High return, high risk...

PORT ELIZABETH - There is a school of thought that believes that you should invest in only the most beaten-up, dumped, dropped and destroyed shares. This contrarian school is based on the premise that while it is high risk, the depth of pessimism around some companies creates such value in the share prices that the few companies that do manage to stage a turnaround will produce such spectacular returns that it will justify the risk (from a portfolio perspective).

Ignoring the blue chips, the rest of the JSE has not performed very well over the last year and a bit.  Especially looking at the small-cap sector, there are a large number of beaten-up shares there after companies missed profit forecasts or-worse-reported a loss or two.

Looking only at the common stocks listed on the JSE and using a stock filter showing all share prices that have lost over 50% in the last year reveals an interesting list of both small caps and not-so-small caps (refer to the end of the article for a full list).

Much publicised and scrutinised Super Group, Blue Financial Services, and African Dawn Capital appear on this list.  While it is quite possible that each of the company's operating fundamentals are dragging them down, all the negative publicity around them is also not helping to support their share prices.  Another counter on this list dragged down by clouds surrounding them include the troubled empowerment investment group, Vunani, whose debt-fuelled BEE investments and highly dilutive rights offer might lead to a small market blow-out...

It is quite interesting to note that the massive local communications monopoly (that the Competition Commission kept conveniently overlooking till a recent slap on the wrist), Telkom, has seen its share price plunge over 61.74% in the last year.  While the recent brush with the Competition Commission did not help, the telecoms group's share price is mostly a function of our local telecoms market opening out with greater (and healthier) competition.

Perusing this list of discarded stocks makes for an interesting shopping list, but there are a couple that I believe have higher chances of recovering than others:

Skinwell (JSE:SKW) (formerly Placecol) is attempting to mould its business into a franchisor model, but cash flows have been seriously constrained.  While the product seems competitive, the financing problems have seen the company recently launch a highly dilutive rights offer...albeit, one that was underwritten by management and related parties. 

Skinwell's just concluded a rights offer which saw management buy just below 50% of the shares on offer and reinvest just under R3m back into the business. While R3m is quite small, the vast majority of it came from the CEO's own bank account.

Good incentive for him to get the business working...

The niche financial services software group, Silverbridge Holdings (JSE:SVB), just released interim results for the year showing revenues increasing by 17%, profits up by 143% and heps jumping 134%.  Despite this, the SVB share price is down over 54% for the year to date, albeit this could also be a symptom of the shares serious lack of liquidity.

Silverbridge's core application (SDT) helps financial service companies lower costs, thus the current tight economic conditions present opportunities for its sales team.  In the most recent interim results the company goes on to say how its Board "...remains positive in its outlook for SilverBridge. The group's fundamentals are sound and are supported by products and services that are well positioned to capitalise on market conditions. The group's annuity revenue provides a foundation for future growth."

Did I mention that Silverbridge pays dividends...?

Finally, SA French's core business is the sale and rental of tower cranes by Potain France. The latter being the successful foreign crane manufacturer, with whom SA French has an exclusive local distributorship agreement for sub-equatorial African.

Since listing SA French (JSE:SFH) has seen its results hurt by a drop in sales coupled with massive financial gearing that created interest expenses gobbling up any remaining profits.  With a last reported debt:equity (D:E) of 0.81 at June 30 2009 the group is highly geared, but this ratio has come down since December's D:E of 0.99 showing how the group is slowly paying off its expensive debt.

As the construction industry's outlook is uncertain, many construction companies are not investing in expensive capital items (like cranes), but rather renting them.  Sanyati's latest results explicitly state this.  This allows the construction businesses to control its variable/fixed cost mixes and hopefully maintaining a profitable margin on the contracts that it is certain it has secured. 

From SA French's perspective, though, this sudden industry demand for rental means that its high margin sales have dried up...albeit, the group's rentals (and its associated annuity cash flow) have shot up.

As a business, SA French is over 26 years old and, given this track record, should be able to weather the storm till the eventual upswing soars sales.  This is especially true given that its rental agreements include a "to buy" option in them offering future profitable sales value to the group.

Adding further to SA French's appeal is the fact that its tangible (ie, excluding goodwill and intangibles that may well give rise to an impairment in a failing business) NAV per share is 32.10c or significantly above its current share price of 9c.  The prior year's loss amounted to only 6.2c per share, thus even a year twice as bad as the last would leave the tangible NAV more than double the current share price (ie, 19,7c tangible NAV per share left) and one year closer to the turnaround.

While the above analysis's are one-sided (a proper dissention of the risks facing each company mentioned would simply take too long for the purposes of this article), my guess is that at least one of the three turnarounds I've picked will return alpha over the next year or couple.  This possibility does come at a large risk as the term "catching knives" aptly describes the act of buying into a sinking share price.

*Keith McLachlan, from SmallCaps.co.za, either already owns or has bids in the market to buy ADW, SKW, SVB, and SFH shares.

COMMENTS

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telkom "the telecoms group's share price is mostly a function of our local telecoms market opening out with greater (and healthier) competition." the 60 plus % drop in Telkom is largely due to the Vodacom unbundling. Problem with manyof these . .more companies (including the ones mentioned) is they have all their eggs in one basket so very risky but yes you can get some massive returns when sentiment (and company profits) pick up. . .less by JJ on November 04 2009, 08:07 Find this comment inappropriate? Report it

Telkom Share Price Uuuh, Telkom's price dropped because of the unbundling of Vodacom! by Realist on November 04 2009, 08:41 Find this comment inappropriate? Report it

@JJ Thanks for the correction regarding Telkom. by Keith on November 04 2009, 08:54 Find this comment inappropriate? Report it

Always interesting Keep writing Keith - always a breath of fresh air... by Ben on November 04 2009, 09:04 Find this comment inappropriate? Report it

What about SALLIES Have you covered these two ? by Zoro on November 04 2009, 09:12 Find this comment inappropriate? Report it

health warning Every one of the companies mentioned in the above article has a high risk of failure. bear in mind that on the way to zero everything goes past down 80%. Having said that, there are some terrific bargains in small caps, just not any of those . .more mentioned. I'll list some below (disclosure: my fund is long these). - ABE Construction Chemicals - Been in business 75 years and basically shares the market with one other company, has R10m of cash on the balance sheet and no debt, owns own properties, and is trading at around 3x EBIT. - Gooderson Leisure - Hotel owner at half of tangible book value, strong balance sheet - Taste Holdings - Owns Scooters Pizza & NWJ Jewellery franchises. Franchises are good businesses bc of lower variability in earnings (gets % of Franchisee revs), and very low capex requirements. Others: BJM, GMB, AFT, ARH, KDV. . .less by wisdom on November 04 2009, 09:52 Find this comment inappropriate? Report it

and by the way ADW is an absolute fraud. Sadly, I got called out of my short position. Check out accounting correction today... Ask them what "inventory" is on their balance sheet If their business is financing low cost housing, how come they . .more liquidated a multi-million rand hotel in Somerset West? and why do they finance middle class cluster home developments? Do a few google searches on their partners (allegro, dodgy building contractor, etc) SKW and SFH are zero's (check out the debt....the equity holders dont own the companies, the banks do). SVB may be OK...havent decided yet. . .less by wisdom on November 04 2009, 09:56 Find this comment inappropriate? Report it

Tawana Any advise on Tawana (TAW). i realise they are not down 50% over this year, but are over 90% down over the last two years. by Winn on November 04 2009, 10:41 Find this comment inappropriate? Report it

Small caps Wisdom ABE has far more than 1 competitor. There are plenty of companies in this space! Taste.... got to worry that the legacy businesses (Scooters / Maxi's) are performing poorly. Relative to Debonair's the pizza biz has performed . .more badly. Overall your suggestions are pretty interesting... To my mind a far better risk / reward payoff than scrapping the bottom of the AltX barrel! . .less by Charlie Chaplin on November 04 2009, 10:46 Find this comment inappropriate? Report it

"Did I mention that Silverbridge pays dividends...?" The board of directors of the Group, taking into account the current uncertain economic circumstances and from a conservative approach will not recommend for approval by the shareholders, a final dividend or capital distribution . .more for the year. . .less by Piet on November 04 2009, 11:08 Find this comment inappropriate? Report it

@winn Simply read some of Tawana's press releases and reports and judge for yourself if you spot any quality assets of good prospects. I cannot see any at all!!! This company is going nowhere by Richard on November 04 2009, 11:19 Find this comment inappropriate? Report it

ADW How is your ADW shares doing today Keith? by Hatorri Hanzou on November 04 2009, 11:44 Find this comment inappropriate? Report it

Topfix Keith, what are your views on Topfix? PSG seem to accumulating stock... by Builder on November 04 2009, 11:54 Find this comment inappropriate? Report it

Incompetence This article is atrocious with so many mistakes and holes, surely moneyweb can do better than Keith by Jack Struwich on November 04 2009, 13:11 Find this comment inappropriate? Report it

charlie? Hey Charlie, thanks for your comments. Would be obliged if you could name additional competitors to ABE with rough market share. To my knowledge, in the construction space, ABE and SIKA have roughly equal market share, distantly followed by BASF . .more with an irrelevant share (I think they may actually leave the SA mkt). I think that SIKA, Freeworld and Duram have competing products in consumer space. I agree re Scooters/Maxi's underperformance, but hey, everything has a price. TAS is at 3.2x EV/EBIT, vs FBR at 9.5x. Look at it a different way, you're buying taste for less than they bought NWJ for (and I regard that as having been a bargain purchase) . .less by wisdom on November 04 2009, 13:13 Find this comment inappropriate? Report it

Replies @Ben: Thanks, appreciated. @Wisdom: Good comments. I support Gooderson and Taste (and in fact own shares in them too), and ABE is also a good business. Especially around Taste I agree with your sentiment that while FBR is obviously a market . .more leader...investing into it comes at a price. Even adjusted for risk, I believe that Taste is under-valued and should provide good growth into the future. @Winn: Unfortunately Tawana is a bit off my coverage universe and I'm not confident enough on it to express any form of opinion. @Charlie Chaplin: Please refer above reply to Wisdom. @Piet: I am aware that they passed up on their previous dividend, but the group's policy is to generally pay one, which with profits growing in the current year this should follow through. Even Anglo has passed on its dividend, so--while this is not a great historical sign--it is also not the worst. @Builder: Topfix is another small cap that I'm becoming increasingly interested in... Perhaps I will write a short future article on it...? . .less by Keith McLachlan on November 04 2009, 14:17 Find this comment inappropriate? Report it

Topfix 2 Hi Keith Please write one, I enjoy your articles as they are straight to the point. I bought shares in it yesterday as 1) The recently announced a R 100 million contract signed over the next three years 2) . .more The CEO has been buying shares of late 3) Paladin Capital own around 18% of the company and PSG Capital/Paladin seem to be buying more 4) Apparently Jannie Mouton owns like 0.7% of the company 5) F Swart, CEO of Paladin Capital is on its board 6) Its trading at a PE ratio of 5 times . .less by Builder on November 04 2009, 14:57 Find this comment inappropriate? Report it

Topfix 2 Yeah would appreciate an article on it. Will it be on your site or moneyweb? Keep up the good work! by Builder on November 04 2009, 15:02 Find this comment inappropriate? Report it

ADW – Have you lost your nerve Keith? I have read your article at http://smallcaps.co.za/index.php?option=com_content&task=view&id=628&Itemid=2 ADW Massive Write-downs & Questions You say you are selling out and acknowledging you made a mistake, based not on the . .more share price slump, but on profitability concerns, and accounting problems. Does it not bother you how Nedbank can turn up at the AGM and dismiss the CEO, FD and COO, leaving the company vulnerable with no leadership? A common assault? A reconstructed board emerges with no legitimacy in terms of shareholder involvement. The new board does nothing to bring clarity, or stability, rather spreading innuendo about the doings of the previous management. Note, the SENS of this morning brought no relevant facts to the fore. None at all. It merely reflects a long list of impairments and other discretionary accounting entries that create the impression that the company is worth nothing. You have extended the implication to question the profitability of this company, which, in your own words a few months ago: It is this same business model that has seen it compound exceptional growth over the previous five years at an above market level.. and the reality is that the business s operations are driven by the same fundamentals that will ensure the share price snaps back to fair value in the long-term. . .less by Jack on November 04 2009, 17:02 Find this comment inappropriate? Report it

../2.. The company is clearly under attack from perception engineers who have mercilessly shaken the tree and the only rationally conclusion is that these guys are planning to raid the company with a hostile takeover or to otherwise dilutive existing . .more shareholders by capital raising initiative. Accept for questions about the provider of capital to Allegro, which is a separate nonrelated company, I would bet there is little wrong with this outfit and it will fly again once the credit markets ease. . .less by Jack on November 04 2009, 17:07 Find this comment inappropriate? Report it

topfix (today was my first post, and really getting into it). Topfix may be OK, but the industry is EXTREMELY cyclical (check out Asthead in the UK, almost went bellly up last cycle) Francois will be very impressed that he is one of your . .more reasons for owning, but bear in mind that PLD is valued at a premium to NAV, so the more they buy, the more the crazies will bid up their stock! . .less by wisdom on November 04 2009, 20:15 Find this comment inappropriate? Report it

Small caps @ Wisdom: a few other competitors include Darachem (do Flash Harry retail product), Duram, Pekay. Don't have info on market shares but a number of the private businesses are fairly sizeable. by Charlie Chaplin on November 05 2009, 04:53 Find this comment inappropriate? Report it

thanks charlie dude, did you post that at 10 to five in the am? by wisdom on November 05 2009, 09:51 Find this comment inappropriate? Report it

@wisdom Thanks for giving me reason to relook at ABU. I agree with you that its a promising small cap and, so, I wrote a little piece on it at: http://smallcaps.co.za/index.php?option=com_content&task=view&id=630&Itemid=31 Hope you find . .more it interesting! . .less by Keith McLachlan on November 05 2009, 15:03 Find this comment inappropriate? Report it

Small caps @ Wisdom: yip. Early starter :) Early bird hunting for value in the small caps? Not finding many gems @ discount prices. Most of the cheap stuff is probably priced right. Agree with you about ABU. Seems cheap Taste: oddly enough . .more I agree with your comments re: NWJ. This has been a decent biz for a long time. Not sure if the Taste acquisition is a basis for previous MD to retire / resign? . .less by Charlie Chaplin on November 05 2009, 15:19 Find this comment inappropriate? Report it

thanks keith good look at ABE. I never get that complex with valuation. here's how I think about it: At share price of 110c, and 100m shares out, the mv is R110m, less net cash of say R16m, and owned property of R32m, you're essentially paying R62m for a . .more business that generated R35.6m of EBIT for the last year. PS - I cant post on your website bc of a faulty security code. . .less by wisdom on November 06 2009, 08:27 Find this comment inappropriate? Report it

@Wisdom Interesting perspective on seeking value, but we both arrive at the same conclusion. I've been subject to quite a bit of spam recently on www.smallcaps.co.za so I've been forced to install the security code. Its only necessary for . .more non-registered users, though, so if you register (at http://smallcaps.co.za/index.php?option=com_registration&task=register) and log in, then you can post comments directly from your account without any security code needed. Hope that helps! . .less by Keith McLachlan on November 06 2009, 09:19 Find this comment inappropriate? Report it

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