There is a common belief among many statisticians and economists that cycles always revert to the historical mean. This infers that although a share price may spike or drop in the short-term, over the long-run, it is likely that results will sit around the average.
We, at Lincoln Indicators, see the merits of such a concept. However, we have adapted this philosophy specifically to share investing. We believe that the price will always “revert to quality”. In other words, eventually the share price will reflect the quality of the company.
It is true that with share investing, there will be periods where there is a disconnect between the price of a share and its underlying fundamental qualities. This is symptomatic of a market where prices can change every millisecond, often in anticipation of a positive or negative event. This forward-looking behaviour can often result in volatile share prices, which are subject to a popularity contest rather than driven by business factors. This may mean that there are times when great quality businesses do not see their fundamental performance reflected in the share price – which can create a buying opportunity.
On the other hand, there will be times when a share price can rally on nothing more than an idea, a restructuring plan and/or hope.
However, as the father of fundamental analysis Benjamin Graham once famously said: “In the short-run, the market is a voting machine, but in the long-run it is a weighing machine.” This is because over the long-run real business factors such as margins from sales, management performance, maintaining manageable levels of debt, strong cash flow generation and profit growth will be the cornerstone of success. While the price of a stock may run ahead of a company achieving these fundamental qualities, ultimately the price will reflect the impending quality of the business.
We received a timely reminder of this important concept at the start of 2018 when a once darling of the stock of trading chat forums threw up its hands and embarked on another turnaround strategy.
Yowie Group is a confectionary manufacturer and seller, known globally for its chocolate which contains a toy known as a “Playmate”, in the form of an endangered animal. Named after the mythical Yowie, Australia’s version of the Yeti, the product was created in 1995 and was a staple of any child’s shopping list. Following a fallout between the founders and business partner Cadbury, which resulted in a lengthy halt in production, Yowie restored control. With a global vision tucked under its arm, the company re-listed in late 2012, closing on the first day of trade at $0.195.
What followed was a rapid rise in share price to an all-time high of $1.32 on August 18, 2015, representing an increase of 575 per cent. Throughout this stellar rise, Yowie was regularly discussed across chat forums, over backyard fences and in the cabs of Australia. However, a review of the company’s financials revealed a different picture. Notwithstanding its rising revenues, the company was consistently unable to generate a profit. Further, this translated into cash flow constantly flowing out the door. The only thing keeping the company afloat was the raising of capital through the issue of shares in the 2013, 2014, 2015 and 2016 financial years. With the constant cash and profit drain we believe the company has been exposed to unacceptable levels of financial risk since re-listing in 2013.
Following another $US7.3 million loss last year, 2018 started with another disappointing update to the market. The company announced slower than expected revenue growth, as well as the resignation of chief executive Bert Alfonso, demonstrating that the company had hit another bump in its road to growth and profitability.
We sincerely wish Yowie’s, new chief, Mark Schuessler, and its shareholders eventual success on their long-term strategy. However, to us the risks of investing in the stock have been clear for many years. With the price closing at $0.14 on the day of its most recent announcement, it is, in our opinion, a case of the price now reverting down, reflecting the poor quality of the underlying company.