THE R R E E D D H H O O T T VALUE INVESTOR GUIDE TO ULTIMATE STOCK MARKET SUCCESS * The Red Hot Value Investor’s Guide to Ultimate Stock Market Success * * 2 * THE RED HOT VALUE INVESTOR GUIDE TO U L T I M A T E S T O C K M A R K E T S U C C E S S © Copyright 2001 Fleet Street Publications Ltd. All rights reserved. No part of this book may be reproduced by any means or for any reason without the expressed written consent of the publisher. * The Red Hot Value Investor’s Guide to Ultimate Stock Market Success * * 3 * CONTENTS Introduction 5  Your advantage over the “P rofessional” 5  Why Penny Shares? 5  Potential problems with Penny Shares 6 Chapter One: Filter Out The Losers 8  Introduction 8 Part One: The non - financials 8 1. Management is crucial 8 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 7. The Mission Statement 11 8. Market and industry charac teristics 11 Conclusion 12 Part Two: The Financials 12 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 gro wing and adding value for shareholders? 14 4. Cash is King & Tax is unavo idable 15 5. Do not ignore the Balance Sheet either 15 Chapter Two: Valuation, The Final Filter 17  Back to valuation 17  Assessing the true value of a company 18 Chapter Three: Special situations 21 Chapter Four: Stop - loss, profit taking and top slicing 22  The point of setting stop losses 22  Top Slicing 23  Summary 24 Conclusion 25  One last piece of advice 25 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 shar es 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 sel l 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. * The Red Hot Value Investor’s Guide to Ultimate Stock Market Success * * 4 * 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 a nd private clients through a co ordinated approach to research. This includ ed 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 iden tify 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. * The Red Hot Value Investor’s Guide to Ultimate Stock Market Success * * 5 * Introduction Any fool can make some money from buying shares but, follow a few simple rules and take advice from the right quarter s, and you can make serious amounts of money. The aim of this booklet is to guide you towards those serious rewards. Remember that there is a significant difference between a gambling - type share purchase and creating wealth over time through proper share s election. It might seem foolish or naive to suggest that absolutely anyone can make money from shares. Yet history shows that over the long term equities outperform all other forms of investment. So, if you are happy to pay fat management fees to a City f und manager you can entrust your cash to him and he will deliver you an annual gain that will, to a greater or lesser degree, match the average return of the JSE Securities All Share Index. Over the past few years that return has been a creditable, if not outstanding 13.6% 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 fund manager, the so - called “professionals.” Your advantage over the “P rofessional” 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 of conglomerates that have dozens of listed subsidiaries (come offshore). The reason is that, if he were to put all his cash into just a few stocks, he might well end up owning them entirely. In other words, he is forced to invest in companies that he has only limited faith. This argument, that a concentrated portfolio is actually less risky than a diversified one, has been expounded, and put into practice over many yea rs, 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 extremely difficult for him to buy or sell enough shares to make a significant difference to the shape and balance of his portfolio. Remember that portfolio managers’ remuneration is largely dependent on the increasing value of his portfolio. For the private individual, selling or b uying a holding that may be significant to you, but is almost insignif icant to the wider market, should present no such problems. 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 are expected to deliver rapid pr ofits growth and this will inevitably, over the long run, come to be reflected in the performance of their shares. The most authoritative academic research on this subject comes from the London Business School which showed that - except in the depths of re cession - the universe of smaller companies outperform their larger counterparts every year. * The Red Hot Value Investor’s Guide to Ultimate Stock Market Success * * 6 * The star small caps do even better and - every year - will be found at the top of the performance league tables for quoted shares. Instinctively, many of us who ha ve worked for large bureaucratic organizations will agree that smaller companies are better focused, more efficient and organized than their larger counterparts, where decision making seems to take an eternity and where length of service often counts for m ore than current performance. 2. “Professional” analysts in the broking community often overlook smaller companies as these do not generate sufficient brokerage. Many of the smaller cap stocks trade infrequently and have low share prices. In South Africa b rokerage is calculated on a percentage basis, so the lower the price the lower the commission – to the point where many of the larger stockbrokers have set minimum 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 of transaction), 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 leng thy note on Anglo or Dimension Data - even if their research created little added value - because that report would probably generate far more commission income than from spending the same amount of time discovering 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 announcement when, belatedly, investors pile in causing the shares to soar in value. Even when a formal results announcement is made the market may not always realise its full impact so there is often time to buy the stock 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 higher rewards, 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 to just one event. For instance, if Comparex wins or loses the ne xt big order for e - commerce technology it could make a difference of, say 5%, to its share price. For a smaller Info Tech company operating in the same or similar sphere, just as the potential upside of a big contract win is enormous, the potential downsid e from a big contract loss could be devastating. Careless stock selection, when choosing between JSE Industrial 40 companies, is unlikely to lose you (or make you) significant amounts of money in relatively few weeks. The same is not always true for Penny Shares. 2. The second potential problem with Penny Shares is one of marketability, which itself adds to the risk 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 move sharply 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). * The Red Hot Value Investor’s Guide to Ultimate Stock Market Success * * 7 * For instance , in 1998 news that VCM listed company Whetstone had developed (and had approved and sold 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 ha d risen from 140 cents to over 470 cents. When news broke that the contract had fallen through, the share fell all the way to 15 cents. As a result of the higher risks associated with Penny Shares, it would be suicidal to invest all your cash in just one stock, as nothing in life is absolutely guaranteed - even the greatest investors get it wrong occasionally. 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 rew ard profile. If you feel you wish to invest in another company outside your existing portfolio, you should perhaps consider realising your gains on one of your current investments as excessive diversification carries its own risks. You should always consid er banking substantial gains, because every growth stock will, one day, mature to a stage where its rate of growth will start to decline. The successful Penny Share investor can have no room for sentimental attachments 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 on your tr avels since it will contain analysis, available nowhere else, as well as the distilled insights, views and suggestions of hundreds of contacts from the markets, industry, political connections and business dealings. It was one of my industry contacts in 1 997 that pointed out former IT giant Computer Configuration Holdings (CCH) as a possible recommendation. On approaching the CEO, I discovered that they had publicly announced a successfully acquisition that would make a significant difference over the shor t time. Analysts ignored this newly listed, 200 cents a share company, but to their detriment. With 12 months the company had seen its share rise to 4700 cents. The reverse happened in 1999, when the company had grown too fast. I recommended that investors “take profits.” Shortly after this, the company was 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 on the stockmarket that you can not 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 you r chances of picking the next CCH and start creating your own wealth building portfolio. * The Red Hot Value Investor’s Guide to Ultimate Stock Market Success * * 8 * Chapter One: Filter Out The Losers Introduction There are over 500 Penny Shares quoted on the JSE Securities Exchange, in which you could invest and each week var ious contacts will suggest looking at over 30 shares that have some potential. It may sound perverse, but the way to spot the winners from a given universe of stocks is by eliminating all the obvious losers. That’s Warren Buffett’s strategy: he will alway s look at the downside of any prospective investment and, if it looks too risky, he will walk away, however tempting the upside. As the 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 state ments and profit & loss accounts.  Both filters are based on common sense and experience. These are qualities that should always be the basis for all investment decisions, but are too often ignored in the hype one hears from certain stockbrokers and read a bout - 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 witho ut 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 among corporate post - mortems. Like most people who read that p ublication, we now look nervously when we see a finance director wearing a bow - tie and grow even more jittery if, contained within an unusually designed annual report, is a picture of a fountain gushing in the atrium of the company’s headquarters building. 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 rewarding shareholders, rather than to rewarding themselves. In 1 990, a group of directors formed a retail company 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 I discovered that “if Rusfurn reaches …eps ….the directors gain an additional ….million shares.” A quick analysis suggested that the additional shares would significantly dilute earnings in the * The Red Hot Value Investor’s Guide to Ultimate Stock Market Success * * 9 * following financial year – to the detriment of the shareholder. I recommended that i nvestors bail out at 120 cents a share and, within six months, the share had crashed to less than 10 cents, the company ultimately sold piece meal.  However, it is always heartening to see that the board has a significant stake of, say, more than 5% in any smaller company as that gives them a real incentive to drive the share price forward. On the 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 grow th. There is often also the potential that 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 remuneration increases, bear little relationship to the company’s record of adding value for shareholders. Always check that a company’s senior managers are demonstrating real financial commitment to the company, rather than to themselves, by t aking home pay commensurate to the size of the business and pay rises commensurate with its success. Notes in the annual reports about “material transactions” with other companies in which a director has an interest are often signs that managers are toppin g up their salaries via the back door. If this is the case, we would rather invest elsewhere.  Finally it is always worth noting recent share purchases or selling by directors. If the top men are lightening their equity holdings, that cannot be seen as a v ote of confidence and perhaps you should follow suit. The reverse is also true. There are several internet sites that provide free access to main shareholder structures, the best of these is www.bfanet.com.  As important as the management’s financial inter est in maximising shareholder value, is its ability to deliver that value. It seems heartless, but you should rarely give a failed chief executive a second chance - it pays to back proven winners, rather than even those who have failed once before. Jeff Li ebsman is an example of a failed businessman who made a strong comeback. In the early 1990s he wielded significant power in a conglomerate called W&A, only to see the group fall apart. However, by late 1997 he had re - grouped – with new investors and consul tants – he had set up Corpgro and a host of other listed entities. What I’m trying to say is, who you follow is dependent on the amount of knowledge you have on the person, the type of venture he is pursuing and 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 vessel onto the rocks had also m anaged to send another ship to the ocean floor. There are currently more than 4,000 company directors in Britain who have already been involved in 10 or more company failures. While figures are not available for South Africa, I can state that personal rese arch shows that 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 someone who has already failed? 2. Never back those who break their promises  J ust as perennial losers should be shunned, so too should those vehicles that persistently fail to meet expectations. The Stock Market will not tolerate “promises of profits tomorrow” forever, and a * The Red Hot Value Investor’s Guide to Ultimate Stock Market Success * * 10 * record of issuing profits warnings will inevitably see the shares de - rated, and unlikely to be re - rated even if the profits warnings cease. The market adage is that profits warnings usually come in threes. Sadly it is often in fours or fives.  The bottom line is that well - managed firms in growth industries do not issue regular profits warnings, either overtly through the Stock Exchange or covertly by telling brokers to cut their forecasts. 3. Listen to what a company’s rivals are saying  Before investing in a particular company check what its rivals are saying ab out their current trading and prospects. If the company you are thinking of backing seems to be singing from a completely different 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 be true, 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 something bad. If you were aware of that inside information, the chances are that you would not think the share was still cheap.  If you still think a particular stock looks cheap after it has started to fall, wait until it stops falling and has 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 Market equivalent of the old adage: “Never catch a falling knife.” In the investment w orld that can be a very useful 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 six mo nths, and possibly considerably more. However, traders have large research departments, with analysts who monitor all share recommenda tions (especially those made by someone with a record of success) very carefully and will respond to such tips by marking the shares up. So, if by the time you come to buy, the shares are already trading at 14 cents, any subsequent purchaser will already have lost most, if not all, of the subsequent upside. But if you and other sensible investors hold off from buying immedia tely, the traders will call the price lower in order to drum up business. Thus, it often pays to be patient and wait a few days or weeks in order to make your purchase. 5. Avoid companies that change advisers or directors frequently  To lose one non - execu tive director or one key adviser is acceptable, to lose two is careless and to lose more is terrifying.  An unexplained resignation by a non - executive director, or change of sponsoring stockbroker or merchant bank is always worth investigating. When these supposedly impartial directors or [...]... start to do their first few deals Thus, there will still be big profits to be made and, hopefully, you will not have to wait too long to see them * 21 * * The Red Hot Value Investor s Guide to Ultimate Stock Market Success * Chapter Four: Stop-loss, profit taking and top slicing In the current volatile market in which South African find themselves, it is not unusual for investors to wake up to find... Investor s Guide to Ultimate Stock Market Success * Chapter Two: Valuation, The Final Filter It is the Red Hot first rule of investment that a bad stock that fails to pass the investment criteria is never a buy, whatever its share price The Red Hot Value Investor filter system should by now have weeded out those stocks that will never outperform the market by enough to make them a satisfactory home... glossy photos of fat-cat executives In other words, the content is unlikely 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 * 12 * * The Red Hot Value Investor s Guide to Ultimate Stock Market Success * However, it is the final section, the notes to the accounts,... Red Hot Value Investor s Guide to Ultimate Stock Market Success * loss It is difficult enough to invest in a familiar market, but into the globalised world the risks mount up quicker than the potential profits  Intermittently Red Hot Value Investor will recommend selling out altogether, because we hear rumours of an impending sea change Sometimes that may appear premature, but it would be prudent to. .. slightly more than the value of International Finance Ltd’s share price * 20 * * The Red Hot Value Investor s Guide to Ultimate Stock Market Success * Chapter Three: Special situations Too many investors look for Special Situations – trying to identify the next Big Thing – often resulting in a specific industry becoming popular That popularity will always be temporary and, when lost, investors won’t return... worth the wait Although Red Hot Value Investor highlights only those stocks that it expects to see make significant gains on a six months perspective the successful investor must be prepared to be patient Back to valuation  Over time there have been well known investment gurus, here and in the UK Perhaps the best known investor in Britain today is Jim Slater, for whom it is hard not to have the greatest... Red Hot Value Investor s Guide to Ultimate Stock Market Success *  Those quality stocks that appear to he sitting on generous PEG multiples of well over 1.5 are worth monitoring, because - should their share price retreat over time or they are dragged down with the rubbish during an overall market correction - they could well come back into buying range  However, that is for the long term In the more... find yourself lumbered with some perennial under-performers The 50% tripwire will in affect, not absolve you, from that tough decision of when to sell the investment that, while not crashing, does not perform * 22 * * The Red Hot Value Investor s Guide to Ultimate Stock Market Success *  The level at which you set a stop loss position is thus very much down to your own attitude to risk If you are... 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 an investigation of the opportunities and threats that the company faces in the environmental factors * 11 * * The Red Hot Value Investor s Guide to Ultimate Stock Market Success * within which it operates; including,... we outline That is your choice, but it would be foolish to ignore the potential offered by stop loss and top slicing theories when managing your portfolio * 24 * * The Red Hot Value Investor s Guide to Ultimate Stock Market Success * Conclusion Contrary to what some pundits may have you believe, investing sensibly does not mean backing just dull multinationals like Old Mutual or Liberty Life After all, . THE R R E E D D H H O O T T VALUE INVESTOR GUIDE TO ULTIMATE STOCK MARKET SUCCESS * The Red Hot Value Investor s Guide to Ultimate Stock Market Success * * 2 * THE RED HOT VALUE INVESTOR GUIDE. some of the more illiquid stocks on the Development Capital Market (DCM) and, especially, on the Venture Capital Market (VCM). * The Red Hot Value Investor s Guide to Ultimate Stock Market Success. Stock Market Success * * 4 * 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