Three checks to make when facing earnings downgrades

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“The market doesn’t care how you feel about a stock or what price you paid for it.” – Howard Marks

Most stock market participants are required to deal with earnings downgrades from time to time: they can hurt, or they can be a fantastic buying opportunity. When a downgrade occurs in a company within our investment universe, we follow a checklist. If we can comfortably answer yes to each item, it helps rationalise our thought process. If supported by a foundation of quantitative and qualitative analysis of the company, industry, and competitors, there may be an opportunity to either enter a new position or add to an existing holding. If not, we are unlikely to invest or may reduce or exit an existing position.

The three items to check are:

1. Has management been consistent in their rhetoric?

“There’s a big difference between probability and outcome. Probable things fail to happen—and improbable things happen—all the time.” – Howard Marks

From our experience, a high-quality management team is the biggest factor to consider when investing in small companies. We meet with management teams on a regular basis, and over time, we gain an understanding of actions versus words. Management rhetoric – whether it is consistently good or consistently bad – is a key factor. We would prefer a management team deliver downbeat news consistently rather than being too hopeful and incorrect. The market tends to look through poor divisions or issues if they can be siloed from the rest of the business, or if the issues are short term in nature. The market is much less forgiving on failed hype.

A recent example is BSA (ASX:BSA), a telecommunications and engineering services business. Its HVAC construction operation has been consistently underperforming. It is a competitive market sector and there does not appear to be significant improvement on the horizon. However, management has been consistently upfront with investors about the health of this division which is dragging heavily on earnings. Ongoing poor results with no unexpected negative surprises make it easy to ‘look through’ and focus on what is going well in the rest of the business, namely its unique exposure to the maintenance of the NBN which is beginning to contribute to company earnings.

2. Has there been a change in strategy?

“To be an investor you must be a believer in a better tomorrow.” – Benjamin Graham

In our view, investing in small companies requires a long-term investment horizon (three years+). Internally we have a minimum hurdle rate of 20% p.a. return over a three-year period when assessing a company to invest in. Taking a long-term view means we are ‘buying into’ a strategy set by a company’s board and management team. It is difficult for a business to perform to expectations all the time, however if the strategy remains on course then we are likely to be more tolerant of downgrades.

If there is a sudden change of direction from the previous strategy, then this is a concern. This should not be confused with pragmatic management, which we would define as being flexible within an overarching plan, as opposed to a change of plan itself. An unexpected change in strategy can often indicate a shift from acting in the best interest of shareholders, to the board and management focusing on their own interests.

For example, during 2015, CML Group (ASX:CGR), an invoice financing business, experienced unexpected losses due to outstanding construction loans. The loans were unrecoverable and caused a large P&L hit at the time. Management made it clear that the construction industry was not part of their strategy for growth and it should diminish as an exposure over time. We felt the overall business strategy had not changed.

3. Would I buy it lower?

“Unless you can watch your stock holding decline by 50% without becoming panic stricken, you should not be in the stock market.” – Warren Buffett

Sell-side analysts will typically release their updated (or downgraded) reports within 24 hours of a result. This can mean you see a further decline in stock price after the fact, as bearish medium-term outlooks are often applied by analysts. The inverse usually happens following a positive announcement. Oversold and overbought stocks are most likely to exist at this point in time.

If the information released to the market causing the downgrade doesn’t impact your original investment thesis, then your margin of safety has improved, potentially dramatically. Despite the short-term facts changing, you should ask yourself ‘does this change my two- or three-year target price?’ Furthermore, if the share price continues to decline ‘would I be again happy to buy at lower prices’? If we can answer these questions with confidence, then this will contribute to our decision to either enter or exit a position.

The overall message is not to view every earnings downgrade as a negative. If we can become comfortable with these three key checklist items, we believe opportunities can present themselves which may not seem so obvious to other market participants.

 

Robert Miller is a Portfolio Manager at NAOS Asset Management, a boutique funds manager investing in emerging and small-mid cap industrial companies. This content has been prepared without taking account of the objectives, financial situation, or needs of any individual.

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