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Is the time right to buy these 'down and out shares' today?

by , 11 February 2016

What a time we've had…

Since November 2015, the JSE All Share Index crashed 11.8%. The Small-Cap index dropped 18%!

You might've thought you were prepared for a market crash like this when you started investing…
But I bet you're panicking now.

It's tough. It's scary. And it really isn't nice to see your entire portfolio of shares crash like this.

Today, I want to give you some good and bad news…
 
First, the bad news… These crashes, on average, last a month longer than investors are prepared to hold on for…
 
You see, once panic hits, investors give up and sell everything. Then the crash stops. Shares hit rock bottom and the sharks come in and clean out all the good shares selling at deep value prices.
 
I'm sure you're wondering when that'll be then? Well, that's the good news…
 
Since November 2015, the JSE All Share Index crashed 11.8%. The Small-Cap index dropped 18%!
 
You might've thought you were prepared for a market crash like this when you started investing…
But I bet you're panicking now.
 
It's tough. It's scary. And it really isn't nice to see your entire portfolio of shares crash like this.
Today, I want to give you some good and bad news…
 
First, the bad news… These crashes, on average, last a month longer than investors are prepared to hold on for…
 
You see, once panic hits, investors give up and sell everything. Then the crash stops. Shares hit rock bottom and the sharks come in and clean out all the good shares selling at deep value prices.
 
I'm sure you're wondering when that'll be then? Well, that's the good news…
 
What history tells us about stock market crashes
 
I had a look at the last 30 years of the JSE’s history and found an interesting pattern.

The stock market has only fallen for three months in a row (or longer) eleven times in the past thirty years.

That means we’re looking at roughly one big shakeout happening every three years.

Notable three month or longer stock market declines in the past 30 years
 
Year Decline % Duration
1988 -52,93% 6 Months
1990 -18,64% 4 Months
1992 -16,32% 3 Months
1997 -18,34% 5 Months
2000 -14,46% 5 Months
2003 -23,47% 5 Months
2008 -13,40% 3 Months
2008 -39,29% 5 Months
2010 -8,86% 3 Months
2011 -9,98% 5 Months
2015/2016 -11,82% How long will this last?
 

The 2015-2016 crash is a bit behind schedule, considering the last one happened in 2011.

What’s more was that I found these market declines lasted about four months.

At the moment we’re in the third straight month of decline. I expect we’ll see four-five months of decline this time around. So the market will stay tough for the next month or two.

And then it’s over.

The market has a stronger stomach than most investors do!

The JSE All-Share Index went up 3,502% in the past three decades.  That means if you put R100,000 into the index in 1986 you’d have R3,602,478.40 today.

This doesn’t mean much by itself.

But consider this: Since 1985 there’s been 11 crashes. The 1988 flash crash, the ’97 Asian Financial Crisis, the dot-com bubble and the 2008 recession are the most noteworthy.

That’s a record of 11 crises that (at the time) seemed like it would be the end of investing as we know it forever. Yet our market still managed 3,502% gains through all of these shocks!

Throughout this time there’s been countless investors cashing out their money, they just couldn’t stomach the on-going crises, but if you stand back and forget about this noise for a while you’ll see it doesn’t really matter!

Here’s the good news – after nearly every decline the market soars!

Fortunately I’m not just the bearer of bad news today. There’s a silver lining to this dark cloud…

For the past ten crashes on the JSE, eight were followed by strong upticks in the stock market. The two exceptions are the initial crash of 2008 and the crash in 1997.

On average the stock market soared 28.39% in the six months following a crash!

Following the crash of 1988, the market actually jumped 42%.

So, in all likelihood we’ll end the year on a better footing than we started it.

If you were thinking “Should I sell everything now?”

Definitely don’t.

Should you consider selling some of your shares?

Yes.

What should you sell?

Well, the way I do it, is I look at all of my open positions and determine which ones are the least desirable.

Those shares which are exposed to the most risk out of the lot. That can even include shares with big gains.

Those are the shares I cut.

You see, the reason I pick shares that sell at discounts to their value, is to make sure if a market crash or downturn comes the shares don’t have a lot of space left to fall. And if they do fall more, they only become more attractive because of what they’re actually worth.

Two of my favourite ‘down and out shares today’

This is one of the shares to own in 2016

Rolfes have taken a beating. The company owns a division that produces agricultural chemicals. And because of the drought we’re in market followers have been wary of the share in worry of the company not being able to deliver this year.

But that’s far from true.

Firstly Rolfes is a diverse company and sells into many industries. It owns businesses right throughout Africa as well. So trouble locally doesn’t spell doom for it.

But more importantly Rolfes made a massive acquisition in the past six months.

It bought a share in a company called Bragan Chemicals. Bragan supplies chemicals to the food industry. So this business in itself is defensive.

The price Rolfes paid for this acquisition was a bargain – and it’s already paying off big time.

Rolfes announced that its earnings, for the six months ended 31 December 2015, will be 20%-25% higher than last year.

What’s more, there were R4 million transaction costs involved in the Bragan Chemicals transaction as well. If you strip out these costs (because they won’t be repeated in the coming year) you get earnings that are 32%-37% higher than the previous year.

We’re talking 30.5cps earnings for a half year.

That means on an annualised basis Rolfes is trading on a PE of 4.7.

The Rolfes share price immediately shot up from 250c to 288c following this news. But there’s more upside.

This earnings announcement actually exceeds my expectation. My forecast for full year 2016 was 53cps. If the company matches first half performance earnings could come in between 55cps and 60cps.

If the company trades on a PE of 10 that means a target price of R6 compared to the current share price of R2.88…

The weak rand has done its job for Merafe

Merafe is a rand hedge share.

The company sells ferrochrome in dollars. The price is fixed on a quarterly basis. But the rand has weakened so much, so fast, that the company’s income in rands has skyrocketed.

I’ve maintained the company is worth R1.40-R1.80 for a while.

The fact is, with the weak rand the company is coining it.

Add to that Merafe’s new production facility, Lion II, produces ferrochrome with around 35% less electricity than older ferrochrome smelters and you’ve got a recipe for profit.

The share has recently dropped a lot. Obviously there’s the weakness in our own market. But investors have also become fearful of all resource companies.

Merafe’s recent announcement proves this fear is unfounded.

In fact, the company has a lot of profit potential!

How do you like a 51%-74% increase in earnings?

Merafe has increased earnings per share from 8.6cps to around 13-15cps up to the end of 2015.

This has happened thanks to a combination of three factors:

Merafe profit booster #1 – Lower debt repayments

One year ago Merafe owed R189 million in short term debt and another R617 million in longer term debt with Standard Bank and Absa. Its sum total of all cash minus all debt was equal to –R1,251 million.

It’s paid off a lot of this in the past year using profits from its operations. Now its cash balances minus all debt is equal to –R660 million. It’s paid off the entire short term debt facility it had in place. It’s also reduced the Absa+Standard Bank debt facility to R559 million.

In short this means a lot less interest expenses. Let’s say the company reduced debt by R281 million. And it paid 10% on all of this debt. That translates to a R28.1 million reduction in interest payments for the coming year. That’s equal to 1.1cps extra profit.

Merafe profit booster #2 – Higher and cheaper production thanks to Lion II

As I explained, Merafe’s newly built Lion II smelter produces ferrochrome at a much lower cost than older smelters. So this facility adds a lot more profitable production to Merafe’s bottom line.

In the past year Merafe increased production from 334,000 tons of ferrochrome to 372,000 tons of ferrochrome.

Lion II only started producing at full capacity towards the middle of 2015. So 2016’s results should show even higher production at an even lower cost basis!

Merafe profit booster #3 – A weaker rand means more profits

Just consider this: Merafe at R13 to a dollar earns R12.61 per pound of ferrochrome it sells. At R15.59 this grows to R15.12 per pound. That’s a 20% increase thanks to a weaker rand. At the current R16 to the dollar the company’s profits are even bigger!

Most of 2015 only saw the rand at R13 to the dollar. So the R15 and R16  dollar we’re seeing right now is providing a massive boost over and above the higher profits Merafe’s already reporting.

I expected between 14c and 18cps earnings from Merafe. So the 15cps earnings it is due to report is nicely within my expectations. The share price shot up 52% in a single day when this news came out. And even now the share is cheap. The current share price is 70c. At 15cps earnings the company is on a PE of 4.67. A realistic PE range for Merafe is between 7.5 and 10 – which gives a fair value of between 112.5c and 150c.

Of course we’re in a bear market. And things can still get worse over the next month, two or three. But bear markets don’t last forever. And when they turn upward it’s often an explosive rise. That’s why I like these ‘down and out’ absolute value opportunities. Shares with growing profits and upside potential that everyone’s ignoring.

Because once they appear on the radar’s of the mainstream they’ll soar.

Here’s to unleashing real value


Francois Joubert
Red Hot Penny Shares Editor, RedHotPennyShares.co.za

P.S. Join me on the 27th of February for the annual Red Hot Penny Shares Bootcamp and I’ll share my favourite ‘down and out’ value opportunities with you.


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