the red hot value investor guide to ulti mate stock market success

The fund manager is controlling millions of Rands and so -especially when dealing in relatively illiquid smaller company shares - it’s extremelydifficult for him to buy or sell enough sh

GUIDE TO

ULTIMATE

STOCK MARKET SUCCESS

THE RED HOT VALUE INVESTOR

GUIDE TO

ULTIMATE STOCK MARKET

SUCCESS

© Copyright 2001 Fleet Street Publications Ltd All rights reserved No part of this book may bereproduced by any means or for any reason without the expressed written consent of the publisher

 Your advantage over the “Professional” 5

 Potential problems with Penny Shares 6

2 Never back those who break their promises 9

3 Listen to what a company’s rivals are saying 10

4 Let the trend be your friend 10

5 Avoid companies that change advisers or directors frequently 10

6 Listen closely – what is said is often not what is meant 11

8 Market and industry characteristics 11

1 Do not be obsessed by litigation, but do not ignore it 13

2 Are the company’s accounting policies both reasonable and normal? 13

3 Is the company really growing and adding value for shareholders? 14

4 Cash is King & Tax is unavoidable 15

5 Do not ignore the Balance Sheet either 15

Chapter Two: Valuation, The Final Filter 17

 Assessing the true value of a company 18

Chapter Four: Stop-loss, profit taking and top slicing 22

 The point of setting stop losses 22

All gains exclude dividend payments and dealing costs We do try to research all our recommendations and articles thoroughly, but we disclaim’ all liability for any inaccuracies or omissions found in this publication Do remember that shares are, by their very nature, speculative, and that generally investments in smaller companies have a higher risk factor, so you should never invest more than you can safely afford as you may not get back the full amount invested It can also be more difficult to sell or realise such an investment The past is not necessarily a guide to future performance Before investing, readers should seek professional advice from a stockbroker or independent financial adviser.

INTRODUCING THE RED HOT VALUE INVESTOR

EDITOR JACQUES MAGLIOLO …

Jacques Magliolo, the editor of The Red Hot Value Investor, is exceptionally well placed to

assess the volatile South African market He was a head of research and a director of a leading Johannesburg-based stockbroking firm, where he specialized in global investment strategies to assess how these affect local companies His investment philosophy and the strategy that he developed was to target Institutional and private clients through a coordinated approach to research This included global market economic, business and political research, specific company analysis and identifying anomalies and market trends More specifically, research was conducted in the following way:

A Strategic Research

1 Conduct global market research to identify global trends.

2 Determine how those trends affect South Africa, i.e political, business and economic.

3 Identify sectors that would be most affected by these trends.

B Company Analysis

1 Conduct industrial and financial analysis on companies identified through global market analysis.

2 Recommend shares to clients.

C Update these companies through information documents.

D Use company analysis to complete portfolio and asset allocations.

E Use information database to detect anomalies between equities and warrants.

Author of Share Analysis and Company Forecasting and The Business Plan: A Manual for

South African Entrepreneurs, he has contributed to, among others, the Financial Mail, Business Day and the UK-based Petroleum Economist and The Daily Mail He has also been a columnist

for the Mail & Guardian and The Star.

Born in Morocco, Jacques moved to South Africa 30 years ago and began his career for the Financial Mail in 1987, before moving into stockbroking in 1990 As investment strategist, he has also been involved in the development of complex investment models to identify market anomalies in both equities and warrants.

Any fool can make some money from buying shares but, follow a few simple rules and take advice fromthe right quarters, and you can make serious amounts of money The aim of this booklet is to guide youtowards those serious rewards Remember that there is a significant difference between a gambling-typeshare purchase and creating wealth over time through proper share selection

It might seem foolish or naive to suggest that absolutely anyone can make money from shares Yethistory shows that over the long term equities outperform all other forms of investment So, if you arehappy to pay fat management fees to a City fund manager you can entrust your cash to him and he willdeliver you an annual gain that will, to a greater or lesser degree, match the average return of the JSESecurities All Share Index Over the past few years that return has been a creditable, if not outstanding13.6% over the last year

Our philosophy at the Red Hot Value Investor is that passive investment is a short-sighted policy,

because there are so many advantages that you, the private investor, holds over the institutional fundmanager, the so-called “professionals.”

Your advantage over the “Professional”

1 Your biggest asset is that you can concentrate your firepower on the handful of shares that you expect to deliver the greatest returns The fund manager would like to do so, but is

forced to invest in a multitude of complex financial instruments, like derivatives, and in a host ofconglomerates that have dozens of listed subsidiaries (come offshore) The reason is that, if hewere to put all his cash into just a few stocks, he might well end up owning them entirely In otherwords, he is forced to invest in companies that he has only limited faith This argument, that aconcentrated portfolio is actually less risky than a diversified one, has been expounded, and putinto practice over many years, by the greatest living investor, Warren Buffett

2 Your second biggest advantage is speed The fund manager is controlling millions of Rands

and so -especially when dealing in relatively illiquid smaller company shares - it’s extremelydifficult for him to buy or sell enough shares to make a significant difference to the shape andbalance of his portfolio Remember that portfolio managers’ remuneration is largely dependent onthe increasing value of his portfolio For the private individual, selling or buying a holding that may

be significant to you, but is almost insignificant to the wider market, should present no suchproblems You, and I, can move in or out of a position almost immediately with no problems

Why Penny Shares?

Why should I invest in shares in smaller companies, those (for the purposes of Red Hot Value Investor)

with a market share price of less than R10 a share?

1 Firstly, the academic evidence is that smaller, younger and more entrepreneurial companies areexpected to deliver rapid profits growth and this will inevitably, over the long run, come to bereflected in the performance of their shares The most authoritative academic research on thissubject comes from the London Business School which showed that - except in the depths ofrecession - the universe of smaller companies outperform their larger counterparts every year

The star small caps do even better and - every year - will be found at the top of the performanceleague tables for quoted shares.

Instinctively, many of us who have worked for large bureaucratic organizations will agree thatsmaller companies are better focused, more efficient and organized than their largercounterparts, where decision making seems to take an eternity and where length of service oftencounts for more than current performance

2 “Professional” analysts in the broking community often overlook smaller companies as these donot generate sufficient brokerage Many of the smaller cap stocks trade infrequently and have lowshare prices In South Africa brokerage is calculated on a percentage basis, so the lower theprice the lower the commission – to the point where many of the larger stockbrokers have setminimum limits For instance, if a stockbroker sold 100,000 De Beers shares at the current price

of R305 a share, the broker would earn about R61,000 (brokerage at 0.2% of value oftransaction), but if he sold one million share in micro-lender Unifer at a price of 81 cents a share,

he would earn only R1,620.0 The “professionals” would rather write a lengthy note on Anglo orDimension Data - even if their research created little added value - because that report wouldprobably generate far more commission income than from spending the same amount of timediscovering the joys of, and the potential value in, smaller companies

That is how some smaller company shares with dynamic growth prospects can remain unnoticed.Trading in such shares may be minimal until the company makes a formal stockmarket announcementwhen, belatedly, investors pile in causing the shares to soar in value Even when a formal resultsannouncement is made the market may not always realise its full impact so there is often time to buy thestock after its initial re-rating and still make significant gains

That is not to say that making money from penny shares is easy, because commensurate with higherrewards, the Penny Share sector also comes with higher risks It is the aim of the system of share

selection methodology outlined in this booklet and for Red Hot Value Investor is to steer you away from

those risks Never forget there are risks

Potential problems with Penny Shares

1 The principal danger (as well as the main attraction) is the potential gearing of Penny Shares tojust one event For instance, if Comparex wins or loses the next big order for e-commercetechnology it could make a difference of, say 5%, to its share price For a smaller Info Techcompany operating in the same or similar sphere, just as the potential upside of a big contractwin is enormous, the potential downside from a big contract loss could be devastating Carelessstock selection, when choosing between JSE Industrial 40 companies, is unlikely to lose you (ormake you) significant amounts of money in relatively few weeks The same is not always true forPenny Shares

2 The second potential problem with Penny Shares is one of marketability, which itself adds to therisk of this game Not only can the difference between the buying and selling prices (the spread)

be large in percentage terms, but also if there is little trading in the shares the price can movesharply on even the smallest trades This is particularly true for some of the more illiquid stocks

on the Development Capital Market (DCM) and, especially, on the Venture Capital Market(VCM)

For instance, in 1998 news that VCM listed company Whetstone had developed (and had approved andsold to a US company) a new petrol additive that could become the answer to world emmision problems,sent the company share price soaring In a matter of week the price had risen from 140 cents to over 470cents When news broke that the contract had fallen through, the share fell all the way to 15 cents As aresult of the higher risks associated with Penny Shares, it would be suicidal to invest all your cash in justone stock, as nothing in life is absolutely guaranteed - even the greatest investors get it wrongoccasionally.

At Red Hot Value Investor we believe that you should build up a portfolio of between 10 and 15 smaller

company shares that mirror your own risk reward profile If you feel you wish to invest in anothercompany outside your existing portfolio, you should perhaps consider realising your gains on one of yourcurrent investments as excessive diversification carries its own risks You should always considerbanking substantial gains, because every growth stock will, one day, mature to a stage where its rate ofgrowth will start to decline The successful Penny Share investor can have no room for sentimentalattachments to a particular share, even if it has served him exceptionally well in the past

Following the Red Hot Value Investor’ system for spotting growth opportunities is a good start on the

journey to making big gains from smaller company shares Our monthly publication should assist you onyour travels since it will contain analysis, available nowhere else, as well as the distilled insights, viewsand suggestions of hundreds of contacts from the markets, industry, political connections and businessdealings

It was one of my industry contacts in 1997 that pointed out former IT giant Computer ConfigurationHoldings (CCH) as a possible recommendation On approaching the CEO, I discovered that they hadpublicly announced a successfully acquisition that would make a significant difference over the shorttime Analysts ignored this newly listed, 200 cents a share company, but to their detriment With 12months the company had seen its share rise to 4700 cents The reverse happened in 1999, when thecompany had grown too fast I recommended that investors “take profits.” Shortly after this, the companywas swallowed up by another IT company and practically disappeared from sight

Not every Penny Share will be a winner like CCH and on that basis you should never invest money onthe stockmarket that you cannot afford to lose There are literally hundreds of stocks out there that offer

the potential for making similar gains By using Red Hot Value Investor’ proven method and by gaining

the best possible sources of information you can dramatically increase your chances of picking the nextCCH and start creating your own wealth building portfolio

Chapter One: Filter Out The Losers

great man puts it: “Rule number one of investment is not to lose money Rule number two is to remember

rule number one.”

The Red Hot Value Investor filter method of share selection comes in two parts:

 Non-financial: Even the semi-numerates who run local government departments might

understand

 Financial: This requires some understanding of balance sheets, cash flow statements and

profit & loss accounts

 Both filters are based on common sense and experience These are qualities that shouldalways be the basis for all investment decisions, but are too often ignored in the hype onehears from certain stockbrokers and read about - all too often - in the mainstream press

Part One, the non-financials

“Despite my appreciation of structural models in forecasting, I do not believe in mechanical model-based forecasting, estimating the model and letting it make the forecast without intervention of the forecaster.” (Laurence Meyer, Member of the Board of the US Federal Reserve, 1998)

A well-known analyst some years ago produced a lengthy tome studying common features amongcorporate post-mortems Like most people who read that publication, we now look nervously when wesee a finance director wearing a bow-tie and grow even more jittery if, contained within an unusuallydesigned annual report, is a picture of a fountain gushing in the atrium of the company’s headquartersbuilding Despite this, Red Hot’s actual filter criteria are rather more straightforward

1 Management is crucial

 Firstly they must be committed in a financial sense to growing the business and so rewardingshareholders, rather than to rewarding themselves In 1990, a group of directors formed a retailcompany called Rusfurn, which incorporated a number of large mass discounters (Dion, now part

of Massmart) and furniture groups After a lengthy discussion with the CEO and financial director Idiscovered that “if Rusfurn reaches …eps ….the directors gain an additional ….million shares.” Aquick analysis suggested that the additional shares would significantly dilute earnings in the

following financial year – to the detriment of the shareholder I recommended that investors bail out

at 120 cents a share and, within six months, the share had crashed to less than 10 cents, thecompany ultimately sold piece meal

 However, it is always heartening to see that the board has a significant stake of, say, more than5% in any smaller company as that gives them a real incentive to drive the share price forward Onthe other hand, too great a stake and there is a danger that the firm may be run as a comfortable

“family” firm, not one with an ethos of maximising earnings growth There is often also the potentialthat the directors listed the company to maximize their personal wealth (push the share price up),before selling the company to the highest bidder

 It is equally disheartening to see senior managers, whose pay levels and annual remunerationincreases, bear little relationship to the company’s record of adding value for shareholders Alwayscheck that a company’s senior managers are demonstrating real financial commitment to thecompany, rather than to themselves, by taking home pay commensurate to the size of thebusiness and pay rises commensurate with its success Notes in the annual reports about “materialtransactions” with other companies in which a director has an interest are often signs thatmanagers are topping up their salaries via the back door If this is the case, we would rather investelsewhere

 Finally it is always worth noting recent share purchases or selling by directors If the top men arelightening their equity holdings, that cannot be seen as a vote of confidence and perhaps youshould follow suit The reverse is also true There are several internet sites that provide freeaccess to main shareholder structures, the best of these is www.bfanet.com

 As important as the management’s financial interest in maximising shareholder value, is its ability

to deliver that value It seems heartless, but you should rarely give a failed chief executive asecond chance - it pays to back proven winners, rather than even those who have failed oncebefore Jeff Liebsman is an example of a failed businessman who made a strong comeback In theearly 1990s he wielded significant power in a conglomerate called W&A, only to see the group fallapart However, by late 1997 he had re-grouped – with new investors and consultants – he had set

up Corpgro and a host of other listed entities What I’m trying to say is, who you follow isdependent on the amount of knowledge you have on the person, the type of venture he is pursuingand who his backers are These must form a major part of your decision making process

 A UK survey published in October 1996 by the business information group CCN showed the extent

of serial failure among company directors More than a fifth of those who had steered one vesselonto the rocks had also managed to send another ship to the ocean floor There are currently morethan 4,000 company directors in Britain who have already been involved in 10 or more companyfailures While figures are not available for South Africa, I can state that personal research showsthat 33% of all companies in South Africa head for bankruptcy every year

 Ask yourself: whatever the odds, should you risk your wealth, your portfolio of shares to someonewho has already failed?

2 Never back those who break their promises

 Just as perennial losers should be shunned, so too should those vehicles that persistently fail tomeet expectations The Stock Market will not tolerate “promises of profits tomorrow” forever, and a

record of issuing profits warnings will inevitably see the shares de-rated, and unlikely to be re-ratedeven if the profits warnings cease The market adage is that profits warnings usually come inthrees Sadly it is often in fours or fives.

 The bottom line is that well-managed firms in growth industries do not issue regular profitswarnings, either overtly through the Stock Exchange or covertly by telling brokers to cut theirforecasts

3 Listen to what a company’s rivals are saying

 Before investing in a particular company check what its rivals are saying about their current tradingand prospects If the company you are thinking of backing seems to be singing from a completelydifferent hymn sheet than those of its competitors, it is not one that should pass the filter test.Experience and common sense should always tell you that if something sounds too good to betrue, it probably is not true

4 Let the trend be your friend

 It is usually better to invest in shares that are on an upward trend than one that is on the reverse,

as the sensible investor should let the trend be his friend A share may look cheap, but if its price is

on a persistent downward path that often means that someone, somewhere, knows somethingbad If you were aware of that inside information, the chances are that you would not think theshare was still cheap

 If you still think a particular stock looks cheap after it has started to fall, wait until it stops falling andhas instead risen for a couple of days before buying If you buy falling shares in the hope “surely

they cannot go any lower” or if you buy shares that fail the normal Red Hot Value Investor filters

just because they “look cheap” you will quite possibly get badly burnt This is the Stock Marketequivalent of the old adage: “Never catch a falling knife.” In the investment world that can be a veryuseful phrase to remember

 Having said that, you should also not chase a price up If Red Hot Value Investor tips a stock at 10

cents it is due to our belief that you can reasonably expect to make a 30% return on that within sixmonths, and possibly considerably more However, traders have large research departments, withanalysts who monitor all share recommendations (especially those made by someone with arecord of success) very carefully and will respond to such tips by marking the shares up So, if bythe time you come to buy, the shares are already trading at 14 cents, any subsequent purchaserwill already have lost most, if not all, of the subsequent upside But if you and other sensibleinvestors hold off from buying immediately, the traders will call the price lower in order to drum upbusiness Thus, it often pays to be patient and wait a few days or weeks in order to make yourpurchase

5 Avoid companies that change advisers or directors frequently

 To lose one non-executive director or one key adviser is acceptable, to lose two is careless and tolose more is terrifying

 An unexplained resignation by a non-executive director, or change of sponsoring stockbroker ormerchant bank is always worth investigating When these supposedly impartial directors or

advisers, whose supposed role is to protect shareholders interests, quit without explanation, westart to become concerned Those who sold their shares in Wooltru when Colin Hall resigned asexecutive chairman, were considerably better off than those who ignored the warning signal.

 Unless both the company and the departing non-exec or adviser can give a cogent and plausiblereason for the parting of ways, the company does not merit your financial support

 When there is a series of boardroom resignations or a repeated changing of advisers or brokersyou should become extremely concerned At best, it may suggest that the company’s seniormanagement find it hard to maintain decent business relationships At worst, it suggests rathermore serious problems Either way, the company involved is not one in which you should invest

6 Listen closely – what is said is often not what is meant

 In 1996, a colleague (a stockbroker) and I interviewed the directors of a Cape Town based Foodlisted company The directors said that “everything is positive,” and “we expect a 25% earningsgrowth rate this year.” Despite their attempts at conveying a positive message, they seemeduneasy After the discussion, my colleague turned to me and said that he was going back to theoffice to advice clients to continue to accumulate the share He then asked me for my advice

 This is what I said: “I believe that they (the company) is about to be de-listed, with head officeusing this company to reverse list another operation, possibly the Johannesburg-based holdingcompany.” He looked at me, slightly confused and, shaking his head, asked me how I hadconcluded that scenario I pointed out that the directors had avoided any question relating to headoffice and had not provided a reasonable explanation as to how Head office would expand all itsfood operations into Africa They would need a listed vehicle to fund such a venture!

 Within three weeks of my statement to my colleague, the holding company announced a de-listing

of the Cape Town firm I had proved myself to our institutional clients, yet all it took was gut feeland listening closely In other words, try to know that people often say more by not speaking at all

If you are “listening” you can get an investment edge

7 The Mission Statement

 A mission statement is necessary for a company to give focus to their strategy Essentially, aStatement enables business to bring people together with a focused, common ideology anddirection In addition, the company can make sure that the whole strategic planning process isintegrated throughout the entire group

 However, if the mission statement is too broad, it results in blue sky type planning, which should berestricted to Boardroom brainstorming sessions A statement that is too narrow results in channelvision and foregone opportunities This implies that a brief look at a company’s statement shouldgive the investor an understanding of the general direction that the firm should be taking If not,why invest in a company that cannot even keep to its own agenda

8 Market and industry characteristics

 Another non-mathematical method of determining whether a company has a suitable strategy is aninvestigation of the opportunities and threats that the company faces in the environmental factors

within which it operates; including, politics, economics, finance, global threats and opportunities,technology, social change and labour issues.

 The dilemma strategists face is what factors to include and exclude when setting up key criterionfor decision making One approach is to identify key characteristics of the environment arising out

of product life cycle and other major factors that affect business Some key filters includecharacteristics of the markets, competitors, market fragmentation, entrepreneurial flare ofmanagement and possible synergies arising out of a takeover, acquisition, merger etc Stateddifferently, a company, market or share is considered attractive if its potential for providing asignificant contribution to objectives (mission statement) can be met, i.e earnings growth, cashflow, return on investment or assets, dividend income or capital growth

Conclusion

 Thus, even before analysing the financial statements of a company by referring to its last publishedAnnual Report and any formal Stock Exchange announcements made in the past couple of years,

someone using the Red Hot Value Investor’ filter-system should be able to eliminate at least half, if

not more, of the 500 smaller company shares on offer as being unsuitable for his or her portfolio

 Remember: unless a company’s managers have a record of success and show financialcommitment and confidence in the business; unless those managers have a record of meetingexpectations and there is a record of boardroom continuity and of stable relationships with theiradvisers; unless the company makes promises that appear realistic in relation to those of its rivals;

and unless the share price is, at worst, stable, then the company has failed the Red Hot Value

Investor’ non-financial filters.

 As such it does not merit a place in your investment portfolio

Part Two: The Financials

The non-financial filters will probably have already weeded out at least 33% of the three dozen or socompanies that financial and other contacts suggest that we investigate every week, and so it is only atthis stage that the company’s Annual Report truly comes into its own as one attempts to gauge thefinancial health and prospects of the business As before, there are a number of filters that should beenough to eliminate all but a few potential candidates for investment

It might be surprising, but it is always worth starting corporate detective work at the back, rather than thefront, of a company’s annual report At the beginning, there should be a statement from both thechairman and CEO outlining the events of the past year and putting as positive a spin as is possible onthe company’s prospects Reading between the lines of his statement can unearth a few concerns, butthe first third of an annual report normally contains nothing more than merely a restatement of a handful

of corporate clichés and a collection of glossy photos of fat-cat executives In other words, the content isunlikely to be either particularly useful or especially aesthetically pleasing

In the middle of an annual report are the Income Statement, Balance Sheet and Cash Flow Statement.More is outlined later