Small Cap Value Report (2 Oct 2014) - XAR, IDEA

2nd Oct '14 by Paul Scott

49 comments 24787 reads

Good morning. Or rather bad morning for me, as I've been hit by a nasty profit warning - an occupational hazard for small caps investors I'm afraid, but still painful every time it happens.

Xaar (LON:XAR)

Share price: 262p
No. shares: 76.4m
Market Cap: £200.2m

A maker of innovative industrial inkjet print heads, Xaar is having a very bad year - this is the third profit warning from the company, and at 262p the shares are now down 77% from their peak of 1162p in Dec 2013. The problem is that it has looked good value after each profit warning, but unfortunately business appears to be spiralling down more quickly than management expected, as demonstrated by this graph of broker consensus - which will take another lurch down after today's warning.

Profit warning - the key sentences are below;

As stated in the Interim Results announcement on 28 August 2014, demand for Xaar's products from the ceramic tile market softened during the third quarter of the year as a result of a slowdown in construction activity in China. The Company's exposure to China is significant, as almost half of the world's ceramic tile output is reported as manufactured and consumed in China. Revenue into the global ceramic tile market represented around two thirds of the Group's sales in 2013.
Monitoring of the ceramic tile market in China has indicated a further decline in activity resulting in excess manufacturing capacity being idled. As a consequence, forecast orders from Xaar's OEMs in this market for the remainder of the year have further reduced, such that the Board now expects total revenue for 2014 to be 5%-10% below the bottom of the previously announced range of £115-125 million.

A 5-10% further reduction in 2014 turnover doesn't sound too bad on its own, but my concern is that an industry with excess capacity being idled is probably going to pretty much switch off capex. The market has known for a while that 2013 was a one-off good year for Xaar, with exceptionally strong demand from Chinese tile makers, so it's not the fact that business is now declining that is the issue - it's more that the downturn is far more severe than the market, or indeed the company, expected it to be.

That removes one of the key planks supporting the company's valuation - i.e. decent earnings from legacy…

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Paul Scott

2nd Oct '14

Hi Cisk,

Good points. I normally look for big Director buying (£100k or more) in small caps as a buying signal, if it confirms my other research/analysis on the company. So it can be a trigger which persuades me to push the button.

However, as you correctly state, it's doesn't always work - it certainly hasn't at Xaar (LON:XAR), where clearly the decline in Chinese demand has caught out the Directors, as they wouldn't have been buying a few months ago at much higher share prices. On reflection, and with hindsight, the chunky Director selling at XAR earlier this year was a bigger & better signal than the Director buying over the summer.

PuriCore (LON:PURI) was also a case where huge Director buying (about £700k) has not translated into share price out-performance.

It's all about skewing the odds in our favour though. So over the long term, I am sure that heavy Director buying in small caps is on balance a positive indicator.

Regards, Paul.

cyberbub

A very interesting discussion today, laying bare the emotions that many investors (including me) experience all the time... you have to be emotionally as well as intellectually strong to succeed in investing... 'cutting your losses' is not easy to do, for example, as many of us know...

I am lucky enough to be 1300% up since almost going bust in late 2008 in the big crash, but I am happy to admit that this is due to take some big risks (a few foolish ones mixed in with the rational ones), and also against a backdrop of a massive rebound in the wider markets starting in 2009. The truth is that I have not made any significant 'net' gains since 2012, which has been very frustrating - a few spectacular winners, but a series of more modest losers.

I am a bit worried that the markets are poised for a substantial downturn this autumn... but then I remember being worried about the same thing last October, and it didn't happen!

The reality is that none of us can tell the future - we need to psychologically accept the risk of loss, in order to be able to invest.

Sorry - that was probably a bit 'stream of consciousness' rather than anything useful! :-o

superrupededupe

Good luck with keeping individual holding sizes to a maximum of 2-3% of the portfolio, whilst maintaining 15-20 investments.

I know what you mean, though! Keep your chin up.

For what it is worth, I think most people could do with a more rigorous set of rules about when to invest in stocks in the first place. This might then obviate the need for more arbitrary rules governing size of position / averaging down by giving you the confidence to be patient on some of your 'losers' and hold on to some of your winners until such time as the market makes you an offer you can't refuse.

foxy1959

Hard to find a bul anywhere at present, very bullish, I expect a last quarter rally for that reason alone.

Re Xaar, I do not hold, but given the new equipment due in 2015 I wonder how many Chinese companies are merely delaying capital investment until the new machinery comes online?

Bul? Bull!

MichaelFBS

Thanks Ed. Will look forward to it. But when you say "discussion room navigation" so you mean there is a discussion room but I havent found it.

boothbym

I'm glad I haven't got into Xaar yet and they say never try to catch a falling knife, but Xaar it certainly looks like it has long term potential. The next generation of print heads P4 are supposed to be commercially viable for textile printing, books, brochures, magazines, folding cartons and flexible packaging. This potentially is massive. The question is when to get in. Probably some time in 2015 as P4 heads are supposed to appear in 2016.

One thing I have found amongst small caps to be a reasonably reliable way of making money in investing, is to look for companies that have just done a substantially discounted placing, but for a good reason, ie. to advance a reasonably credible business plan. E.g. a 25% dilution at a 40% discount say... I am not a big enough or well-connected enough fish to be invited to participate in such placings, but you can almost always guarantee that the SP will drop to the placing price, and often a little below. Wait until it reaches the placing price, check that there is a good volume going through at those prices, buy a load, and then sit back. I have found in the last 7 years of investing that you can almost exactly predict the 'steps up' as the different people who bought in the placing take their different %age profits... 10%, 25%, 50%, 100% and (if you're lucky) 200% or more. Or if you have the patience to wait for 2 years, you could have bought LGO at 0.4p in 2012 at the price of a large placing, and sold this autumn at 6p, a 15-bagger. You could have done exactly the same with REM, 0.4p placing early in 2014, buy at the same price, sell a few months later at 2p.

Sorry this is probably chickens and eggs to many posters here, but just my view. The returns from the placings tactic are not always huge, but (as long as the company is neither a blue-chip nor a hopeless AIM basket case) you can make money.

That all sounds a bit mercenary, and yes I do like to do proper analysis/research and invest in shares for the long-term and follow their progress etc. But there is almost as much risk in that approach - who knows what banana skins await even the best companies? Sometimes it's nice just to make a relatively quick profit!

Good luck to all - no advice intended of course.

DarwenLad

Last weekend I happened to be passing through Cambridge, and decided to have a look at Xaar's HQ on the Cambridge Science Park. Since it was Sunday the place was deserted but I was rather unimpressed by the Xaar buildings spread over three sites. They were just anonymous buildings with no sign - other than a poster saying Xaar was hiring staff - to indicate that this was the HQ of one of Cambridge's high-tech companies. Realise that flashy HQ's can be just as misleading as rather scruffy anonymous office blocks, but I was left with a feeling that Xaar might not be all that it is cracked up to be. The rather large size of its workforce was another worrying sign.

jonesj

Buying companies cheaply following temporary setbacks can be a great way to make money. The tricky part is to work out for sure if the setback really is temporary.
Going back a few years, one nice example was Jennings brewery in Cumbria. That was already attractively valued, then the foot and mouth outbreak knocked sales.
However, it's usually more difficult to spot such opportunities.

As for Xaar, anyone selling to China needs to be really good, otherwise their product just gets copied & market share is lost.

Ramridge

Hi cyberbub - interesting strategy. From your experience can you give me some examples of false positives? i.e. where your expectation actually went the other way and lost money?

Ramridge I would say that companies like BHR failed this model. I had been tempted to buy in there a couple of years ago, but luckily didn't... It is one of the basket cases that I mentioned! I could come up with some other ones but have just been for a few jars at the pub so am struggling slightly!

The trick is to spot the companies that are small, lack bargaining power so are forced to have a heavy discount in their placing, but actually have a decent business (or assets that are expected to develop into a good business). The way you confirm this is that when the SP falls to the placing level, monitor it for a few days or a week or two. If the placing is at 0.4p say, and you see lot of buys going through at 0.43 say, followed by regular block sells at 0.42, what this means is that a good chunk of the placing holders are selling out for a 5% profit (=0.42p) and the MMs are making their turn by selling them on at 0.43p. If you can detect this pattern then you can be confident buying very large amounts at 0.43p, (a) because you know there are large sellers willing to take 0.42p, and (b) once the 5% sellers are exhausted, you will move up to the 10% sellers, who will take 0.44p to sell... once they are exhausted it will move up to the 25% sellers at 0.5p... and so on. If the placing was done when the SP was at say 0.6p, ie. a 33% discount, you will have a decent chance of getting back to 0.6p, ie. the 50% profit level from 0.4p, at which point you can sell out... or put in a trailing stop-loss or whatever.

I did this on LGO twice. The first in early 2012 when there was a large placing at 0.4p, and I sat and waited until it took off from that level and then averaged down heavily to 0.9p (having bought as high as 3p... sigh...). Within a couple of months the SP was hitting 2p... sadly I made a botch of selling out, but the argument is sound... In 2013 there was another placing at 0.4p, I bought a load at 0.45p when I realised that the placing was being heavily bought up... sold at 1.2p a few weeks later.

As I said above, exactly the same pattern could be observed on REM in 2014 after a large placing at 0.4p... it took about 3 months for the bulk of the placing holders to sell out for their 5-10% profit, but as soon as that had happened, then (supported by positive news flow!) the SP made a massive run for 2p...

Again recently, I bought a load of SAV around 4p, the recent price of a placing with a bucket shop...I was confident because holdings RNSes indicated that the bucket shop's holding was being reduced down towards zero... as soon as they had stopped selling, the SP broke the 50% profit level (6p) fairly sharpish... I am still holding because I expect it will run for the 100% level (8p) on a stream of good news in the next few weeks. I might (or might not) sell out there.

Some people swear by charting and 20-50-200 MA lines etc etc. That can be useful, but I think there is also a lot to be said about analysing simple human-nature behaviour to understand what is happening, and using 'round numbers' in terms of percentage gains. Many, many large investors or low-quality instis take part in a placing and have absolutely no interest in the company, and will sell automatically at a 5% profit... after all, if you can do this reliably several times a year, why not??

The key is to spot those companies for which a heavily discounted placing is just a bump in the road, and distinguish them from the companies for whom the placing is a desperate last-ditch way of keeping them going... not always easy, but then investing never is!

Good luck all - no advice intended.

valueinvestorshouse

what a day! this was a real bummer today for Xaar's price. I have seen voices above where people just called a day and said they can't value this stock any more.

well, I tried and - playing very conservative assumptions I am getting at the rock bottom of £120m market cap and another quite conservative version of £170m so not far from where the stock is today. This is not by the way an attempt at guessing a share price movement as this is going to be a totally different story - but I was wondering at what conservative levels one would see the value in the stock.

you can see the basis of my estimates here: http://www.valueinvestorshouse.com/is-xaar-an-obvious-steal-now/

cig

Are there more recent studies of this effect's current size and exploitability? My expectation would be that in pure form it's probably smaller than (or close to) trading costs, as often happens with well known short(ish) term effects.

Personally I usually stay put, or sometimes top up if I'm within single-idea commitment limits, if I still believe the business has good 3 to 5 years prospects.

iwright7

3rd Oct '14

If Xaar are correct that the China tile industry demand is soft because of reduced China construction then more tiles will be available, which means lower tile prices. A increased margin opportunity for the UK tile retailers such as Topps Tiles Topps Tiles (LON:TPT) to make hay maybe? Stockopedia shows TPT Y1 +44% EPS and Y2 +22% EPS growth on a low PER which for me is a much more attarctive proposition than trying to judge the Xaar bottom.

Ian

Ramridge, another recent one was FLOW, where I still have a large holding. They did a large placing at 16p last year, the SP trickled back down the that price, then made a run northwards - you can see the pullback at the 100% level at 30p on the chart - though it continued onwards.

Or IKA, there was a large placing at 60p this year, the SP stayed in the 60-70p range while the short-termers sold out (I bought at 65p), and then it has run towards the 100% level, peaking in the last few days at 118p intraday... I am keeping a close eye and will see if it starts falling back or carries on...

DYOR

Hi cyberbub - well you got me sufficiently interested to spend some time carrying out back testing. I guess I will have to go back two or more years to have a decent statistically significant population to start with. The tests will be in two parts, one blind and the other simple decision tree whether to invest or not. I will let you know how I get on.
Best.

Hi Ed,

I've been giving your post some more thought overnight, and I think it is worth emphasising that the data you presented is only covering 90 days - so it's a trader's strategy to sell on profit warnings, not an investors strategy. Providing you can time your re-entry point well, then this strategy would probably work most of the time.

I wonder do you have the same data, but extended out over (say) a year - because I bet the correlation would reverse, at least somewhat - which is probably why it was clipped at 90 days by the original analyst who created that data.

However, another proven strategy is to do exactly the opposite of this - i.e. to buy beaten down stocks - isn't it called "dogs of the Dow"? Where the stocks which have fallen the most in one year (so they will almost certainly have had profit warnings) statistically out-perform the general market in the following year.

If I could afford my own team of researchers, analysis of profit warnings (for small caps) would be my number 1 priority to research - i.e. to work out the statistical probabilities for when it's best to sell, and when best to hold or buy more. The trouble is every situation is unique, so there isn't a rule that will give the correct answer in every case.

I think the key thing with every profit warning is to work out whether the factors giving rise to disappointing profits are relatively minor, temporary factors which can be readily recovered from (in which case I would not sell, indeed would buy aggressively if the stock fell a lot). Or alternatively, if the profit warning is down to more serious, structural problems with products or markets, then it would be time to sell immediately.

In the case of Xaar (LON:XAR) I originally thought the first & second profit warning were temporary softness in a key market. However, profit warning 3 made it abundantly clear that things were going more seriously wrong, and it was the announcement of 20% reduction in staff which really reinforced that point. You only make deep cuts to your workforce if demand is seriously tailing off & is not likely to recover any time soon.

Fascinating topic that we should bounce around more.

Regards, Paul.

Cheers Ramridge. Another example is QFI, I bought at 5p in 2012 (still holding a fair few). 6 months later the SP was at 10p and the company announced a placing at 7p. The SP immediately declined but because Mr Market knew that it was only a bump in the road, it only fell to 7.5p intraday before reversing. You can clearly see the 100% resistance where placing holders sold out at 15p or so.

I forgot to mention last night the 200% resistance level on FLOW this week at around 44p.

I wish I could remember all the others I have observed this on... I would be interested to see your analysis in due course. Cyberbub at gmail com. Thanks!

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Small Cap Value Report (2 Oct 2014) - XAR, IDEA

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Paul Scott

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