Price does not equal to Value: Cheap for a reason but value exists

Philipp Wörz of Alphen Asset Management writes that smaller companies present both opportunity and hazard.

Judging from the graph below it is evident that investors in smaller, less established companies have had a particularly tough time over the last 3 years with the maximum loss of blood for occurring for shareholders that have targeted the AltX listings. Excluding dividends, R100 invested in 2006 is worth R51 for typical AltX investors versus R120 and R153 for those invested in the Top 40 and mid cap indices.

In today’s article we will briefly investigate how the various sectors stack up relative to each other and where potential value could be found.

The dividend yield and earnings yield of a company is by no means the only indicator of value, but it remains simple and useful when evaluating a company’s attractiveness. Looking at the current valuation of the various sectors as per I-Net it would appear that the fledgling and alternative indices are currently in the doldrums.

Even though there are good reasons why fledgling and ALtX companies have performed so poorly of late, when spotting opportunities in the smaller company part of the market, one should be careful not to take above valuation metrics at face level due to the substantial number of firms that are currently reporting negative earnings – in many cases goodwill related – and thereby distorting the particular index’s valuation. As can be seen in the following table, the lower one moves down the size and quality spectrum, the larger the percentage of firms reporting losses.

It is interesting to note that if one removed the loss making companies from their respective indices, the valuation picture changes dramatically.

As evidenced by the data in table 3, some of the smaller businesses that are listed on the AltX and fledgling indices appear to offer good value, when looked at on an equal weighted basis, relative to the Top 40 and mid cap indices.

It is clear that there are good reasons why the AltX and Fledgling companies have performed so poorly both in absolute terms as well as in relative terms over the last two to three years. Although management is sometimes quick to blame the economic environment for a business’s poor operational performance, some of the smaller companies have also shown poor management and financial controls, which is often hidden during good times but brought to the forefront when conditions toughen.