X does not mark the spot for solid alternative investments
• Although many of AltX’s stocks may look unfavourable, there could be exceptions
The willingness to do things differently may be an essential ingredient for success in the stock market. So while most investors are looking for something to do, an alternate approach may be to look for sufficient reason not to do anything. Besides, as hedge fund manager David Tepper likes to say, having a “too hard pile” is such a huge advantage in life.
Here’s how it can be applied to the 42 companies listed on AltX, based on last week’s closing prices and the last set of fullyear results.
There’s no point looking at those businesses that have been suspended. Nor do we want to look at those businesses showing a loss, particularly for some time, as we’d have to pin our hopes on a turnaround. Most turnarounds don’t turn. Given that something like two-thirds of businesses that temporarily become unprofitable fail to regain their high-water mark, we would rather not look at any company reporting negative earnings. That includes Advanced Health, African Dawn Capital, Alphamin Resources, Buffalo Coal, Chrometco, Imbalie Beauty, Jubilee Metals Group, Kibo Mining, Mainland Real Estate, Nutritional Holdings, PSV Holdings, Renergen and Universal Partners.
We don’t yet have a set of full-year results for Heriot Reit, so we’re going to pass on that one too. We especially want to avoid those companies showing a net profit together with a negative operating cash flow, namely Etion and Mater Plastics. This is for two reasons: operating cash flow offers a more reliable picture of a company’s performance than reported earnings (it’s harder to manipulate cash than earnings); and because non-cash items deducted from net income are added back to operating cash flow, the latter should be the bigger of the two.
Next, we turn to a company’s ability to remain solvent in the short term (able to meet shortterm debt and other current liabilities) by comparing current assets to current liabilities (its current ratio).
More conservative investors will look for a current ratio of 2-1, meaning current assets are twice as large as current liabilities, but we’ll settle for a current ratio of 1-1.
Even so, 12 AltX listed companies have a current ratio of less than one. Six of these have already been discarded, which means adding Ah Vest, Global Asset Management, Heriot Reit, New Frontier Properties, Newpark Reit and Transcend Residential Property Fund to the list.
The next group of businesses we want to avoid are those that have too much debt. And while ideally we’d like to separate those companies that are on the ropes from those that are borrowing big to grow big, we take the easy way out by simply avoiding those businesses where debt exceeds equity — where the total debt to equity ratio is greater than 1. As is the case at Advanced Health, African Dawn Capital, Chrometco, Global Asset Management, New Frontier Properties and Nutritional Holdings, all of which have already been discarded.
That leaves us with 13 of the 42 companies we started with as we turn to the question of value. Here we rely on three of the more commonly used ratios for an answer: price to earnings (P-E), price to cash flow (P-CF) and price to book (P-B).
While acknowledging the shortcomings of the P-E ratio, it remains the most widely used determinant of value. According to Investing.com, towards the end of 2017 there was a large cluster of companies listed on the JSE with a P-E ratio below or equal to 14, which in many markets would be considered relatively cheap, and only a few companies with a P-E ratio above 28. We think this is expensive, settling instead on a maximum P-E of 20. Which rules out Go Life International, trading on a P-E ratio of 31.
We couldn’t find a guideline price to cash flow for the JSE, whereas we found out that the P-CF for the S&P 500 is 14.
Drawing the line on P-CF of 20, none of the companies still on our list has a P-CF greater than 20.
The P-B ratio, which compares the price of a company with its net asset value, is popular with value investors and widely used by market analysts. According to Investopedia, any value under 1 is considered good, indicating a potentially undervalued stock. This way we’d lose five of the 12 companies still on our list. Instead we chose to keep them all by setting the P-B at 3.
The penultimate selection hurdle is the rate of return on equity (ROE). In calculating our hurdle rate, we took a risk-free rate of 8%, to which we added market risk of 8%, giving us a hurdle rate of 16% and thereby taking out Accentuate, Anchor Group, Astoria Investments, Mettle Investments, N Vest Financial Holdings, Oasis Crescent Property Fund, Telemasters and Vunani. This leaves us with only four: Alaris, ISA, Silverbridge and Workforce.
The last hurdle is liquidity. Lack of liquidity usually associated with smaller companies is, by itself, good enough reason to shun them. We say liquidity alone says relatively little about investment safety in the long run, but we think a closely related issue, insider ownership, is important. Too high insider ownership, meaning 55% or more, is risky because it might be held by those who don’t see the advantage of higher share prices or by someone waiting for an opportune time to sell.
Insiders own more than 55% of each of the four companies left on our list, providing us with what we’re after: sufficient reason not to do anything.
That’s not to say there are no investment opportunities here. There may well be. Negative operating cash flows don’t always signal problems, companies in high-growth phases shouldn’t be expected to be profitable, a high P-E ratio may be justified and if we look hard enough we might find exceptions to every hurdle.
But why should we, when those who are ultimately responsible for the share performance of these companies, while often bemoaning the lack of adequate media coverage, analysis and consensus, are seldom willing to do more than comply with the regulatory requirements and release obligatory financial information every six months. As if that should be enough to shift the negative sentiment that is attached to small caps and new listings in their favour.
THAT’S NOT TO SAY THERE ARE NO INVESTMENT OPPORTUNITIES. IF WE LOOK HARD WE MAY FIND EXCEPTIONS