Lessons from a 94.7% profit

Only one win­ner out of four stocks and that's all it takes to come out ahead in a spec­u­la­tive play

Money Magazine Australia - - CONTENTS - STORY GREG HOFF­MAN

Back in Au­gust 2013, gold stocks were deeply out of favour and I asked in this col­umn whether the sec­tor would ever shine again. I put money on the line, back­ing a hand­ful of ju­nior min­ers, ex­plain­ing how in the past I’ve “tried to pick the eyes out of such beaten-down spec­u­la­tive sec­tors and my con­clu­sion is that it’s bet­ter to make a few more in­di­vid­ual in­vest­ments (or spec­u­la­tions, as they might be more prop­erly called) rather than con­cen­trate your fire­power”.

It’s now time to re­visit the re­sults. But rather than trawl through what has hap­pened at each of the four min­ers’ op­er­a­tions, more prac­ti­cal in­vest­ing lessons can be gleaned from a higher-level re­view. The ac­com­pa­ny­ing share price charts also sum­marise each stock’s to­tal re­turns, in­clud­ing div­i­dends, over the past three years.

The first thing that jumps out at me is that three of the four stocks showed neg­a­tive re­turns. And two of those were losses of more than 50%. Yet the over­all re­sult was a spec­tac­u­lar av­er­age pos­i­tive re­turn of 94.7%.

That’s be­cause North­ern Star Re­sources proved to be an enor­mous win­ner, de­liv­er­ing a 522.8% re­turn in just three years. The prof­its from this one win­ning stock were more than enough to off­set the losses on the three losers and still pro­vide a juicy over­all re­turn for the in­vest­ment in the en­tire quar­tet.

This is what the eg­gheads call “asym­me­try of re­turns”. In the share­mar­ket, all you can lose is 100% of your in­vest­ment. But when things go right, you can make a many hun­dred­fold re­turn. It’s a phe­nom­e­non that a lot of us strug­gle with when we first ap­proach the share­mar­ket. That you could get fewer than 50% of calls “right” yet still pro­duce great re­turns is coun­ter­in­tu­itive. And it’s even more dif­fi­cult for peo­ple in “high stakes” ca­reers to come to grips with – ca­reers where you need to get things right 95% of the time or more.

Con­sider an anaes­thetist. If only one in four pa­tients came out of their anaes­thetic as an­tic­i­pated, the anaes­thetist would rightly be con­sid­ered grossly in­com­pe­tent. Yet, as we’ve seen with these four gold stocks, the re­sults in the share­mar­ket from such a low strike rate can still mean a great over­all re­turn.

I’ve now sold these four gold stocks for the port­fo­lios I man­age, which is some­thing you might con­sider if you fol­lowed suit on

this in­vest­ment idea. More prof­its may lay ahead but this re­sult is bet­ter than I would have ex­pected three years ago and I’d pre­fer to have the prof­its in the bank at this point. For me, ju­nior gold min­ers were a cycli­cal play, not a core long-term hold­ing.

To­day’s op­por­tu­ni­ties

Now let’s turn to stocks that are in the dog­house to­day, ones that might have the po­ten­tial to pro­duce the kind of gains our group of gold ju­niors have de­liv­ered.

I’ve iden­ti­fied a cou­ple of po­ten­tial can­di­dates in the on­line re­tail game. Both are for­mer dar­ling stocks that have fallen swiftly this year. And the mag­ni­tude of the falls has been breath­tak­ing.

On­line sur­fwear re­tailer Surf­Stitch (ASX: SRF) is the first. Less than a year ago, in­vestors poured $50 mil­lion into Surf­Stitch. At $2 a share they were valu­ing the com­pany at more than $500 mil­lion, a truly ex­tra­or­di­nary num­ber.

The man­age­ment team of this on­line re­tailer of sur­fwear prod­ucts was ob­vi­ously charis­matic enough to charm in­vestors into part­ing with their cash to back them as they ex­panded well be­yond Surf­Stitch’s suc­cess­ful core busi­ness.

To­day the shares are chang­ing hands at closer to 20¢ each and the valu­a­tion is less than $60 mil­lion. That looks at­trac­tive to me next to the $61 mil­lion worth of cash Surf­Stitch was sit­ting on at De­cem­ber 31 (the com­pany has no debt).

Buy­ing com­pa­nies for their “cash back­ing” is a time-hon­oured strat­egy for value in­vestors, although it doesn’t work ev­ery time, of course. The idea is that if you are only pay­ing for the com­pany’s pile of cash, you’re ba­si­cally get­ting its busi­ness for noth­ing. If that busi­ness is prof­itable, or has a good chance of be­com­ing so, then the at­trac­tion is self-ev­i­dent.

That said, I’m writ­ing this be­fore Surf­Stitch has re­leased its full-year profit re­sults. If its cash bal­ance at June 30 is close to that $61 mil­lion mark, I’ll be tempted to add to the small po­si­tion I re­cently bought. But the com­pany has fore­cast a loss for the fi­nan­cial year, so it bal­ance may have fallen since De­cem­ber.

The rea­son it’s cheap is that Surf­Stitch is a com­pany in tur­moil. A co-founder left un­ex­pect­edly in March and in­vestors have been sur­prised by a string of profit down­grades. The most re­cent one ar­rived on June 9 and was as se­vere as it was opaque. It re­ferred to an amend­ment re­lat­ing to “the grant of a per­pet­ual li­cence to a third party”, to use con­tent from a Surf­Stitch ASX an­nounce­ment in June.

There was no dis­clo­sure of who the third party was and the ef­fect of the “amend­ment” was neg­a­tive $20.3 mil­lion. But it’s not clear to me whether this is sim­ply an ac­count­ing ad­just­ment or an ac­tual cash loss (for in­stance, if the money had been re­ceived by Surf­Stitch, has it now been re­paid?). The full-year ac­counts should re­veal the an­swer.

All up, it’s a spec­u­la­tive sit­u­a­tion in which I won’t be risk­ing too much at this point.

I’ve also been track­ing Tem­ple & Web­ster (TPW), which sells fur­ni­ture and home­wares on­line through both the tem­ple­andweb­ster. com.au and mi­landi­rect.com.au web­sites.

Its share price has fallen from $1 in De­cem­ber to less than 20¢. That gives the com­pany a valu­a­tion of around $20 mil­lion com­pared with its cash pile of $18.4 mil­lion as at June 30. Like Surf­Stitch, Tem­ple & Web­ster has no debt.

The com­pany ex­pects to lose money again in the 2017 fi­nan­cial year be­fore achiev­ing break even at some point in 2017-18. It hopes to sur­vive us­ing the cash it has on the way to even­tual prof­itabil­ity. I’m ner­vous enough about that prospect to watch from the side­lines for a while yet un­less the share price or busi­ness prospects change dra­mat­i­cally.

As with the gold min­ers, I’d pre­fer to take a port­fo­lio ap­proach with these on­line re­tail­ers. Un­for­tu­nately, the mar­kets don’t al­ways de­liver what we want and I have only been able to iden­tify these two as po­ten­tial can­di­dates.

And it’s a shame that I sim­ply can’t get com­fort­able enough with Tem­ple & Web­ster to in­vest at this point. So Surf­Stitch re­mains my sole spec­u­la­tion in the sec­tor at the mo­ment.

That you could get fewer than 50% of calls right yet still pro­duce great re­turns is coun­ter­in­tu­itive

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