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Don’t follow the herd into low-quality earnings

Apr 12 2018 11:19
Simon Brown

In light of a possible takeover of Murray & Roberts (at 1 500c and rejected by the board), shareholder activist Albie Cilliers (@albie_cilliers) tweeted the following stats for construction companies: Losses from highs in 2007/8: Group Five -98.6%; Murray & Roberts -91.2%; Aveng -98.6%; and Basil Read -99.5%. 

Not forgetting a number who have not survived (Sanyati, RBA, Buildmax and Protech). A bleak picture. 

We can also add some recent share price collapses in other sectors – Aspen Pharmacare off 44% since the highs of early 2015 and shopping-mall owner and developer Resilient down 67% since the highs of January.

This can do serious damage to your portfolio, damage that we need to try and prevent, because investing is as much about finding winners as it is about avoiding losers. Now, as I have written before, one of the secrets of investing is that our upside is unlimited, as stocks can go up multiples of 100%, while the downside is capped at a 100% loss. 

But avoiding the 100% losses make a huge difference to our overall returns.

Considering the stats above, there are two key points worth making.

The first is about the sectors you invest in. Construction is always going to be highly cyclical; the boom in the lead-up to the 2010 Soccer World Cup was never sustainable and the profits of these companies had to come down dramatically – which they did. 

Furthermore, construction is not a sector in which a company can really have a significant moat. 

Your edge against competitors bidding for the same work is really about price, which means a price war that drives down profits.

Buying at the highs was really just blindly following the herd, buying low-quality, unsustainable earnings with no true competitive edge. 

Low-quality and/or cyclical sectors are never long-term buy-and-hold investments. They are for trading – you buy them when they start to move and hold until the party starts to end. 

This is easy to type, but incredibly hard to do, as many who have been buying construction stocks in the past few years have learnt.

The second issue concerns Aspen and Resilient. Both have solid moats in that they own either solid medical brands or properties. Neither is cyclical, as we always need medicines or are always going shopping. 

Here the mistake was in not using the one piece of power that investors have at their disposal – the price they paid. 

The companies’ future earnings, deals etc. are beyond investors’ control, but what we pay is within our control and we must exercise it. 

So, it is critically important when we’re buying quality for a long-term buy-and-hold portfolio that we decide what price we’re prepared to pay – and don’t spend a cent more. 

In the case of Aspen, that would have meant never paying the R440 price the share traded at. 

You would have started buying at some point when the price started falling, and probably would have paid more than the price the share eventually reached. 

But at least you have a much lower average and therefore much less pain. 

Taking it a step further: If I think R100 is a good price, for example, I will use that as a starting point for my buying, but will buy in chunks from R100 to maybe 7 500c. 

So, if the share keeps on falling, I keep averaging in and getting the better price.

The risk here is that the share price continues below 7 500c or only drops to 9 000c before moving higher again. Neither is ideal, and, truthfully, both will happen at times, but you’ll have quality stock at quality prices. 

This article originally appeared in the 12 April edition of finweek. Buy and download the magazine here or subscribe to our newsletter here.

investment  |  portfolio  |  construction
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