Identifying The Risk

This story features FLEETWOOD LIMITED, and other companies. For more info SHARE ANALYSIS: FWD

By Rudi Filapek-Vandyck, Editor FNArena

The key message of the eBooklet I published in January this year (Make Risk Your Friend, see bottom of this story) is not simply that a certain type of stocks represents a much better risk-reward profile than most others when circumstances are challenging, it's that a whole lot can be said in favour of trying to identify what are the risks involved when picking investment options and deciding on strategies.

On my observations, too many investors (and their advisors too) treat risk as a static concept. This explains why too many rely on what worked yesterday.

Investing in the share market can generate unusually high returns when investors manage to pick downbeaten stocks that are about to make a come-back at some point after the purchase. This is what makes every punter's heart beat faster. This is why news outlets and broadcast media spend so much time on the top ten of daily movements in share prices.

It's the same attraction as the multi-million dollar lottery prize. It just makes one return to where the real action is, time and time again.

Some experts despise all comparisons between the share market and Las Vegas casinos, or state sponsored lotteries or even the horse races. They argue the advantage the share market offers is that investors can genuinely skew the odds in their favour.

I agree with this view. It's why I opened this week's Weekly Insights with yet another reference to my eBooklet from earlier this year. Learn how to identify and to deal with risk, do enough research and bend the odds in your own favour, and your strategies are poised to pay off.

It's not the same as gambling.

One of the obvious sectors that comes to mind are companies that provide equipment and services to miners and energy producers.

There was a time when little else seemed to go up decisively in the local share market, and investors had been slow in catching up that miners were spending hand over fist, while companies such as Fleetwood ((FWD)), NRW Holdings ((NWH)), Lycopodium ((LYL)) and ALS Ltd ((ALQ)) were having a free banquet off it.

Then suddenly everybody wanted to own a piece of the action and things got a little carried away.

Ironically, that mini bubble happened just before the world's big miners started listening to their shareholders by cutting back on inefficient spending and pay more attention to return on investments and to shareholders' rewards.

We all know what happened since. Engineering firms and services providers were abandoned en masse, creating a massacre not seen since the general meltdown in 2008. Most of the speculative money had shown no appetite to return to the sector until earlier this year.

The prime pin-up for this segment of the Australian share market is Monadelphous ((MND)). Most among you who have paid attention to my writings and my market analyses over the years know that Monadelphous featured regularly in my writings, my live presentations and my TV appearances.

The reason for this is as simple as can be: the stock has been the most consistent performer for shareholders between 2004-2012, outperforming its major clients BHP Billiton ((BHP)) and Rio Tinto ((RIO)) by an incredibly wide margin.

Growth. Dividends. High quality management. Return on equity. Beneficial industry dynamics.You name it. It was all there, and in spades.

But all good stories must come to an end, eventually. Sometime in 2012 I reversed my view and declared the golden legacy for Monadelpous was about to arrive at its natural expiry date.

Mind you, that was when Monadelphous (from memory) was trading in the high teens-early twenties and the shares subsequently went on to surge to a high of $28, before collapsing and costing a lot of Johnnie-come-latelies a lot of money.

There are more than just a few conclusions that can be drawn from this experience, but let me highlight the one that I think matters the most: it is possible to recognise the risk that is yet to announce itself on the share market's horizon and to act cautiously when nobody else is.

The trick is then not to feel silly when a group of short term oriented traders and punters take over and add a whole new chapter to the share price.

As we all know today, I only looked "silly" for a limited time, just like I once upon a time did when Rio Tinto shares hit $120 and when crude oil futures hit that same price level. Ultimately I was very happy not to be around when everyone started looking for the exit, all at the same time.

Here's my favourite question to all those market commentators who like to think Mr Market is wise and efficient, fully informed and he knows what he is doing: what the heck were those market participants thinking when they pushed Monadelphous shares from $20 to $28 between late 2012-early 2013?

This also shows the difficulty in not getting carried away, as an investor, by the herd mentality of the short term traders.

The shares subsequently plunged to $15 and have staged a few mini-come backs to try to reconquer the $20, but failed and are now trading on 6%-plus (fully franked) dividend support around the $18 price level.

Seems like a good bargain, no?

I have little doubt many a market participant/commentator feels inclined to think this is the case. The fall from $28 has been both relentless and large and this for a company that is without the slightest doubt the best among its peers, having rewarded shareholders since 2004 in ways nobody could have predicted.

Time to remember that famous Warren Buffett quote (believed to be Charlie Munger's instead) about how investors tend to look into the rear view mirror when they should be looking forward. On my own analysis, investors should be paying more attention to changes to industry dynamics than they do to management quality.

Monadelphous does have a top notch management team and a very good relationship with its key customers, but it has been the change in industry dynamics that caused the share price to crash this year, as it has done for so many others in the sector.

Other former stock market favourites have fallen out of favour as a result of deterioration in industry dynamics. Think Blackmores ((BKL)) and Reckon ((RKN)). The same process is now likely taking place for Coca-Cola Amatil ((CCL)) unless the company's foray into spirits and alcohol proves a winner. One can even make the same point for former high flyer Cochlear ((COH)).

One of the key reasons as to why investing in the share market is so treacherous is because investors tend to take guidance from each other, assuming that whoever bought the stock before they did must have some kind of superior knowledge. Wow! Monadelphous shares are running from $20 to $28, someone must have knowledge out there that something good is about to happen to the company…

Turns out it was simply a game of musical chairs and when the music eventually did stop, there wasn't one chair missing, instead there were only a few chairs available so everyone headed for the exit.

Within this context I note Forge Group ((FGE)), one of the other high quality representatives of this sector, is still mulling over what is speculated to be a highly dilutive capital raising while Ausdrill ((ASL)) just issued a sudden-shock profit warning and the board at Macmahon ((MAH)) has told its shareholders things really are still dire and tough, and unlikely to change anytime soon.

Admittedly, Downer EDI ((DOW)) just announced one big contract commitment from Gina Rinehart's Roy Hill iron ore project.

As I stated in my opening sentences, if you are able to narrow down your choices to the likes of Downer EDI, while avoiding nasty surprises from the likes of Forge Group and Ausdrill, then by all means use that talent. In all other cases, make sure you don't underestimate the risks that are still attached to picking seemingly low hanging fruit in the sector of engineers and contractors, where earnings visibility is traditionally not very high. Right now there is little to no visibility at all, including maintenance contracts.

A recent report by analysts at Moelis on Monadelphous reiterates that very same point, effectively questioning why investors would park their money in places where management teams who are running the show have no clear insights into what tomorrow is likely to offer.

Moelis analysts highlighted one important factor when it comes to Monadelphous' future outlook: a rather remarkable divergence between falling capex intentions by major customers Rio Tinto and BHP Billiton and an implied minor decline for Monadelphous only in the years ahead. I wholeheartedly agree with Moelis, this simply doesn't seem right.

If BHP and Rio have the intention to reduce their spending by 16% over the coming years, how can consensus project a decline in revenues for Monadelphous of 4% only?

Moelis comes up with a few potential explanations, such as Monadelphous is expected to win a larger share from what is being spent by Rio and BHP; or the company will gain more contracts among smaller miners; or the company will compensate with a successful (and rapid) expansion into LNG. All these scenarios are possible, but they are also implausible, thus high risk.

A time will come when shares in companies like Monadelphous will offer more potential reward than risk, but that time is nowhere near, in my view.

I see two years of rapidly declining capex by major miners casting one large shadow over the sector and both investors and the people running these companies have yet to find out exactly how this is going to translate into day-to-day industry dynamics.

Also, I believe the widespread idea that services providers to the energy sector are by default in a better position than your typical mining sector services provider is likely to be proven wrong as top tier energy producers worldwide are now embarking on the same capital efficiency processes as have done the large mining companies.

Beware for the industry response if crude oil prices start falling in 2014 as some experts are now predicting. It is for this very reason that CLSA recently initiated coverage on WorleyParsons ((WOR)) with a negative rating.

I think the key message for investors is to not simply jump on board because the share price looks cheap compared to history or in comparison to the rest of the share market.

It's what lies ahead that will determine whether the investment is going to reap rewards. I personally find it difficult to bend the odds in my favour in a sector that remains under such a big cloud as are Monadelphous and its peers.

Moelis has kept a Sell rating on Monadelphous, citing "limited revenue visibility" as the key reason, alongside the fact that "consensus forecasts are inconsistent with the shape of the capex profile of the major miners".

Those major miners, mind you, are responsible for more than half of total annual revenues. Moelis has set a target price of $15.60 for the shares.

(This week's Weekly Insights was written on Monday, 18 November 2013 on a sunny balcony of my hotel in Canberra where I will give my final presentation of 2013 to local members of the ATAA on Tuesday evening. Note: there has been a last minute venue change. This story was initially published in the form of an email to paying FNArena subscribers on Monday).

(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. All views are mine and not by association FNArena's – see disclaimer on the website)

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THE AUD AND THE AUSTRALIAN SHARE MARKET

This eBooklet published in July this year forms part of FNArena's bonus package for a paid subscription (excluding one month subscriptions).

My previous eBooklet (see below) is also still included.

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MAKE RISK YOUR FRIEND – ALL-WEATHER PERFORMERS

Things might look a lot different today than they have between 2008-2012, but that doesn't mean there are no lessons and conclusions to be drawn for the years ahead. "Making Risk Your Friend. Finding All-Weather Performers", was published in January this year and identifies three categories of stocks that should be part of every long term portfolio; sustainable yield, All-Weather Performers and Sweetspot Stocks.

This eBooklet was released in January this year and is included in FNArena's free bonus package for a paid subscription (excluding one month subscription).

If you haven't received your copy as yet, send an email to info@fnarena.com

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Rudi On Tour

– I will present to ATAA members in Canberra this week Tuesday, November 19, which shall be my final presentation for calendar 2013. Note there has been a last minute venue change. Please contact ATAA for details.

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