Avoid The Torpedoes!

This story features BOART LONGYEAR GROUP LIMITED, and other companies. For more info SHARE ANALYSIS: BLY

By Rudi Filapek-Vandyck, Editor FNArena

Probably the most surprising development throughout 2012 has been the ever-so-increasing gap between profit estimates and share prices. Something that became rather noticeable from mid-year onwards.

If I had to illustrate this gap on a price chart (which I haven't, but let's assume I had) it would show one big alligator mouth opening wider as the year progressed. Just so we're all clear on this matter: at the bottom would be investors' earnings per share forecasts which have taken quite a big hit this year while share price action would mark the upper side. The share market is up double digits this year (ex-dividends) which probably says it all.

Profit forecasts are the traditional anchor for equities, but it is not that uncommon for share prices to ignore them. The rally in 2009 would be another recent example of when investors decided to ignore immediate profit forecasts. Of course, those profit forecasts will return as an anchor at some point. By early 2010 the rally that took off in March 2009 had fully priced in profits for (most) Australian companies and this is why share prices essentially went nowhere for the rest of that year (amidst high volatility).

This year, amidst downward pressures in the US and continued severe downgrades elsewhere including in Asia and in Australia, general confidence has risen that the world economy will be in a better state in the second half of 2013 and in subsequent years. This has, again, led investors to take a leap of faith and ignore what immediately lies in front of them. Profit prospects for FY14 are thus the new gospel for those investors looking to jump on board the sentiment driven train.

However, this year's prospects cannot be completely ignored in the meantime, as there's still plenty of room for bad news announcements; especially for companies in sectors facing downward pressures and headwinds. This was again highlighted by the fact that directors at unlisted food company Gourmet Food Holdings and Waterwheel voluntarily called in the administrators on Monday.

In the share market, NRW Holdings ((NWH)) is yet another example. Surely most investors would have thought that after the caning the share price received since May this year, which saw the share price more than halve over the period (from above $4 to less than $2) would prove more than sufficient to account for the quick reversal in revenues and profits at the mining services provider, but there was yet another profit warning and sell-off to come. As I write today's story, the share price is close to $1.30 but still falling in an otherwise up-trending market.

On present consensus forecasts, NWH shares are now offering in excess of 12% in prospective dividends (fully franked) while trading on the super-low Price-Earnings (PE) ratio of four times the current year's earnings per share (EPS), suggesting investors are now taking an extremely negative view. But then it's difficult to confidently play the role of value investor when price action on charts continues to show weakness and management is still forced to issue profit warnings.

NRW Holdings is far from the only one in a sector that simply could do no wrong before May this year. Investors who owned shares in the likes of Boart Longyear ((BLY)), Norfolk Group ((NFK)), Sedgman ((SDM)) or Imdex ((IMD)), among many others, know all too well what I am referring to.

Another victim in that very same segment of the local stock market is Fleetwood Corp ((FWD)), manufacturer of mobile accommodation for miners, retirees and holiday seekers. Fleetwood has received numerous mentionings in my stories and analyses in past years as it is, and remains, one of the best dividend stories in the Australian share market. Since 1995, which is as far as the dividend history goes on the company's website, dividends to shareholders have not been reduced once – in 24 years! Yet this financial year it will happen, if current estimates can be taken as a guide.

The good news is, every single stockbroker in our database who covers the stock believes it will be a one-off and FY14 should see a resumption of that long-standing positive trend. If accurate, one would have to assume today's share price (below $9 whereas $13 was achieved earlier in the year) reflects excessive market pessimism.

With the general pick-up in global economic momentum still looking uneven and fragile, and with growth outside mining and energy investments in Australia still largely elusive, short term dangers for valuation traps and investment return-damaging torpedoes go beyond the mining and energy services providers. Obvious candidates for caution are companies in the traditional media space, local property developers and discretionary retailers.

Analysts at UBS recently released research on the subject and their findings suggest investors are probably better off by sticking to a cautious approach (trying to avoid the damaging torpedoes) than to take on more risk as the latter might see them owning shares in a company such as the aforementioned NRW Holdings prior to yet another sudden sell-off.

According to UBS's research, a 25% fall in the share price is 4.4 times more likely to occur when earnings growth rates are falling or low, as is the general context in Australia right now (still falling and low).

The analysts have tried to compile a list of companies most likely to turn into a "torpedo" this financial year. These companies are: Lynas Corp ((LYC)), Paladin Energy ((PDN)), Atlas Iron ((AGO)), Whitehaven Coal ((WHC)), Arrium ((ARI)), Boart Longyear ((BLY)), Fortescue Metals ((FMG)), Sims Metal Management ((SGM)), BlueScope Steel ((BSL)), PanAust ((PNA)), QBE Insurance ((QBE)), Alumina Ltd ((AWC)), Leighton Holdings ((LEI)), Boral ((BLD)), Fairfax Media ((FXJ)) and Seven West Media ((SWM)).

Those are just the candidates amongst members of the ASX100. Has anyone else noticed the over-representation of miners?

UBS released a second list for smaller companies in Australia: Mt Gibson Iron ((MGX)), Coalspur Mines ((CPL)), Linc Energy ((LNC)), Bathurst Resources ((BTU)), Intrepid Mines ((IAU)), Mirabela Nickel ((MBN)), FKP Property Group ((FKP)), Ten Network ((TEN)), Gryphon Minerals ((GRY)), Billabong ((BBG)), Gindalbie Metals ((GBG)), Western Areas ((WSA)), Discovery Metals ((DML)), Aquila Resources ((AQA)), Beadell Resources ((BDR)), Imdex, Independence Group ((IGO)), Sandfire Resources ((SFR)), Saracen Mineral ((SAR)), Macmahon Holdings ((MAH)), APN News & Media ((APN)) and Bradken ((BKN)).

Of course, not all of these names will turn into a bomb in the months ahead. This is simply an exercise by UBS to pinpoint where the highest risks for a negative surprise are located in today's share market. The underlying message from the analysts is nevertheless worth repeating: investment returns in the short to medium term are most likely going to be determined by how many torpedoes investors find in their portfolio, rather than by the winners they managed to pick. This is definitely one message worth keeping in mind.

Incidentally, quant analysts at Macquarie have lined up their favourites and least favourite stocks for December, and the second list reveals quite significant overlap with the UBS research, so here are some of Macquarie's quant(itative) selections:

Most favoured: Carsales.com ((CRZ)), ResMed ((RMD)), REA Group ((REA)), Monadelphous ((MND)), Flight Centre ((FLT)), TPG Telecom ((TPM)), Regis Resources ((RRL)), Flexigroup ((FXL)), CSL ((CSL)) and Graincorp ((GNC)).

Least favoured: Whitehaven Coal, Lynas Corp, Fairfax Media, BlueScope Steel, Aquila Resources, Atlas Iron, Sundance Resources ((SDL)), Mesoblast ((MSB)), Sims Metal and Independence Group.

Lastly, a special mention has to go out to Perth-based IT developer and services provider ASG Group ((ASZ)). Earlier in the year I used this stock as an example of how dividend support can be used as an alternative strategy for investors. Of course, such strategies are only valid for as long as the company doesn't cook up any nasty surprises. Unfortunately, ASG Group did exactly that during the August reporting season. Making matters far worse, management turned itself into the market's laughing stock when it tried to cover up what had gone wrong during the year by almost literally trying to rewrite history.

Apart from several low quality adjustments to its accounts for the year, ASG Group management included in its so-called "normalised earnings" revenues and profits that would have been booked if certain members of staff had not been redeployed in developing the company's cloud service during the year. It led to a special mention of the company, and its spurious reporting, in a dedicated report by Octa Phillip on questionable practices that had been observed during the August reporting season, with jokes such as "ASG- if we had invented the iPod we'd be called Apple".

Here's one direct quote from that report: "In a category all of its own, ASG, a stock not exactly noted for straightforward accounting at the best of times, puzzled the investment community with its attempt at rewriting history with a new definition of normalised EBITDA."

As it turned out, investors did not take all of this lightly and ASG Group shares have proved one of the share market's torpedoes this year. Loss of confidence is much more difficult to reverse than losing it in the first place. I apologise for using ASG Group as an example for what can be, otherwise, a valid investment strategy. I also remain very firm in my general views: investing in equities is risky and challenging at the best of times. Investors are better off not taking on board the extra risks that open up when company directors put their own financial rewards first or when they turn to creativity to cover up what went wrong during the year.

It would appear ASG Group sits in the latter group and that is a big No-No. (Wish I had known this earlier).

(This story was originally written on Monday, 3 December, 2012. It was published on the day in the form of an email to paying subscribers).

P.S. I made a promise and already received some questions about it, so here's a brief update on my current e-booklet in progress: "Make Risk Your Friend". I am progressing well in my writings, but it's taking longer than I initially anticipated. I am still hopeful I will be able to deliver a finished product in the next few weeks. I will keep you all updated.

Good news for FNArena subscribers: colleague Greg Peel recently finished an in-depth market update on rare earths elements (REE) which has been published in e-booklet format, for FNArena subscribers only. If you haven't received your copy yet, send an email to info@fnarena.com

(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions.)

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