Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 251

Three checks to make when facing earnings downgrades

“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.

 


 

Leave a Comment:

     

RELATED ARTICLES

Best-in-class, ‘pure-play’ companies give clearer focus

Single-period measures do not work for great growth companies

‘Super-defensive equities’ may rescue struggling 60/40 portfolios

banner

Most viewed in recent weeks

Unexpected results in our retirement income survey

Who knew? With some surprise results, the Government is on unexpected firm ground in asking people to draw on all their assets in retirement, although the comments show what feisty and informed readers we have.

Three all-time best tables for every adviser and investor

It's a remarkable statistic. In any year since 1875, if you had invested in the Australian stock index, turned away and come back eight years later, your average return would be 120% with no negative periods.

The looming excess of housing and why prices will fall

Never stand between Australian households and an uncapped government programme with $3 billion in ‘free money’ to build or renovate their homes. But excess supply is coming with an absence of net migration.

Five stocks that have worked well in our portfolios

Picking macro trends is difficult. What may seem logical and compelling one minute may completely change a few months later. There are better rewards from focussing on identifying the best companies at good prices.

10 reasons wealthy homeowners shouldn't receive welfare

The RBA Governor says rising house prices are due to "the design of our taxation and social security systems". The OECD says "the prolonged boom in house prices has inflated the wealth of many pensioners without impacting their pension eligibility." What's your view?

Six COVID opportunist stocks prospering in adversity

Some high-quality companies have emerged even stronger since the onset of COVID and are well placed for outperformance. We call these the ‘COVID Opportunists’ as they are now dominating their specific sectors.

Latest Updates

Retirement

10 reasons wealthy homeowners shouldn't receive welfare

The RBA Governor says rising house prices are due to "the design of our taxation and social security systems". The OECD says "the prolonged boom in house prices has inflated the wealth of many pensioners without impacting their pension eligibility." What's your view?

Interviews

Sean Fenton on marching to your own investment tune

Is it more difficult to find stocks to short in a rising market? What impact has central bank dominance had over stock selection? How do you combine income and growth in a portfolio? Where are the opportunities?

Compliance

D’oh! DDO rules turn some funds into a punching bag

The Design and Distribution Obligations (DDO) come into effect in two weeks. They will change the way banks promote products, force some small funds to close to new members and push issues into the listed space.

Shares

Dividends, disruption and star performers in FY21 wrap

Company results in FY21 were generally good with some standout results from those thriving in tough conditions. We highlight the companies that delivered some of the best results and our future  expectations.

Fixed interest

Coles no longer happy with the status quo

It used to be Down, Down for prices but the new status quo is Down Down for emissions. Until now, the realm of ESG has been mainly fund managers as 'responsible investors', but companies are now pushing credentials.

Investment strategies

Seven factors driving growth in Managed Accounts

As Managed Accounts surge through $100 billion for the first time, the line between retail, wholesale and institutional capabilities and portfolios continues to blur. Lower costs help with best interest duties.

Retirement

Reader Survey: home values in age pension asset test

Read our article on the family home in the age pension test, with the RBA Governor putting the onus on social security to address house prices and the OECD calling out wealthy pensioners. What is your view?

Sponsors

Alliances

© 2021 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.

Website Development by Master Publisher.