Should you buy companies torpedoed in a downgrade?

I mostly like watching the market hammer companies that downgrade earnings guidance. Some overhyped stocks deserve a thumping; others fall too far, creating opportunity. The downgrades are a brutal reminder that earnings ultimately drive valuations.

Link Administration Holdings (LNK), Costa Group Holdings (CGC), Appen (APX), Reliance Worldwide Corporation (RWC) and Flight Centre Travel Group (FLT) headline a list of companies lowering profit guidance this quarter or missing market expectations on guidance. The downgrade deluge has led to price falls of 20% or more in some stocks.

Often, stocks fall by double-digit amounts on the downgrade, then have a hefty fall the next day as investors, including those in different time zones, digest the news.

It feels like the market punishes companies more severely after downgrades than in years past. I haven’t seen local research measuring downgrades and the market reaction, but price falls these days seem bigger and faster when companies unexpectedly disappoint.

Algorithmic trading partly explains some of this change. When a downgrade is announced, an army of computer-based trading programs dump the stock, causing it to breach technical price support. That, in turn, encourages more selling as technical analysts dump the stock.

The nature of earnings guidance also contributes to the larger-than-usual sell-offs. Many ASX 100 companies issue guidance in a narrow range and analyst forecasts gravitate around that. When the downgrade arrives, the herd-like market has to change direction as one because there is less variation in earnings forecasts.

Momentum-based trading is another factor. We’ve all seen overhyped, overvalued growth companies rise to unsustainable prices, downgrade their earnings and get slaughtered. When a stock on a 40-50 Price Earnings (PE) multiple disappoints, the reaction is savage.

The boom in passive investing could be a smaller contributor to this trend. A mid-cap company, for example, downgrades earnings and after a 20% share-price fall leaves the ASX 200. An Exchange Traded Fund (ETF) that mirrors the ASX 200 can no longer hold the stock and has to sell. ETFs collectively are lifting their ownership of Australian stocks, meaning companies have to pay more attention to index inclusion.

These and other emerging trends are magnifying share-price volatility when earnings are downgraded. Companies deserve to tumble when they disappoint. But in some cases the falls are disproportionate to the downgrade and the market overreacts.

I believe that was the case with Reliance Worldwide Corporation (RWC), which downgraded earnings principally because of seasonal factors around a warmer winter (which meant fewer frozen pipes needing replacement) and Brexit uncertainty affecting its European operations.

The market’s treatment of Link Administration (LNK) also looks harsh. More on Link later. Price falls in other companies that downgraded earnings in the past few months look like they were warranted. The valuation of tech star Appen still looks stretched, even after price falls.

Contrarians who buy companies that are torpedoed when they downgrade earnings should remember a few things. The first downgrade is rarely the last; companies that lower earnings guidance often do so again because they underestimate the magnitude or duration of the problem. Also, it takes a lot to win back market confidence when a high-flying company disappoints. The market questions the earnings outlook and the PE multiple that should be applied. Worse, investors question management’s skill and credibility – and analyst views on the stock.

I look for key signs when assessing companies after a downgrade. Was the downgrade because of temporary factors, such as unfavourable weather conditions or geopolitical uncertainty? Or because of structural factors: an acquisition not producing expected gains, a product failing to gain market acceptance or market-share loss? Beware the latter.

Moreover, how large was the downgrade and does the company look overly cautious in its revised guidance range? A stock that lowers its guidance by, say, 7% because of seasonal factors can be crunched 20% by the market, even though it’s not a huge downgrade.

Valuation matters most. How does the stock’s forecast Return on Equity compare to its historic average and to its rivals? How does the PE compare? Is the valuation factoring in too much bad news and not seeing a near-term earnings recovery when market conditions improve?

Reliance Worldwide is a case in point (I outlined a positive view on it after the downgrade last month). The plumbing group fell too far, too fast after its downgrade. Do not expect a quick recovery; Reliance will take time to win back market confidence.
 

Link Administration Holdings

Link, a provider of super funds administration and share register/data services, also offers value after its downgrade-driven fall in late May and early June. To recap, Link said underlying earnings (EBITDA) for the full year will be $350-$360 million. Analysts reportedly had expected around $390 million, making it among the larger recent downgrades.

The market’s response stunned: Link shed almost a quarter of its value and hit a record low of $5.56. Link shares were issued at $6.37 in a 2015 Initial Public Offering and the stock almost touched $9 in early February 2018. Now, the share price looks like it has fallen off a cliff.

Link said Brexit uncertainty was hurting UK business sentiment and the company’s European operations. Several UK IPOs (which Link would have provided share-registry services for) were postponed because of Brexit. Less corporate activity in the UK also hurt earnings.

Regulatory change in Australian superannuation will also affect Link’s earnings. The Federal Government’s Protecting Your Super Package will reduce fees for low-balance accounts and return more lost super money to members.  Link said some super funds were moving to transfer identified inactive member accounts to an eligible rollover fund to facilitate early consolidation.

Link serves some of Australia’s largest industry super funds, so the bring-forward of low-balance account consolidation will affect its earnings. Extra costs from the remediation of client-migration activity have persisted longer than Link expected.

Lower-than-expected capital-markets activity in Australia and New Zealand, which means softer demand for Link’s corporate services, also contributed to the guidance downgrade.

These are significant issues and Link’s downgrade is sizeable. But the reasons are more temporary than structural in my view and several problems were beyond Link’s control. Brexit will eventually be resolved and UK corporate activity will improve, as it will in Australia. Link super funds administration challenges look like more of a timing impact than a lasting headwind.

There’s no obvious rerating catalyst for Link in the near term; Brexit will hang over the stock for some time and the super changes will take time to be fully felt. Weaker corporate activity could persist for a while yet given subdued business confidence.

The key issue is valuation. At $5.56, Link is on a Price Earnings (PE) multiple of 13.6 times FY20 earnings, Morningstar numbers show. Link traded on an average PE above 20 in the past two years. The forward PE is at a decent discount to the broader market.

Morningstar values Link at $8.90 a share. It wrote after the downgrade: “Fundamentally, we view current issues as relatively minor and short-term in nature and we maintain our positive long-term outlook on the stock.” Macquarie’s 12-month price target is $7.10.

An average share-price target of $7.18, based on the consensus of eight broking firms, also suggests Link is undervalued at the current $5.56. Let’s not get too carried away; most brokers were wrong on the way up with Link this year and their price targets will be revised lower.

Also true is that one of the market’s higher-quality mid-cap stocks is trading at a record share-price low. That’s despite Link acquiring a 44.2% stake in the Property Exchange of Australia (PEXA). The provider of digital property settlement services had an enterprise value of up to $1.6 billion.

Link has made good progress since listing on ASX in 2015, yet the three-year annualised total shareholder return is now minus 9% (including dividends). The downgrade wiped off three years of share-price gains in a blink.

The market reaction looks excessive, but further losses in the next few months are a good bet as investors seek reassurance that another Link downgrade is not coming.  Expect Link to get worse before it gets better in an impatient market, but few investors pick the absolute bottom after share-price falls.

Better to stand aside until the price plunge subsides and avoid ‘catching a falling knife’ as they say in markets. And wait for the share-price to form a sideways base. An expected dividend yield of about 4%, fully franked, should provide some comfort as investors wait for a recovery in Link’s share price.