Rudi’s View: Investing In Non-Profitable Companies

rudi-views
Always an independent thinker, Rudi has not shied away from making big out-of-consensus predictions that proved accurate later on. When Rio Tinto shares surged above $120 he wrote investors should sell. In mid-2008 he warned investors not to hold on to equities in oil producers. In August 2008 he predicted the largest sell-off in commodities stocks was about to follow. In 2009 he suggested Australian banks were an excellent buy. Between 2011 and 2015 Rudi consistently maintained investors were better off avoiding exposure to commodities and to commodities stocks. Post GFC, he dedicated his research to finding All-Weather Performers. See also "All-Weather Performers" on this website, as well as the Special Reports section.

Rudi's View | Oct 20 2022

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.


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