Rudi’s View: Investing In Non-Profitable Companies

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In this week's Weekly Insights:

-Investing In Non-Profitable Companies
-Corporate Updates: Early Signals
-Peak Resources?
-FNArena Talks

By Rudi Filapek-Vandyck, Editor FNArena

Investing In Non-Profitable Companies

The 2022 patience-testing, volatile bear market for global equities has shown investors risk is not simply a four letter word; it should be properly managed, or else the damage can be stomach-churning if not soul-destroying.

A few share market truths that have shown themselves in spades throughout the year:

-history is not a perfect guide
-small cap companies are riskier than large cap companies
-beyond macro and sectors, individual, company-specific characteristics ultimately matter
-risk-off bear markets punish more and more harshly than risk-on periods reward
-Loss-making companies are among the riskiest options overall

As per usual, there are always a plethora of exceptions, but each of the above general statements would be backed up by detailed stats and data analysis.

Consider, for example, during the extremely volatile month of September large cap stocks in Australia lost -5.4% in share price value but small caps retreated by -11.2% over the month.

Then again, look underneath the share market's bonnet, and we discover many of the best performing stocks over the three months past are small cap companies, including Tyro Payments ((TYR)), Liontown Resources ((LTR)), Life360 ((360)), Paladin Resources ((PDN)), IPH Ltd ((IPH)) and Mesoblast ((MSB)).

For good measure: virtually all of the worst performers from the past three months are small cap companies, including Appen ((APX)), EML Payments ((EML)), Ramelius Resources ((RMS)), Codan ((CDA)), Imugene ((IMU)) and Pointsbet Holdings ((PBH)).

And just to prove that generalisations are seldom without exceptions on the share market: as at last Friday, the S&P500 is down -22% year-to-date and -14.5% from twelve months ago while the S&P Small Cap 500 is down -19.39% and -16.24% respectively.

Yes, indeed, life as an investor is only simple and straightforward when sitting in cash on the sidelines (but only for a while).

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Details and exceptions matter when it comes to making investment decisions. A truth once again highlighted by recent research into loss-making companies by the Quant desk at Macquarie is not every loss-making company is doomed for annihilation, simply because not every loss is permanent or of the same making.

Before we dig into the finer details, let's start with some general numbers.

Since 1995 (28 years) 32% of the ASX300 have been a loss-maker of some form. For the MSCI World index, which is of higher market capitalisation, the corresponding percentage is 18.

Macquarie's research suggests companies that become loss-makers are of lower quality, carry higher risk and operate with poorer momentum. Loss-makers, it turns out, are also more likely to surprise negatively, pay no dividend, experience higher volatility in their shares, but were also more frequently a target of takeover offers.

The recent August reporting season in Australia revealed 28% of the ASX300 is a loss-maker of some form; below the long-term average of 32%.

The most obvious form is through reporting a negative result, i.e. no profit but a loss, but that's not the worst sin or highest risk proposition in the share market; much worse is the company that doesn't generate positive cash flows from its operations. The worst proposition is when a company does both.

Macquarie research suggests these so-called double loss-makers are most at risk of remaining a loss-maker, and continue underperforming over time. The most common form of loss-making is via the total in cash flow that is available to all shareholders and holders of corporate debt, otherwise known as the FCFF (free cash flow to firm).

Compared with the previously mentioned 32%, historically 21% of the ASX300 have been FCFF loss-makers, and 10% of the MSCI World. When it comes to share price performance, FCFF loss-making is worse than reporting an accountancy loss.

This makes instinctively a lot of sense as cash flow keeps the business running, including maintenance and new investments, and a lack of it might force the company to raise more capital, in a positive scenario.

What also makes a lot of sense is that when times get tough, both economically and in financial markets generally, these are the companies destined for relative underperformance, if not sharp underperformance.

The above also means that even if a company reports an accountancy profit, it'll still feature as a loss-maker if the cash flows are negative and deemed insufficient. The opposite equally holds true: a company might report a negative result (loss) but with positive cash flows the share market might still treat it as a higher quality performer.

And since we are talking about the share market, forecasts are important too. On Macquarie's analysis, analysts are reasonably accurate when predicting a loss for a currently profitable company; 69% accuracy in Australia and 79% for the MSCI World. Analysts are particularly accurate when forecasting another loss next year for companies that are currently loss-making with 93% accuracy in Australia and 63% globally.

Alas, the numbers look a lot worse when analysts try to predict a profit for companies that are currently loss-making with Macquarie's analysis putting accuracy at only 49% in Australia and 63% globally. The quant analysts suggest the higher accuracy percentage for the MSCI World relates to higher market cap and lower risk companies.

In Australia, we might also draw a straight line to one of Macquarie's general observations: loss-makers are more prone to delivering a negative surprise. In particular this year's bear market in Australia has pushed out the timing by 12 months or longer for many a non-profitable, small cap technology company to achieve break even.

From technology start-ups to energy explorers, and everything in between: one company's loss is not necessarily equal to another. Some companies are perennial loss-makers, and treated accordingly. Others are loss-makers, but growing strongly in a young and developing new market. A loss can mean a nasty one-off, or the start of decline for a maturing business model.

Details matter. Situation matters. Context matters. As do forecasts and perception.

Completely unsurprisingly, Macquarie found loss-makers among small cap resources companies generate the largest tracking deviations.

Most importantly, investors should not treat the above mentioned below long term average of 28% in loss-makers in August as a positive. Most individual categories were above their respective long term average, reports the broker.

Net profit loss-makers reached 21% versus 18.6% long-term; operational cash flow loss-makers were 15% versus 12% long-term; the doubles reached 12% in August versus a long term average of 9%.

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For investors, it is important to know the largest underperformers are usually found among double loss-makers and those forecast to become loss-making in the following year; cash flow is more important than the accountancy bottom line.

Serial loss-makers and high long-term growth companies tend to underperform in milder form, but underperformance rules generally during times of risk off, otherwise known as a down market, when economies are weak and under duress. Loss-makers perform better in case of a successful turnaround (no surprise here).

Equally unsurprising, distinguishing winners from losers among loss-makers is usually related to a cheaper valuation, less risk, better operational momentum and higher margins, as well as paying a dividend, experiencing fewer extreme events and carrying a more positive track record (positive surprises in the past).

Applying all of the above, loss-making companies considered least likely to underperform include Orica ((ORI)), Lendlease ((LLC)), Service Stream ((SSM)) and Origin Energy ((ORG)) while those most likely to underperform include Novonix ((NVX)), Tyro Payments and Zip Co ((ZIP)).

Other companies Macquarie would not toss overboard include Data#3 ((DTL)), Champion Iron ((CIA)), Washington H Soul Pattinson ((SOL)), Unibail-Rodamco-Westfield ((URW)), Auckland International Airport ((AIA)), Sigma Healthcare ((SIG)), Estia Health ((EHE)), Sky City Entertainment ((SKC)), Centuria Capital ((CNI)), Karoon Energy ((KAR)), and Capricorn Metals ((CMM)).

Those to avoid, according to the research, also include 5E Advanced Materials ((5EA)), Vulcan Energy Resources ((VUL)), Betmakers ((BET)), Australian Strategic Materials ((ASM)), Life360, Imugene, Pointsbet Holdings ((PBH)), EML Payments, Mesoblast, Incannex Healthcare ((IHL)), Siteminder ((SDR)), and Telix Pharmaceuticals ((TLX)).

The irony here is, of course, some of the companies mentioned in the latter selection have been among the best performers on the market recently, for whatever reasons.

Corporate Updates: Early Signals

Amidst a global obsession with monthly inflation data (and central bank persistence as an extension of these data), corporate Australia is updating shareholders and investors at AGMs, investor days and quarterly trading updates.

A number of early indications might prove useful for investors in the months leading into year-end and the February reporting season.

The following have caught my attention:

-on Monday, CSL ((CSL)) increased its profit guidance for FY23 to 13%-18% including the recently acquired Vifor, from earlier guidance of 10%-14% ex-Vifor.

The market update includes a warning the strong US dollar might shave -US$200m off its bottom line. Guidance is traditionally provided on a constant currency basis. Such a large, negative FX headwind will erase part of Vifor's positive contribution for the year.

-Also on Monday, Costa Group ((CGC)) effectively issued a profit warning because bad weather has negatively impacted on the harvest for quality grade citrus fruits, weighing down the financial contribution for this year despite strong demand and strong product pricing.

-Still on Monday, Adbri's ((ABC)) CEO is out as the company announced yet another profit warning. The share price fell to an 18-year low on the day.

-Insurance companies have won the legal battle around business interruption policies with the High Court dismissing three appeal applications following favourable rulings prior by the Federal Court of Australia.

-Last week, Bank of Queensland ((BOQ)) broadly met market expectations with its release of FY22 financials, but the regional lender surprised friend and foe with its confidence that margins will benefit more from higher interest rates than any damage suffered from higher costs.

-Baby Bunting ((BBN)) opened the unofficial reporting season locally with a big profit warning as inflation and competition put a big squeeze on the retailer's margins.

A few considerations:

-Inflation remains a tangible problem. Investors might shy away from casually assuming the worst is now behind us, even if share prices for discretionary retailers are suggesting a lot of bad news potential has already been priced in.

Admittedly, Baby Bunting's share price had held up relatively better before last week's profit warning, but it'd be a small miracle if it turned out the only retailer to suffer, and by more than is expected;

-Corporate results this time around are being impacted by far more than simply supply and demand and competition in markets; we have rising costs of debt, currency movements (USD in particular), plus rain on the east coast (and other weather-related impacts).

The latter in particular is not only a risk for agricultural producers such as Costa Group. Upcoming quarterlies from mining companies and energy producers might equally reveal negative impacts.

Analysts at Morgan Stanley already highlighted the higher risk of flooding for open pit operations in Australia, but miners operating underground can still be affected through logistics.

Morgan Stanley sees risks for Whitehaven Coal ((WHC)), Evolution Mining ((EVN)), Newcrest Mining ((NCM)), South32 ((S32)) and BHP Group ((BHP)).

Equally worth keeping in mind: some miners need a better quarter to catch up with full year guidance, including Rio Tinto ((RIO)), OZ Minerals ((OZL)), 29Metals ((29M)), and Iluka Resources ((ILU)).

Also: on estimates by sector analysts at Jarden, the September 2022 quarter might turn out to be the high-water mark for quarterly revenues for Australia's two largest pure oil & gas producers, Woodside Energy ((WDS)) and Santos ((STO)).

And as suggested by Adbri's announcement: building materials companies operate under equally fragile conditions.

-An important difference between Bank of Queensland and Baby Bunting and Costa Group is that banks and other financials are being thrown an extra benefit from RBA rate hikes.

This not only helps with battling headwinds elsewhere, it also increases the chance for a positive surprise, as shown by Bank of Queensland last week.

Analysts are now busy further increasing their forecasts for the sector. This would have translated into a better share price performance if only broader market sentiment had been more positive generally towards risk assets.

Benefits from higher interest rates and bond yields extent to most financials, including Computershare ((CPU)), general insurers, health insurers and specific services providers Challenger ((CGF)) and AUB Group ((AUB)), to name a few.

The latest decision by the High Court has provided general insurers with an extra benefit that cannot be timed or confidently forecast. Insurance Australia Group ((IAG)) has already announced a $350m buyback, as prior provisions can now be wound back.

Suncorp ((SUN)) might pay out a higher dividend, while it remains anyone's guess, or so it seems, what the benefit for QBE Insurance ((QBE)) shareholders might be.

One of the main events that happened locally last week was the strong trading update by Qantas Airways ((QAN)) with management effectively suggesting prior guidance for the full year might now be achieved over the first six months of FY23. In terms of profit upgrades, they usually don't happen with that order of magnitude.

What Qantas' guidance upgrade does signal is the so-called re-opening trade remains well and truly alive and kicking, with further potential for upside surprise.

Within the slipstream of the Qantas surprise, it seems but logical to also think of Aristocrat Leisure ((ALL)), Tabcorp ((TAH)) and companies in the travel and leisure sectors.

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Contrary to what has been suggested by Baby Bunting, strategists at UBS believe too many domestic cyclicals on the ASX have seen share prices fall too far.

Australia won't experience an economic recession next year, assures the broker, but shares are priced for one.

UBS has thus upgraded Discretionary Retailers to Neutral from Underweight and downgraded Consumer Staples to Neutral from Overweight.

UBS strategists main forecast: "We expect equities to remain range-bound over coming months, and stick with our year end target of 7000 for the ASX200."

UBS's key recommendations are to have portfolios overweighted to Energy, Mining and Technology (incl media and telecom).

P.S. those Domestic Cyclicals include Flight Centre ((FLT)), Seven West Media ((SWM)), Harvey Norman ((HVN)), Super Retail ((SUL)), and CSR ((CSR)), as well as Adbri, the banks and Star Entertainment ((SGR)), which has just been fined by -$100m and its licence to operate a casino suspended.

Peak Resources?

Price-Earnings (PE) ratios can be quite deceiving and they certainly don't provide any timing, but when properly used in a broader context, they can equally be illuminating within a broader, longer-term framework.

The chart below depicts the average PE ratio for all resources companies in the ASX200 post 1994. It clearly shows PE ratios haven't been this low since 2008 and in 2022 they are at the second lowest level ever throughout the past three decades.

PE ratios peaked in 1994, in 1998, in 2003, in 2009, and in early 2016. If we overlay the peaks and the troughs with share prices from the past, then history overwhelmingly shows investors, with the benefit of hindsight, the ideal time to buy the sector is when PE ratios are sky-high, not when they are in single digit.

As said, generalised PE ratios don't tell us anything about timing or what'll happen to forecasts from here onwards, plus we can all discuss the different market dynamics between lithium and copper, or between metallurgical coal and scrap metal, but there is a recession coming in multiple regions, and history cannot lie, or can it?

This time is different?

FNArena Talks

Interview with Peter Switzer last week, which contained a lot of macro, micro, broader context and a number of individual stocks (I am first up, followed by the NSW premier):

https://www.youtube.com/watch?v=8Cfwi873Xik

(This story was written on Monday, 17 October, 2022. It was published on the day in the form of an email to paying subscribers, and again on Thursday as a story on the website).

In addition, since FNArena runs a Model Portfolio based upon my research on All-Weather Performers it is more than likely that stocks mentioned are included in this Model Portfolio. For all questions about this: info@fnarena.com or via the direct messaging system on the website).

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