The Hottest Shares To Start Your PowA! Portfolio

Red Hot Penny Shares

How To Make Big Money In

The Exciting World Of

Penny Shares

By Francois Joubert

Chief Investment strategist,

Red Hot Penny Shares

© Copyright 2012 by Fleet Street Publications (Pty) Ltd. All rights reserved. No part of this book may be reproduced by any means or for any reason without the express written consent of the publisher.Fleet Street Publications (Pty) Ltd. Private Bag X16, Northriding 2162. Registered in South Africa No: 1999/019170/07. VAT Reg No: 4430185282

ISBN No. 1 899964 69 X

Contents

Introduction 1Filter out the losers 6Part I: The non-financials 8Part II: The financials 14Valuation: The final filter 22Special situations 27Stop losses, profit taking and top slicing 30Conclusion 33Quips, quotes, tips and clips 36

© Copyright 2012 Fleet Street Publications (Pty) Ltd.

Publisher: Annabel Koffman. Designer: Jeremy Miles. For subscription queries call 0861 114365 and for editorial queries please fax us on 0861 114 716 or e-mail us at rhps@fsp.co.za.We may monitor and record calls to maintain and improve our service.

We do try to research all our recommendations and articles thoroughly, but we disclaim allliability for any inaccuracies or omissions found in this publication. For the purposes of thispublication a “penny share” is a share in a company under R10. Prices quoted at time of

going to print. Shares are, by their nature, speculative and can be volatile. Generally,investments in small companies have a higher risk factor so you should never invest morethan you can safely afford, as you may not get back the full amount invested. The differencebetween the buying and selling price of small company shares can be significant. The past isnot necessarily a guide to future performance. Before investing, readers should seek profes-sional advice from a stockbroker or independent financial adviser authorised by the FinancialServices Authority. Profits from share dealing may be subject to taxation. Levels and basesof, and reliefs from, taxation are subject to change. Registered in SA No: 1999/019170/07,Vat No: 4430185282

FSP Invest

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Introduction

Any fool can make some money buying shares but, by following a few simple rules and taking advice from the right quarters, you can make SERIOUS amounts of money. I’d like to start by sharing two ways that you can use your money.

Model one works like this: You work for money, give it to the man in the shop and get some goods. Now you have goods and no money, so you go to the bank, you get credit and borrow money. Now you give the bank’s money to the man in the shop and purchase yet more goods. You have more goods, less than no money and the stress that goes with it all. If your finances follow this model, you never gain control of your financial situation and will end up being a perpetual slave to debt and your bank manager. Not a pretty picture is it? Yet, this is exactly where most people end up.

In the second model, you work for money and give the bare necessity to the man in the shop. You take as much money as you can and you put it to work for you as early on in your life as possible. Now you’re working for money but more importantly you have money working for you! If you’ve chosen well and use the power of compounding, it won’t be long before the money you have working for you, actually overtakes the money you work for.

I’m not suggesting the money you set aside to work for you should be put in the bank or other low yielding investments though. The growth is just too low there. You need to put your money to work for you in more adventurous places – like the stock market. Yes, it’s more risky, but there’s a direct relationship between risk and reward. No risk… No reward! There’s no better place than the stock market to set you on the way to financial independence…

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Our philosophy at Red Hot Penny Shares, however, is to supercharge the gains you make by taking the front seat and no longer remaining a spectator. There are so many advantages you, the private investor, has over institutional fund managers (the so-called “professionals”). You just need to find out how to use your ‘edge’!

We’ll focus on shares valued at less than R10. These are generally known as penny shares, with the original term referring to shares under $1 or £1. This is where the best advantage lies for you as a “guerrilla investor” in the high-flying world of corporate intrigue and finance.

Your advantage over the “professional”

1. Concentrate your firepower! Your biggest asset is you can concentrate your firepower on the handful of shares that you expect to deliver the greatest returns. A fund manager would like to do this, but is forced to invest in a multitude of complex financial instruments, like derivatives, and in a host of conglomerates that have dozens of listed subsidiaries (some offshore). The reason is, if he were to put all his cash into just a few shares, he might well end up owning them entirely. In other words, he’s forced to invest in companies in which he only has limited faith. This argument, that a concentrated portfolio is actually less risky than a massive one, has been expounded and put into practice over many years by the greatest living investor, Warren Buffett.

2. You’re faster than any big investor can ever be! Your second-biggest advantage is speed. A fund manager controls billions of rands and so – especially when dealing in relatively illiquid smaller company shares – it’s extremely difficult for him to buy or sell enough shares to make a significant difference to the shape and balance of his portfolio. Remember, a portfolio manager’s remuneration is largely dependent on the increasing value of his portfolio.

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For the private individual, selling or buying a holding that may be significant to you, but is almost insignificant to the wider market, should present no such problems. You, and I, can move in or out of a position almost immediately with no problems. That means you can invest in shares fund managers have to overlook because they’re too slow and clunky.

Why are penny shares great for the private investor?

Why should I invest in shares in smaller companies, those (for the purposes of Red Hot Penny Shares) with a market share price of less than R10 a share?

1. Small companies provide rapid growth. Academic evidence is that smaller, younger and more entrepreneurial companies are expected to deliver rapid profits and this will inevitably, over the long run, come to be reflected in the performance of their shares. The most authoritative academic research on this subject comes from the London Business School which showed that – except in the depths of recession – the universe of smaller companies outperform their larger counterparts every year.

Instinctively, many of us who’ve worked for large bureaucratic organisations will agree that smaller companies are better focused, more efficient and organised than their larger counterparts, where decision-making seems to take an eternity and where length of service often counts for more than current performance.

2. Professionals overlook small companies. “Professional” analysts in the broking community often overlook smaller companies as these don’t generate sufficient brokerage. That’s because they usually don’t trade in large enough amounts of money for the broker to really pocket big brokerage.

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Trading in these small shares may be minimal until the company makes a formal stock market announcement when, belatedly, investors pile in, causing the shares to soar in value. Even when a formal results announcement is made, the market may not always realise its full impact, so there’s often time to buy the share after its initial re-rating and still make significant gains.

That isn’t to say that making money from penny shares is easy because, commensurate with higher rewards, the penny share sector also comes with higher risks. It’s the aim of the system of share selection methodology outlined in this booklet and for Red Hot Penny Shares to steer you away from those risks. Never forget there are risks.

Potential problems with penny shares

1. The principal danger (as well as the main attraction) is the potential gearing of penny shares to just one event. For instance, if Group Five wins or loses the next big building contract it could make a difference of, say, 5% to its share price. For a smaller construction company operating in the same space, just as the potential upside of one big contract win is enormous, the potential downside from a big contract loss could be devastating. Careless share selection, when choosing between JSE Top 40 companies, is unlikely to lose (or make) you significant amounts of money in relatively few weeks.

The same isn’t always true for penny shares.

2. The second potential problem with penny shares is one of marketability, which itself adds to the risk of this game. Not only can the difference between the buying and selling prices (the spread) be large in percentage terms, but if there’s also little trading in the shares, the price can move sharply on even the smallest trades. This is particularly true for some of the more illiquid shares.

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At Red Hot Penny Shares, we believe you should build up a portfolio of between eight and ten companies that mirror your own risk reward profile. If you feel you wish to invest in another company outside your existing portfolio, you should perhaps consider realising your gains on one of your current investments as excessive diversification carries its own risks. You should always consider banking substantial gains, because every growth share will, one day, mature to a stage where its rate of growth will start to decline. A successful penny share investor can have no room for sentimental attachments to a particular share, even if it’s served him exceptionally well in the past. Don’t marry a share.

Following my PowA! strategy for spotting great growth opportunities is a good start on the journey to making big gains from smaller company shares. Our monthly publication should assist you on your travels since it contains research and analysis, available nowhere else, as well as the distilled insights, views and suggestions of hundreds of contacts from the markets, industry, political connections and business dealings.

Remember, not every penny share will be a winner. There are literally hundreds of shares out there that offer the potential for making great gains. By using Red Hot Penny Shares’ proven PowA! strategy, you can dramatically increase your chances of picking ‘a blue chip of tomorrow’ and start creating your own life long wealth building portfolio!

Here’s to unleashing real value!

Francois JoubertChief Investment Strategist, Red Hot Penny Shares

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Filter Out The Losers

There are over 200 penny shares quoted on the Johannesburg Securities Exchange, in which you could invest in. Each week I look at the universe of small caps on our market to find ones with the biggest potential.

It may sound perverse, but the way to spot the winners from a given universe of shares is by eliminating all the obvious losers. That’s Warren Buffett’s strategy: He’ll always look at the downside of any prospective investment and, if it looks too risky, he’ll walk away, however tempting the upside. As he puts it: “Rule number one of investment is not to lose money. Rule number two is to remember rule number one”.

My Red Hot Penny Shares PowA! strategy filters shares using four main criteria which I’ve identified as the most important factors that have to be present for a company’s shares to soar. The PowA! strategy uses the exact same principles and techniques as the strategy used by the likes of Warren Buffett but with my own South African twist.

I won’t bore you with the technical details of my decision making process like PE ratios and so on but I still want you to get a basic idea of the power of my share picking system.

My PowA! strategy has four basic tenets, namely Profit, Open communication, the ‘Wow’ factor and Assets. Let’s look at them in more detail…

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Powerful Profits! When I evaluate companies I want to be sure that they’re making money. Not just showing profits on paper. So firstly I want to see money enter the business as cold, hard cash which will turn into money in your pockets!

Openness and honesty! I always ensure the communication channels to us - the shareholders, are clean. That way I always know what I’m buying into and can make an informed decision about the share I’m tipping.

Wow factor! I only tip shares that ‘wow’ me. There’s always a reason why a share’s price skyrockets. I need to know why it’ll make more money tomorrow than it’s making today. I only look for shares that are on the verge of something big! As the market discovers their true value you and I will be banking huge gains! That’s the power of the ‘wow’ factor.

Ambition backed by assets! A company that doesn’t have the money to back its ambitions doesn’t mean much to me. That’s why I look for companies with strength in the balance sheets. I like companies that have high asset values. Especially when compared to their price. That way you get value for money, instead of buying a cash consuming laggard.

If you considered what this strategy is built on, you can actually split it into two separate aspects. Firstly, there’s the non-financial metrics. That would be my Openness and honesty criteria and the Wow Factor! Then you can look at the financial aspects of companies, which would include my Powerful Profits and Ambition backed by Assets criteria. Here you can find a short explanation of everything I look for.

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Part I: The non-financials

“Despite my appreciation of structural models in forecasting, I do not believe in mechanical model-based forecasting, estimating the model and letting it make the forecast without intervention of the forecaster.” - Laurence Meyer, Member of the Board of the US Federal Reserve, 1998

1. Management is crucial

Firstly, it must be committed in a financial sense to growing the business and so rewarding shareholders, rather than rewarding itself.

It’s always heartening to see the board has a significant stake of, say,

more than 5% in any smaller company as this gives it real incentive to drive the share price forward. On the other hand, too great a stake and there’s a danger the firm may be run as a comfortable “family” firm, not one with an ethos of maximising earnings growth. There’s often also the potential that the directors listed the company to maximise their personal wealth (push the share price up), before selling the company to the highest bidder.

It’s equally disheartening to see senior managers whose pay levels and annual remuneration increases bear little relationship to the company’s record of adding value for shareholders. Always check a company’s senior managers are demonstrating real financial commitment to the company,

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rather than to themselves, by taking home pay commensurate to the size of the business and pay rises commensurate with its success. Notes in the annual reports about “material transactions” with other companies in which a director has an interest are often signs that managers are topping up their salaries via the back door. If this is the case, we’d rather invest elsewhere.

It’s always worth noting recent share purchases or selling by directors. If the top men are lightening their equity holdings, that can’t be seen as a vote of confidence and, perhaps, you should follow suit. The reverse is also true. There are several websites that provide free access to main shareholder structures, one of the best is www.fin24.co.za.

As important as the management’s financial interest in maximising shareholder value, is its ability to deliver that value. It seems heartless, but you should rarely give a failed chief executive a second chance – it pays to back proven winners, rather than those who’ve failed before.Ask yourself: Whatever the odds, should you risk your wealth, your portfolio of shares to someone who’s already failed?

2. Never back those who break their promises

Just as perennial losers should be shunned, so too should those vehicles that persistently fail to meet expectations. The stock market won’t tolerate “promises of profits tomorrow” forever, and a record of issuing profit warnings will inevitably see the shares de-rated, unlikely to be re-rated even if the profit warnings cease. The market adage is profit warnings usually come in threes. Sadly, it’s often in fours or fives.

The bottom line is well-managed firms in growth industries don’t issue regular profit warnings, either overtly through the stock exchange or covertly by telling brokers to cut their forecasts.

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3. Listen to what a company’s rivals are saying

Before investing in a particular company, it’s sometimes a good idea to check what rivals are saying about its current prospects. If the company you’re thinking of backing seems to be singing from a completely different hymn sheet than its competitors, it shouldn’t pass the filter test.Experience and common sense tell you that if something sounds too good to be true, it probably is.

4. Let the trend be your friend

It’s usually better to invest in shares that are on an upward trend than ones that are on the reverse, a sensible investor should let the trend be his friend. A share may look cheap, but if its price is on a persistent downward path, it often means someone, somewhere, knows something bad. If you were aware of similar information, chances are you wouldn’t think the share was still cheap.If you still think a particular share looks cheap after it’s started to fall, wait until it stops falling and has, instead, risen for a couple of days before buying. If you buy falling shares in the hope that “surely they can’t go any lower” or if you buy shares that fail the normal Red Hot Penny Shares’ filters just because they “look cheap”, you’ll quite possibly get badly burnt. This is the stock market equivalent of the old adage: “Never catch a falling knife.” In the investment world, this is very useful to remember.

You should also never chase a price up. If Red Hot Penny Shares selects a share at 200c, it’s because we believe you can reasonably expect to make a 50% return on your purchase within 12 months and, possibly, considerably more.

However, traders have large research departments, with analysts who monitor all share recommendations (especially those made by someone with a record of success) very carefully.

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They’ll respond to these tips by aggressively buying these shares and pushing the price up. So if, by the time you come to buy, the shares are already trading at 250c, any subsequent purchase will already have missed most, if not all, of the upside. But if you and other sensible investors hold off from buying immediately, the share price will often retrace slightly and offer a better buying opportunity.

So, it often pays to be patient and wait a few days or weeks before you make your purchase.

5. Avoid companies that change advisors or directors frequently

To lose one non-executive director or one key advisor is acceptable. To lose two is careless. But, to lose more is terrifying.

An unexplained resignation by a non-executive director, or change of sponsoring stockbroker or merchant bank, is always worth investigating. When these supposedly impartial directors or advisors, whose role is to protect shareholders’ interests, quit without explanation, we start to become concerned.

Unless both the company and the departing non-exec or advisor can give a cogent and plausible reason for the parting of ways, the company doesn’t merit your financial support.When there’s a series of boardroom resignations or a repeated changing of advisors or brokers you should become extremely concerned. At best, it may suggest the company’s senior management find it hard to maintain decent business relationships. At worst, it suggests rather more serious problems.

Either way, the company involved isn’t one in which you should invest.

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6. Listen closely – what is said is often not what is meant

Reading between the lines isn’t always easy, but sometimes it pays to take notice of hints that all may not be well. This involves being a psychologist to some degree, but often the small nagging voice deep down inside indicates danger.

7. The mission statement

A mission statement is necessary for a company to give focus to its strategy. Essentially, a statement enables business to bring people together with a focused, common ideology and direction. In addition, the company can make sure the whole strategic planning process is integrated throughout the entire group.

However, if the mission statement is too broad, it results in ‘blue sky’ type planning, which should be restricted to boardroom brainstorming sessions. A statement that’s too narrow results in channel vision and foregone opportunities. This implies a brief look at a company’s statement should give the investor an understanding of the general direction the firm should be taking. If not, why should you invest in a company that can’t even keep to its own agenda?

8. Market and industry characteristics

Another non-mathematical method of determining whether a company has a suitable strategy is an investigation of the opportunities and threats it faces with regard to the environmental factors within which it operates; including, politics, economics, finance, global threats and opportunities, technology, social change and labour issues.

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The dilemma strategists face is what factors to include and exclude when setting up key criteria for decision-making. One approach is to identify key characteristics of the environment arising out of product life cycle and other major factors that affect business.

Some key filters include characteristics of the market, competitors, market fragmentation, entrepreneurial flair of management and possible synergies arising out of a takeover, acquisition, merger, etc. Stated differently, a company, market or share is considered attractive if its potential for providing a significant contribution to objectives (mission statement) can be met (i.e. earnings growth, cash flow, return on investment or assets, dividend income or capital growth).

Conclusion

So, even before analysing the financial statements of a company, by referring to its last published annual report and any formal stock exchange announcements made in the past couple of years, someone using the Red Hot Penny Shares’ filter system should be able to eliminate at least half, if not more, of the 400 smaller company shares on offer as unsuitable for his or her portfolio.

Remember: Unless a company’s managers have a record of success, and show financial commitment and confidence in the business; unless those managers have a record of meeting expectations, and there’s a record of boardroom continuity and of stable relationships with their advisors; unless the company makes promises that appear realistic in relation to those of its rivals; and unless the share price is, at worst, stable, then the company has failed the Red Hot Penny Shares’ non-financial filters.

As such, it doesn’t merit a place in your investment portfolio.

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Part II: The financials

The non-financial filters will probably have weeded out at least 50% of the companies that financial and other contacts suggest we investigate every week, and so it’s only at this stage that the company’s annual report truly comes into its own. You can use these statements to gauge the financial health and prospects of the business. As before, there are a number of filters that should be enough to eliminate all but a few potential candidates for investment.

It might be surprising, but it’s always worth starting corporate detective work at the back, rather than the front, of a company’s annual report. At the beginning, there should be a statement from both the chairman and CEO outlining the events of the past year and putting as positive a spin as possible on the company’s prospects. Reading between the lines of this statement can unearth a few concerns, but the first third of an annual report normally contains nothing more than a restatement of a handful of corporate clichés and a collection of glossy photos of fat-cat executives. In other words, the content is unlikely to be either particularly useful or especially aesthetically pleasing.

In the middle of an annual report are the income statement, balance sheet and cash flow statement. More about these later.

However, it’s the final section, the notes to the accounts, that’s often most illuminating since it contains details of the accounting policies used in the preparation of the annual report; details of litigation the company might face in future; directors’ remuneration; share option packages and other such nuggets. In other words, the notes to the accounts are crucial.

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1. Don’t be obsessed by litigation, but don’t ignore it either

Nearly all companies, especially those doing business in litigation-obsessed places such as the USA, will find themselves involved in a legal case sooner or later. So, just because the company admits it’s being sued in its report and accounts it isn’t necessarily a reason not to invest in it. However, smaller companies can be seriously damaged by just one large and costly legal case, so be careful.

Normally, the directors will give their view on any outstanding litigation claiming, hopefully, that it isn’t “significant” in the context of their overall business or is, in their opinion, “unlikely to succeed”. Since the successful penny share investor is, like Warren Buffett, prudent, unless both of the above caveats are contained with reference to outstanding legal matters, it’s probably safer to walk away.

Equally, if you subsequently discover a company has “neglected” to mention its potential legal liabilities in a public document, it raises such serious concerns about the trustworthiness of its directors you should always walk away.

2. Are the company’s accounting policies both reasonable and normal?

In the notes section of an annual report, the company must explain how it treats accounting issues, such as depreciation of assets, capitalisation of interest payments, and research and development spending. Such matters are crucial as these affect headline profits. You’ll also find a schedule of values for its underlying assets in the notes section – more about these values later.

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Depreciation refers to the amount set against stated profits to cover the reduction in value of fixed assets over time, effectively wear-and-tear. Capitalisation of interest refers to the accounting practice where certain interest costs aren’t written off against profits, but are added to the balance sheet as an asset and depreciated in subsequent years.

The effect on stated profits can be significant. For instance, if a company writes down the value of a piece of machinery over 20 years, whereas its rivals write it off over ten years, the first company would (because it had a lower annual depreciation charge over the first decade) report higher profits than its competitor.

Similarly, by capitalising an unusually high amount of interest costs in a particular year, a company can flatter its profits artificially even if, in subsequent years, its profits will be reduced because it has a greater asset base to depreciate.

Some companies also choose to capitalise research spending rather than writing it off against profits. They claim this is because such spending will have the long-term effect of growing their business. But the most obvious effect of such a policy is to flatter both the income statement (by “reducing” costs) and the balance sheet (by “increasing” net, albeit intangible, assets).

Capitalisation of interest, for instance, isn’t per se a necessary cause for concern. For instance, when building a nursing home, the interest bill prior to opening is a cost, just like labour or bricks, necessary to create the completed final asset. Since the value of that asset is effectively its replacement cost, capitalising interest is probably not unfair.

However, it may become a concern if the policy adopted is noticeably different from that of the company’s competitors. Certain nursing home operators, for instance, used to capitalise interest

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costs until the homes they had built were three quarters full. The mere fact those operators were adopting policies that flattered their profits, while their peers refused to adopt these policies, should have been a cause for concern for potential investors.

Occasionally it isn’t even necessary to check out the policies adopted by rivals. Gut instinct will do! If, for instance, a company says it depreciates its car fleet over more than five years it’s blindingly obvious that, since those cars will need to be replaced before the half-decade is out, the sole purpose of adopting such an unrealistic policy is to flatter profits and earnings per share.

The point about aggressive accounting policies is while they may flatter earnings for a certain time; they do nothing to change the underlying trading position of the company concerned. When an economy’s on the verge of entering a recession, or at least an economic slowdown, it becomes more difficult for the aggressive accounting firms to paper over the cracks and the problems will inevitably start showing up.

3. Is the company really growing and adding value for shareholders?

Moving from the back of the accounts to the middle, one should start with the income statement, which should show the company’s turnover (revenue in the case of finance houses, banks and private equity firms), operating profit before interest and tax, interest paid or received, tax paid, net taxed profits, extraordinary costs, attributable profit and dividends.

These figures are stated for both the current year and the previous year. In the case of a holding company (i.e. a company with subsidiaries), there will be a second set of figures, one for “company” and one for “group”. The group figures are used to assess the whole organisation,

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while the figures for “company” will show you whether the holding company is a trading one, or simply a means to maintain a strategic overview of the whole organisation.

Remember to use one set of figures constantly, or you could end up double counting profits or debt and get a distorted picture of the group’s financial performance.

The income statement isn’t a snapshot picture of the company’s position at the year-end, but a record of its achievements over the previous trading period.

The key test for Red Hot Penny Shares and other potential investors is whether the company appears to be growing in a sustainable manner and in a way that creates extra value for its shareholders. We’d hope to see it had achieved steady turnover growth without having to sacrifice its operating margins – in other words the company wasn’t cutting prices merely to shift stock. The operating margin is calculated by dividing turnover (as a percentage) by operating profit before interest and tax.

More importantly, Red Hot Penny Shares will normally only research shares of those companies with a consistent record for generating steady growth in earnings per share (EPS). Earnings per share is the net profit of a company after paying all costs, including interest and tax, divided by the number of shares in issue, and is a far more useful indicator of growth than pre-tax profits. In South Africa, accounting firms have added what is today referred to as headline earnings per share (HEPS), and is the attributable profits before extraordinary costs divided by the number of shares in issue.

The reason for this calculation is, if a company sells an asset (an extraordinary profit), it could positively distort EPS for that year. HEPS excludes that profit. Of course, if the extraordinary item

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was a loss, the opposite would be true. HEPS is the sustainable growth in a company’s earnings, excluding extraordinary profits or losses.

In addition, many companies can grow headline profits by issuing new shares in order to acquire assets or indeed other companies, but add nothing for shareholders in doing so. For instance, if Company A acquires Company B by issuing fresh equity in a deal that increases its number of shares in issue by 10% and the deal increases pre-tax profits by only 5%, the transaction will look good at the pre-tax level but won’t enhance EPS. It will, in fact, have a dilution effect on earnings.

Unless a company has a consistent record of growing sales without compromising margins and of adding to HEPS, it fails this particular Red Hot Penny Shares’ filter.

4. Cash is king

Newspaper share tipsters and professional investment analysts seem to be extremely obsessed by a company’s HEPS growth. While important, it should never be-the-be-all and end all of industrial analysis, because no business can survive without cash.

You should, therefore, always be extremely nervous if a company’s failing to generate cash at an operational level, something that’ll be apparent if you read the cash flow statement in its annual report. In the long run, companies must generate cash from trading, because they can’t survive forever by running down stock levels or squeezing debtors while pushing creditors for more generous terms. A well-run business in a growth market can live with high borrowings if it’s had to invest heavily, but if it’s failing to generate cash, you should be extremely nervous.

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As a general rule, if cash flow generated from operations falls well below operating profits, then Red Hot Penny Shares would rather stay well clear.

5. Don’t ignore the balance sheet either

The final part of the mid-section of a company report is the balance sheet, a statement of what the company owns (its assets) and owes (its liabilities) at the period end. As such, the balance sheet can be slightly misleading.

For instance, at the end of December, a typical retailer should have lower borrowings and more cash than at the end of November, because it’s just completed its busiest trading period of the year. In the period before the Christmas season, most retailers would have high borrowings to support high stock levels, but little cash. Not surprisingly, most retailers have an end-December year-end in order to make their balance sheets look as healthy as possible in the annual report.

Having said that, balance sheets can be misleading because of timing and strange accounting policies that relate to items such as capitalisation of research spending. Analysts use the balance sheet as an indication of the financial strength of a company.

The most commonly quoted balance sheet ratio is gearing, which is a company’s total debt (long- and short-term loans and bank overdrafts, but less cash) expressed as a percentage of its net assets. If a company’s gearing is high (say heading towards three figures) you might wonder whether it has the organic resources to invest in a new plant for expansion, whether it can afford to increase its dividend or, indeed, whether it has any prospects of ever repaying its debts.

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This is perhaps a little simplistic. Some companies (such as the pharmaceutical giants) actually have very few tangible assets and so can look highly geared. But since they’re highly cash generative and their interest payments are normally covered by profits many times before interest and tax (PBIT), they have real scope to invest, repay debt and still reward shareholders. In addition, a company’s annual report is usually released three months after its year end and, so, any ratio could be significantly out-dated.

Use the balance sheet as a barometer and feel free to phone the company secretary and quiz him or her on the ratios.

When an economy is expected to slow down and interest rates are expected to rise, it pays to be cautious when assessing an investment opportunity, particularly if a company’s gearing looks high in both absolute terms and relative to that of its competitors. It’s unlikely to be a prudent investment for someone keen to follow Warren Buffett’s first rule.

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Valuation: The Final Filter

Red Hot Penny Shares’ first rule of investment is a bad share that fails to pass the investment criteria is never a buy, whatever its share price.

Red Hot Penny Shares’ filter system should by now have weeded out those shares that’ll never outperform the market by enough to make them a satisfactory home for your money.Probably around 75% of South Africa’s penny shares will fail to pass the filter system, and merely by avoiding those laggards, the portfolio of a good fund manager will outperform the universe as a whole.

But, the key to making big gains is buying quality shares when their price is right!

It can’t be said often enough: There really is no such thing as a ‘trading buy, although that’s something few brokers seem to understand. Sure, you may get lucky trading in and out of fundamentally dud shares, making a quick turn here and there for a while. But dud shares with poor managers or negative cash flow will inevitably come up with a shock profit warning, unexpectedly large losses or unforeseen management upheaval.

When that happens, the enormous losses taken by the short-term trader or speculator with a position in the share will more than offset the small trading gains he’ll have made elsewhere.

Instead, I seek to focus on buying into quality growth stocks when the timing and the price is right. That doesn’t mean I expect to see massive gains overnight or even next week. It may take

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months or even over a year before the market realises a company’s full potential. When that happens, the excitement and the profits for those who become involved when we select a share will make it well worth the wait. Although Red Hot Penny Shares highlights only those shares that we expect to see make significant gains in three to 12 months, a successful investor must be prepared to be patient.

Back to valuation

Over time, there have been well-known investment gurus, here in South Africa, in the UK and in the US. Perhaps the best-known investor in Britain is Jim Slater, for whom it’s hard not to have the greatest of respect. Slater’s proven methodology is based on the principle that a share looks cheap if the prospective price earnings growth ratio (that is to say the PE ratio divided by the annual EPS growth rate (e.g. 50%) is less than a certain multiple).

The trouble with such a rigid filter is it can leave one with an exceptionally narrow universe of potential shares, unless the multiple (known as the price earnings growth or PEG Multiple*) is exceedingly generous.

Those quality shares that appear to be sitting on generous PEG multiples of well over 1.5 are worth monitoring, because – should their share prices retreat over time or they’re dragged down with the rubbish during an overall market correction – they could well come back into buying range.

However, that’s for the long-term. In the more immediate term, it’s my job at Red Hot Penny Shares to identify those shares that have passed more rigorous filter checks, which offer the

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potential for delivering significant and sustainable long-term earnings growth, and whose value isn’t yet discounted in its share price.

By using the proven filter methodology and buying only on sensible valuations, there’s no reason the winning streak should come to an end.

Assessing the true value of a company

As stated earlier, another form of valuation can be conducted by assessing the true value of a group. At the back of the annual report, you’ll find a schedule of subsidiary and associate company valuations. These can be used to re-value a company and to assess value relative to share price. If the share is trading at a price less than the re-calculated value; the market has valued the company at a discount to its underlying assets; and if higher, at a premium to underlying assets.

Once the assessment has been completed, the question is to assess the reasons for such a discount or premium. Usually, the assets are undervalued because such valuation was done years ago. Another problem is that a balance sheet is a snapshot in time, but values change constantly.Here’s how you go about re-valuing a company.

Step 1: Re-value the group’s listed assets. Take a holding company’s percentage stake in its underlying companies and calculate the value of its investment at the current share price. Repeat this for all its listed divisions and add these to get a total value.

Step 2: Re-value the group’s unlisted assets. The value of subsidiaries and associates will either be at book value or directors’ market value. A list of the holding company’s percentage

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holding in those companies is also stated here. Now, look at the values and consider if these are realistic – were they valued recently or years ago? If you believe these are realistic, use the figures. If not, take the attributable profit of these underlying assets and multiply that number by the sector price earnings (if a media company, use the Media Index and so on). This will give you a realistic value for this entity. Repeat the exercise for all underlying assets and total these up.

Step 3: Re-value the group’s net cash to debt. Take the last annual report (final or interim) and work out net cash to debt.

Step 4: Work out the total shares in issue. Add up all the shares, including ordinary shares, N shares, preference shares and debentures.

Step 5: Calculation of true net worth of a company. Add the values in step 1, 2 and 3 and divide this by the value in Step 4. The figure is the re-calculated value of the company per share. If this is higher than the share price, the share’s trading at a discount, if lower – the share is at a premium.

“When we put a company through its paces we’re like ruthless military PTIs”

In addition, I have developed my Profit Potential Indicator to measure the potential gains we can make on a share. This is set out as follows:

1. I measure the potential profits a company can make in the next year. This is the difficult part. You can use a number of ways to do this. For mining companies I like to use production

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targets and production costs to calculate future profits. Discussions with management and sometimes even an annual report can give you an indication of what a company’s profits will be in the next year.

2. I calculate the average PE for the company – Using historical data I get the average PE for the company over the last 3, 5 and ten years (if it has such a long history). This I used to see whether the company is over or under valued based on its history.

3. I calculate the average sector PE. This step is similar to the previous one, I just compare the company to its whole sector as well. This is to find out how the company compares to its sector.

4. I then use the most conservative of these two numbers for my Profit Potential Indicator. From here it’s a simple formula!

Target Price = 1 year forward earnings forecast Average PE for company

This target price gives you a reasonable indication of where a company’s share price should be in the next year. And it’s what I use to tell you what your potential profits from a tip could be.

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Special Situations

“Too many investors look for special situations – trying to identify the next ‘big thing’ – often resulting in a specific industry becoming popular. That popularity will always be temporary and, when lost, investors won’t return for many years.” – Templeton (Value Investing).

Both Jim Slater and Warren Buffett are notoriously wary of what might be termed “special situations” – those shares that fail all conventional valuation methods, especially rigid systems such as the PEG theorem. Generally, Red Hot Penny Shares would be inclined to agree that sectors, like biotechnology, e-commerce and software development, are unnecessarily risky. Why risk your hard-earned cash on what could ultimately be a gamble, when you can be fairly sure of making excellent returns from relatively low risk – and certainly low downside – investments elsewhere?

It’s a valid question. The answer is to invest only when you feel you’re in possession of specific information that gives your investment strategy an edge over the wider market. At Red Hot Penny Shares, we have excellent connections in the mining and construction worlds and in oil exploration, another sector where conventional investment criteria such as PE ratios or operating margins mean absolutely nothing.

Of course, such investments will always be subject to unusual risks. As such, selections will always be flagged as being only for speculative investors, for those seeking some real excitement, thrills with the risk of spills, for a small portion of their portfolio.

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Perhaps the most obvious example of a special situation is the shell, a company best defined as a trivial business – or, more often than not, a previously viable business that’s collapsed – which is then taken over and transformed into something more significant.

Essentially, a shell’s only assets are likely to be its stock market quotation, its shareholder list, possibly some inherited tax losses and the intangible value of a new, dynamic management team that’s been brought in to create shareholder value. By far the greatest gains come from investing in a shell during its early stages, before it becomes “just another company” and as the wider market slowly comes to realise the transformation that’s taking place.

There are, of course, various approaches to investing in shells. One could merely trawl through various directives identifying suitable target companies and wait patiently for something to happen. Perhaps a company “doctor” would be inserted by shareholders to find some deals to help create a new company.

Alternatively, a private company may wish to use the shell as a vehicle to achieve a stock market quotation. This would be engineered by a reverse takeover, the shell buying the private business in a reverse takeover. Either way, it could prove a long wait before the randomly chosen shell starts to deliver some value and excitement for you, the speculative investor.

Red Hot Penny Shares would rather use our extensive market and industry contacts to warn you of situations where a new management team with a proven track record’s already in place. Although that might have caused some uplift in the share price, it’s more than probable that the real gains will be made when the new directors start to do their first few deals. So, there will still be big profits to be made and, hopefully, you won’t have to wait too long to see them.

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Recovery shares: This term relates to companies that were once high flyers and, for various reasons, have fallen from grace. Various internal disasters are normally the reason for the share price wipe out.

BUT, don’t write off all of these companies, as many of them can offer huge rewards for the astute investor. Once the “fix it” guys have had a run through the company and put things right, wise investors get a whiff of better things to come and buy in, normally well ahead of the actual fundamental turn around in the company. These can be risky adventures but also highly rewarding. You need to make sure that the actual events that caused the fall out have been addressed. A very good way of seeing that this is the case is in the share price graph. You’ll see the big fall on the left hand side, then a “saucer” bottoming out formation and finally the new upward move.

With recovery shares, the other thing I look for is sales. Buying shares on a low price to sales ratio has been a successful investment approach. The reason, sales are customers and customers are business. It’s much easier to do something about your costs than it is to drum up new sales. You can fire half your workforce today and restore your profit margin, but if no-one wants to buy your product, then there isn’t much you can do about it.

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Stop Losses, Profit Taking and Top Slicing

In the current volatile market in which we find ourselves, it’s not unusual for investors to wake up to find that the value of a whole swathe of their shares has fallen dramatically in just one trading session. One solution to that problem is to apply a “stop loss” to all or some of your portfolio. That’s to say, you set a predetermined selling point that’s triggered if the share price falls through it and, thus, acts as a mechanical aid to selling decisions. It’s a strategy advocated very convincingly by Michael Walters, one of the few financial journalists writing today to command respect in the investment world.

Stop losses are variable and are set as a percentage of the current share price. With a share trading at 100c, for example, a typical 25% stop loss would be set at 75c (100c minus 25% of 100). As the price rises, so too does the stop loss. So, should the shares hit 120c then the stop loss would increase to 90c (120c minus 25% of 120c).

Although stop losses can rise, they never fall in any circumstances. So, in this case, if the shares fall to 92c, the stop loss remains at 90c. If they then subsequently fall by another 2c you sell immediately.

Seeing as we’ve used examples of the Warren Buffett approach, I’d like to add that he’s never used a stop loss in his life! He’s a long-term investor and is happy to ride out market downturns. So, if you’re a long-term investor and you know what you’re doing, it’s quite appropriate to use a

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much wider stop loss or none at all. I think the main point when it comes to the stop loss is you’re comfortable with your choice and it relates to your time frame for the investment.

For Red Hot Penny Shares I don’t use stop losses. There are a number of reasons for this, the most important being that the low liquidity of penny shares increases your risk of getting stopped out due to a pricing fluke. A stock can easily drop 10% in minutes due to low liquidity, and then pop back up. This is the kind of stop we want to avoid.

So what I do to safeguard us, monitor every share each day and evaluate every situation separately. If the reason I thought the share was a buy is still relevant, then I weigh up the risk vs reward. If I feel the risk is too great or that the price will not move up I’ll let you know to close the position in order to avoid further losses.

Top slicing

Red Hot Penny Shares advocates a sensible strategy of top slicing. The golden rule is to sell half your holding when a share doubles. If a particular share doubles in value and you sell half your holding, you’ll cover all of your initial cash outlay and will be guaranteed not to lose any money. If the share price doubles again, then consider selling another half.

That way, you’ll have made a guaranteed gain of 100%. Thereafter, you can just leave your shares to soar and not worry what happens next, because you’ve already banked a massive gain.

The more cautious investor might not wish to wait for a double and may wish to top slice when sitting on a gain of only 66%. Should such a strategy suit your individual risk-profile no-one can argue with you. You can’t lose money on realised gains.

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Intermittently, Red Hot Penny Shares will suggest selling out altogether, because we hear rumours of an impending change. Sometimes that may appear premature, but it would be prudent to warn you.

Summary

Your attitude to stop loss strategies, profit taking and top slicing will depend very much on your own attitude to risk and, occasionally, on your need for cash and your own personal gearing.

Red Hot Penny Shares will suggest, whenever appropriate, on cutting losses or, more usually, on banking some of your gains. You may, however, wish to pursue a more aggressive or cautious strategy than the one we outline. That’s your choice, but it would be foolish to ignore the potential offered by stop loss and top slicing theories when managing your portfolio.

The market has a life of its own, totally independent of the individual companies listed on it. This means you must know what moves the market to make a success of your investing activities.

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Conclusion

Contrary to what some pundits may have you believe, investing sensibly doesn’t mean backing just dull multinationals like Absa or Liberty Life.

After all, some have issued quite ghastly profit warnings in the past that saw their share prices virtually collapse. If you really want security, and are happy with minimal returns, leave your cash in a bank deposit account and hope for a conversion windfall.

We, at Red Hot Penny Shares, believe our members are looking for a little more excitement and much greater returns than those offered by these conglomerates.

That doesn’t mean investing in smaller company shares is like gambling. A sensible spread of investments that have passed my PowA! share selection criteria should deliver significant returns.I admit there’ll be occasional flops, because no matter how perfect any system or share may seem, it’s always vulnerable to unexpected developments. I can’t pretend all the shares I research will be big winners every single time. There will be the occasional upset.

However, I can spot companies with strong management, sound products, healthy finances that appear to be well positioned for growth. If you buy a decent selection of shares, you may not strike gold every time, but you can realistically expect to increase the value of your portfolio over time. That’s something Red Hot Penny Shares is here to help you achieve.

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The vital secret of knowing when to sell:

When the objectives for which you bought the share have been met – sell.

When a share hasn’t performed according to expectation and you’ve given it time to do so – dump it. There can be a multitude of reasons for this – just move on.

Things go wrong within the company or the big picture environment for that matter and it looks like the company’s swimming with an anchor around its neck – dump it.

Shares get overvalued. If this is the case, a new downward trend is in store and, depending on your time horizon, you might want to sell or lighten up.

One last piece of advice

Never change your long-term strategy based solely on short-term market performances. Many traders have such an ego attached to their trading skills, they can’t handle losses. Several losses in a row are devastating, which causes them to evaluate trading methods and systems based on very short-term performances.

Investors must be wary of losing confidence after a few disappointing trades. Performance should be evaluated on many trades and generally only after three years of results.

Statisticians tell us there’s no statistical reliability to a test unless you have 30 events to measure. The investor who chucks his system after four losses in a row is doomed to spend his trading career changing from one system to another.

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Once you’ve found the system that suits you best – stick to it.

Remember, as a shareholder you actually own a small share in the company and, as a result, you have every right to phone the company concerned and request information.

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Quips, Quotes, Tips and Clips

• Penny shares are great for the private investor. The companies are easy to understand and analyse.

• Remember, all of the giant monoliths on the JSE were once fledgling penny shares too.

• Knowledge is power! Know and understand the company you’re investing in. Understand its business model.

• Know at least the basics of human psychology. If you’re aware of what makes the market tick, you’ll be able to get ahead.

• Know what the market as a whole is looking at. Generally, the markets are always forward looking. The share price anticipates, and factors in, tomorrow’s fundamentals now. It’s always well worth looking at that little paragraph in the earnings report headed “prospects”.

• Focus on value or at least potential future value.

• Look for vibrant exciting companies as opposed to miserable has-beens!

• Be careful of who you listen to. Don’t take advice too quickly if it contradicts your own research or “feel” for the company. Be very wary of the opinions of those with vested

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interests. Many times you wouldn’t take advice from market professionals, institutions and brokers in particular. We can’t stress enough the importance of having a forward looking approach to company fundamentals. Let us share some examples. If we’ve seen this once, we’ve seen it a dozen times. An institution or brokerage house will have their analysts put out a report on a company that has just brought out results. They’ll say: “These results aren’t good, we recommend a sell” and the share price goes up! Well it’s all about the future. In most of these cases, the bad results are the end of the bad news and company guidance or prospects indicate better things to come and the market reacts to that now, marking the price up. Sometimes the opposite is true. A company can come out with good results and the share price falls. As we’ve said, it’s all about expectation and if the results were good but below market expectation, the shares will decline.

• Look at the big picture. The sector in which the share is listed will reflect the direction of most of the constituents of the sector. If the sector as a whole is turning down, you can be sure the shares within will go the same way. We can also look at the related sectors in the US markets, since ours will follow to some degree. Most of our penny shares are within the JSE Small-Cap and AltX sector. The US equivalent is the S&P 600. Macro national economic fundamentals are also important. For example, the retail sector benefits from a low interest rate and low inflation environment. We also need to consider the very important role of our currency. Gone are the days when the levels of the rand and international currencies play a back seat role in the market. In many cases, the rand is the main driving force of the market as a whole and rand hedge stocks in particular. When the rand is strong, rand hedge shares suffer. When the rand is weak, rand hedge shares perform well. This can have very little to do with company fundamentals, it’s simply a big picture item in the driving seat.

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• As Warren Buffett says: “Be brave when others are afraid and afraid when others are brave.” Again, this relates very much to having a forward-looking view. An example: The tragic events of September 11 2001 saw the US markets shut down for a few days. When they reopened, the markets tanked and then – while everyone was screaming in fear and terror, with blood in the streets – the markets suddenly turned and began a long strong bull market! Why? All because of a forward looking view. The fearful were selling and the brave were buying their shares.

• Don’t fall in love with your shares. Use them and lose them! Don’t be afraid to cash in when your objectives have been met. When a share goes against you, don’t be afraid to admit the mistake, ditch it and get into something better.

• Don’t overtrade. If you get in and out of shares too often, you’ll dilute your profits with brokerage expenses and give yourself extra stress.

• Be patient. Sometimes things take a fair bit of time to make substantial gains. A temporary downturn in the market is a normal thing – ride it out.

• Ideally you should have eight to ten shares in your portfolio. If you have too many, you’ll be more exposed to the overall market and, therefore, unable to beat the averages. If you have too few, your risk exposure is too great. If you want to take advantage of a new HOT share, you might consider lightening up in some of your existing holdings, so as to keep within the eight to ten range.

• Manage your portfolio. It’s always a good idea to keep a proactive eye on your holdings. Keep your stop loss in place, move it up behind the share and – when you trim your portfolio –

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don’t sell your race horses. Sell the donkeys. Unless your high flyers have reached your target, don’t sell them, let the profits run and trim out the losers.

• If you believe in one company more than another, then hold more shares in it.

• If you don’t see a good opportunity in the market, don’t trade.

• Markets are never wrong in the final analysis, so pay a lot more attention to what the market is saying than to what the madding crowd says. The bottom line is the share price and not your or our opinions of what it should or should not be.

• Don’t ever believe a share can’t go any lower or higher.

• Ban wishful thinking!

• Accept failure and losses as a learning step to victory.

• Forget a loss quickly.

• Don’t take the market to bed with you. Clear your head regularly!

• Try “paper trading” first if you’re new. When your confidence has risen, move into the market.

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• Strategy: Split your available capital into some for solid growth shares and some for speculative recovery shares.

• Strategy: Some like to re-invest 50% of profits, pocketing the rest.

• Any fool can take profits, but a wise investor knows when to take a loss.• A weak heart and volatile shares don’t mix!

• Bears are more violent beasts than bulls. In other words, the downside moves (fear) are faster than the upward (greed) moves. A bear market takes back in one month what a bull market took three months to build.

• Don’t allow failure (a loss) to discourage you.

• Don’t become complacent or over-confident and arrogant. Humility before the market is a fine trait. It gives you clear sight. Pride and arrogance blinds you. It’s far better to humble yourself before the market than have it humble you!

• If you hesitate too long in “pulling the trigger”, the target will have moved!

• Nothing new ever occurs in the markets. Human behaviour repeats itself.

• Trading against the trend is like swimming against a surging current.

• Don’t get blinded by the thrill of victory, be on your guard.

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• Successful traders isolate themselves from the opinions of the masses.

• Don’t average down on a losing share.

• The key to stock market profits is in managing your losses.

• Be flexible and ready to change when circumstances demand.

• Trading success takes time, but is ultimately well worth it.

• Expect to succeed, don’t give up, endure, set high goals.

• It’ll cost you plenty if you think a share’s great and the market doesn’t.

• How well you do will be related to how much time and effort you put in.

• Knowledge pays the best dividends. Know yourself and know your shares.

• Pessimists always lose.

• Relax, it’s only money!

• If an involvement in the stock market raises your blood pressure, rather go and play golf.

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• Aim at financial independence. People who just work for money never get above their needs, but if your money is working for you also, you have a far greater chance of getting to that place of independence.

All the very best with your adventure into this wild and wonderful world!

Here’s to unleashing real value!

Francois JoubertChief Investment Strategist, Red Hot Penny Shares

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Interested in expanding your financial know-how?

Why not take a look at the following resources:

Fear Greed and the Stock Market. Discover the “must-know” secrets to successful investing, and answer all your questions about the stock market.

How to Make Money from Gold. You’ll find every single aspect of gold investments covered for you in this simple, step-by-step detailed e-report.

Index Trader. Why spend your whole life waiting for that one big trade? Grab quick, regular gains of 25% and more! Grab quick, regular gains by trading the daily movements of the market with Index Trader. Viv does all the work, you take the profits.

Forex Trader. In the past, unless you could sit in front of a computer screen pretty much full time, take calls from currency brokers and know who to ring to get an inside scoop at a major bank, making money from Forex was extremely difficult.

Now, you can tap into this lucrative market and make some serious profits from Forex, while you sit back and do virtually nothing.

To find out more about any of the above publications go to www.fspinvest.co.za, or call our customer services line on -+0861 114 365 now.

InvestFleet Street Publications (Pty) LtdPrivate Bag X16, Northriding 2162

Registered in South Africa No: 1999/019170/07

VAT Reg No: 4430185282

InvestFleet Street Publications (Pty) LtdPrivate Bag X16, Northriding 2162

Registered in South Africa No: 1999/019170/07

VAT Reg No: 4430185282