Over the past 12 months, Singapore’s share market barometer, the Straits Times Index (SGX: ^STI), has climbed by a respectable 6.9% to 3,324 points as of yesterday’s close. Investors who bought into the index through an exchange-traded fund like the SPDR STI ETF (SGX: ES3) would have earned even better returns of around 9.5% or so if dividends were factored in. Why shares lose money But, not every share has managed to move up along with the broad market advance. Some shares are languishing near their 52-week lows, while others have made painful losses. When shares…
Over the past 12 months, Singapore’s share market barometer, the Straits Times Index (SGX: ^STI), has climbed by a respectable 6.9% to 3,324 points as of yesterday’s close.
Investors who bought into the index through an exchange-traded fund like the SPDR STI ETF (SGX: ES3) would have earned even better returns of around 9.5% or so if dividends were factored in.
Why shares lose money
But, not every share has managed to move up along with the broad market advance. Some shares are languishing near their 52-week lows, while others have made painful losses. When shares lose money for investors, there are really only two reasons why that’s so: 1) the share was valued too richly in the first place; and/or 2) the share’s business had deteriorated badly.
For shares in the latter camp, it can be fertile ground for bargain hunting if the deterioration turns out to be temporal in nature. But, how can we know if a share’s business is doomed to fail or if it can bounce back strongly?
Over at Fool.com, my American colleague John Maxfield recently wrote a great article titled “Playing With Fire: A Framework for Predicting Failure” which can provide some clues to help answer the question.
This is how John describes his framework for retail companies:
“One of the reasons it’s hard to predict if and when a company will go under is because bankruptcy isn’t simply a matter of solvency — that is, of having more assets than liabilities. If this were the case, even a novice investor would be able to forecast the downfall of the most complex publicly traded corporation. All it would take is a cursory glance at the shareholders’ equity portion of the balance sheet.
This doesn’t mean solvency isn’t important; because it is. But it’s nevertheless rarely the precipitating cause of failure…
… If solvency isn’t the issue, what is? The answer is liquidity. When a company is in its final throes, the most acute problem it faces is the inability to convert assets into cash, which can then be used to buy inventory and satisfy expenses like rent and wages. This happens when creditors lose faith in a company and stop accepting its assets as collateral for lines of credit. It’s this, in turn, which triggers the actual demise.”
He went on to explain how he assesses for liquidity:
“The fact that illiquidity is typically the cause of a retail company’s failure presents a problem for the average investor. This is because it’s far harder to compute than solvency.
The conventional approach is to compare a company’s current assets — such as cash, inventory, and accounts receivable — to current liabilities — namely, debts and obligations that will come due within a year. But this measure, known as the current ratio, can be misleading because it includes inventory and receivables, which often can’t be converted into cash at face value on sufficiently short notice, and because it ignores cash flow, which is the very essence of liquidity.
On top of this, there’s a subjective element to liquidity that can’t be captured in financial statements. This follows from the fact that a company’s liquidity depends on its creditors. And its creditors are less interested in shorthand measures of fiscal health like the current ratio, and much more concerned with beating competing creditors to the punch, thereby securing repayment before it’s too late.
It’s for these reasons that a retail company’s chances of suffering a fatal liquidity crisis can best be gauged with two questions. First, does the company have a history of sustained and accelerating quarterly losses? This matters because losses erode book value, which is a proxy for a company’s ability to borrow. And second, are the company’s operations burning through more cash than they’re generating? If so, then the company has a serious problem on its hands because its cash coffers aren’t being replenished — a fact that won’t go unnoticed by creditors.”
Connecting the dots
Super Group Ltd. (SGX: S10) and Challenger Technologies Limited (SGX: 573) are both retail-types of companies which have seen painful losses in the past 12 months due to a deterioration in their businesses.
|Company||Year-on-year change in profit for the first half of 2014||Share price change over past 12 months|
In light of that, let’s see how they stack up against John’s framework for assessing liquidity. The first test – “a history of sustained and accelerating quarterly losses” – sees both companies pass with flying colours. Neither Super Group nor Challenger Technologies had made any quarterly losses going back to 2007 at least.
As for the second test, both companies also came through with ease. Over the past four quarters, Super Group generated S$16 million in free cash flow (operating cash flow minus capital expenditures) while the corresponding figure was S$8 million for Challenger Technologies.
Foolish Bottom Line
So with the two tests above, it’s perhaps safe to conclude that both Super Group and Challenger Technologies are not facing any sort of imminent threat of bankruptcy. But that said, it’s important to note that we still can’t tell if those two companies can see their businesses rebound strongly – the only thing we know now is that they can survive to fight another day.
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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Chong Ser Jing owns shares in Super Group.