moving news like results and prospects.  This is a variation of the old adage to buy the rumour and sell the news.  The stock market is always looking for growth, and accelerating growth at that.  Decelerating growth will often cause a big problem for growth stocks, because valuations are based on higher growth for longer.  The bottom line is to avoid owning too many stocks that are so expensive that they are vulnerable to any disappointment of other investors’ expectations.

How is “Sell” different from “Take Profits”?

Interpreting our “Take Profits” rating will depend on how much stock you own of the Small Cap in question. If you don’t own much it might mean selling the whole lot to bank profits; while if you own more, it might be a question of just selling a few because the market isn’t liquid in that stock (not many buyers and sellers reflected in a big bid/offer spread). Sometimes you can be lucky enough to take your costs out and let the rest of your holding run for free.]