Throughout the life of a listed company, it will undoubtedly encounter share price swings due to the unpredictable nature of industry and market sentiment. In fact, there are a whole host of reasons why a company may experience a share price fall and when it does, this can be a great time to consider it for your portfolio. But a share price fall does not mean you should automatically buy, and it certainly doesn’t mean you should automatically sell. The reason for the share price fall will ultimately determine what action to take.
We recently did an internal analysis of companies in our portfolios. Many of these we have made good profits on, others have underperformed. But the one characteristic that was common to every single stock was that in the past 12 months they had all experienced a correction (or share price fall) from peak to trough of at least 10-20%. Many have since recovered from this dip, which highlights the volatility that we see every day in the markets, even though earnings are only announced twice a year. I encourage you to run a similar experiment, as it was very eye-opening.
This was an astonishing discovery and speaks volumes to the volatility the market regularly experiences. But what it also suggested is that even high quality companies experience share price falls that can produce excellent buying opportunities.
Let’s take a quick look at why a company’s share price might fall. Firstly, an earnings downgrade will always cause the share price to fall because a share price is based on the expectation of the value of future cash flows. If the reason for the de-rate is likely to be temporary, the earnings might recover in the short term, which could present a buying opportunity. But if the downgrade is indicative of a far more systemic problem that may not be resolved in the short term, this could be a good reason to sell.
An example of the former is RXP Services (ASX:RXP), who in late 2014 announced that some big contracts were delayed, almost halving the share price from $0.61 to $0.35. This is a good example because the earnings for that current period would be lower than anticipated but they would eventually flow, it would just be in the next period. These earnings did eventually flow (and RXP have since diversified and reduced the impact non-renewals might have) and the share price has now recovered to above $0.80. We bought more stock at these low levels and continue to hold it.
As you can see from the graph below, in the last 6 months the stock actually reached a height of over $1.00 and has since retreated to around $0.80; the 20% correction is true again.
iSentia (ASX:ISD) is a good example of what could be regarded as systemic problems, whose share price was as high as $4.93 in December 2015, and after several poor earnings updates, the share price has fallen much more than 20% to be around $1.68 today. iSentia’s problems are much more deeply ingrained with competition and technological change that have been destroying their moat over time. I think they will struggle to really restore shareholder value like RXP have.
Another reason a share price might fall is due to market or industry sentiment. The big banks often trade in line with each other due to their very similar business characteristics. So if one has a particularly poor announcement that is not indicative of the industry direction I would expect to see the other three also experience a decline. This might present a buying opportunity if the earnings of the others are unaffected, as the value to the buyer would be increased.
The automotive retail sector also trades closely together. The two major competitors are AP Eagers (ASX:APE) and Automotive Holdings Group (ASX:AHG). While the businesses are not identical, you can see from the share price charts below that the trends are very similar, despite the fact that at least 20% of AHG’s revenue comes from its unrelated logistics division.
Once final example is Vita Group (ASX:VTG). A few weeks ago the company gave the market some clarity over their relationship and future with key supplier Telstra (ASX:TLS). This included the announcement that Telstra would reduce the remuneration paid to VTG by 10% each year for the next 3 years, beginning on 1 July 2017.
The market reaction was particularly savage, selling the stock down to around $1.00, a level not seen since August 2014. This was the 5th poor update since the share price high of $5.31 in September 2016, and suggests that if a company (even a highly regarded company with excellent management) releases a downgrade and uncertainty remains, it may not be the last downgrade.
Analysts around the country will now be reassessing their models for VTG to decide what they think VTG’s earnings and dividend is likely to look like, and whether or not the changing outlook now represents good value.
The are many other reasons for share price falls but the bottom line is this: if the fall is earnings related, you’ll need to dig deeper and figure out if (or when) the earnings will recover. And if the fall is sentiment related and the earnings are unaffected, then this could be a real buying opportunity. As Buffett says: “be fearful when others are greedy and greedy when others are fearful.”
Farnam holds RXP in its Value Portfolio.
This document has been prepared by Farnam Investment Management Pty Ltd (Farnam) ABN 15 149 971 808 AFS Licence 430574. Australian Unity Funds Management Limited ABN 60 071 497 115 AFS Licence 234454 is the responsible entity of Farnam Managed Accounts. While every care has been taken in the preparation of this document it does not contain any recommendations to buy or sell any particular stock(s) noted. Farnam makes no representation or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. The information in this document is general information only and is not based on the objectives, financial situation or needs of any particular investor. An investor should, before making any investment decisions, consider the appropriateness of the information in this document, and seek their own professional advice. Past performance is not a reliable indicator of future performance. The information provided in the document is current as the time of publication.