Here’s a controversial take: to score the really big wins on the share market, you should disregard much of the so-called fundamentals.
Not that key financial metrics are unimportant. Things such as sales, cash flows and the structure of the balance sheet provide invaluable insights into the nature of a business — and if they reveal an entity that is viable, growing and well capitalised the risks of permanent loss of capital is substantially (but not entirely) mitigated.
But these numbers are all backwards looking; they tell you what has already happened. For well-established, competitive advantaged businesses in stable or growing industries, it’s not entirely unreasonable to simply extrapolate the financials forward. But for a lot of companies — especially those at an earlier stage of development — such an approach will likely lead you astray.
Consider some of the bigger winners on Strawman in recent times.
In the last year Droneshield (ASX:DRO) has seen shares go from 26c to $1.94. That’s a gain of over 640%. But at this time last year, the most recent audited results showed a company that:
- Had a net loss of almost $1 million
- Negative free cash flow of $2.5 million
- Flat YoY operating cash receipts
- Had only $10 million in funding
- Was trading at more than 7x sales
This is, admittedly, a selective view of what was happening back then, but the point is that few investors would have seen a near 8-fold gain in the coming year as likely.
You can make a similar point with Catapult (ASX:CAT), whose shares have doubled over the last 12 months, or Botanix (ASX:BOT) which saw a 200% jump. Both were, and are still, loss making companies whose market multiples were well beyond historic norms in mid-2023.
Sure, sometimes — maybe even oftentimes — the reason for such gains is merely unfounded speculative hype. And, given that, they tend to reverse those gains in rather short order. But not always.
Some companies go on to ‘back-fill’ their lofty market prices by delivering well against lofty expectations. And sometimes beyond even what the most ambitious of investors imagine. For these monsters, shares almost always seem expensive, but then look anything but in hindsight.
So if you’re hoping to identify value it’s essential to look forward rather than backward.
As with all things investing, there’s no set formula to identify stocks that are on the cusp of significant earnings growth. But here are some things beyond the published financials that are worth considering.
Disruptors
Every now and then, a new way of solving a problem emerges. One that is significantly better than the established norm.
Disruptors are rare, and very difficult to spot in their early stages, but if you see a company winning share and building momentum in a large market dominated by lazy incumbents, you don’t want to get too finicky over market valuations.
Regulatory Milestones
Clearing important regulatory hurdles can pave the way for significant growth. This is especially true for sectors like pharmaceuticals.
Of course, plenty of promising candidates tend to clear all the early steps only to falter at the end, but each successful clearance brings the promise of cash flows closer. A good knowledge of the industry is a big edge here.
Strategic Relationships
Small scale trials often precede bigger, more lucrative contracts. Even being considered by a large and cashed-up counterparty is something of a win for an obscure ASX small cap.
While it’s true that plenty of stocks enjoy temporary pumps on over-hyped contracts with big players, some ultimately prove to be the foot in the door that leads to much bigger success.
Heavy investment
Companies investing heavily in research, assets and resourcing can see their earnings dampened in the near term. But growth CAPEX is usually an unavoidable precursor to accelerated growth. More simply, you have to spend money to make money.
If a company is coming towards the end of an aggressive investment program, it could signal something of a coiled spring in terms of revenues and cash flows.
New Team
Sometimes a company can fall short of its potential if it isn’t led by the right team — and there’s no shortage of mediocrity among the c-suites of listed companies.
A new leader with demonstrated form for effective management and smart capital allocation can mark the turning point in a company’s fortunes.
Mergers & Acquisitions
Statistically, most acquisitions don’t add any lasting value for shareholders. But there are some very notable exceptions — the success of ProMedicus (ASX:PME), for example, is entirely the result of its acquisition of Visage all those years ago.
Here you won’t tend to get much insight by looking at pro-forma earnings etc, but if the acquired business provides assets that can enhance and leverage existing strengths, it could be the start of something special.
Operating leverage
Lots of companies like to talk-up their potential for accelerated earnings growth as revenues grow against relatively flat fixed costs. For the most part, this doesn’t always work out to plan — but when it does the bottom-line growth can be extremely unintuitive.
A keen understanding of the unit economics and supporting infrastructure can help you spot the explosion in earnings before they become self-evident in the reported numbers.
Final thought
Could and will are two very different things. And no company is going to give you anything other than the most optimistic outlook.
But if you wait for the proof in the pudding, you’ll likely miss out on much of the upside. That being said, if you presume every moonshot will land you’ll quickly bankrupt yourself.
As Buffett once said, ‘In the business world, the rearview mirror is always clearer than the windshield.‘ But it’s those with an eye to the future that are best placed to score the bigger gains.
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