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.

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