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Sourcing the positives from negative fundamentals

Invest only if profitable right?

This is not the case and it depends a great deal on the business cycle of a company and asset class for that matter, along with the underlying fundamentals.

Profits are one of the main factors investors look for in a company, when deciding if it is a suitable investment or not. Adjusted earnings before tax, depreciation and amortization (EBITDA) is a profit line item that should take high importance when analysing company profitability.

A company showing negative Ebitda on its books is not always necessarily a bad investment. Adjusted Ebitda is a tool used by analysts that can help investors see the true profitability trend of a company.

For example, a one off large write down or incurred expense has the potential to turn Ebitda in one year negative.

Since companies are commonly assumed as a going concern, Ie. A company is expected to keep operating over the long term, if such an event is decided to be non-recurring, then Ebitda is adjusted by re-adding the non-recurring expenses to earnings.

This is a simplified explanation and in real life adjusted Ebitda takes more considerations when adjusting earnings. Though the end result after such adjustments may show positive earnings figures.

Non-profitable companies, therefore, should not all be disregarded when sourcing investment opportunities. Taking the business cycle of companies into consideration is also a beneficial accompanying investment analysis tool.

The business cycle consists of a number of stages. Focusing on three, most companies generally go through a Growth phase, a Transition phase and a Maturity phase.

A company in the growth phase, usually generates high growth and earnings income, with earnings most commonly fully reinvested in positive net present value projects for further growth. The cash demand in this stage is great due to the substantial amounts of expenses and capital expenditures.

An Investor unaware that the company is in the growth stage, may fail to see that profits have been reinvested and may further judge the company negatively based on its negative free cash flows.

Free cash flow is usually the cash available to bond and equity holders of a company, once capital expenditures and investments are seen to. Persistent negative free cash flows are concerning as liquidity (cash) is most definitely needed by a company to address its working capital requirements and/or short term obligations. The failure to generate positive free cash flows may lead a company to increase its leverage through borrowing. Higher leverage increases the risk of a company.

Hence, when investing in a growth stage company, analysis beyond profitability such as company objectives, current & prospective projects and cash flow stream expectations are important determinants to consider before deciding to undertake such risk.

After all, the higher the risk, the higher the potential for positive returns, though confidence on the prospects and going concern of the growth company, through thorough analysis, is required prior to undertaking the risk.

Companies in the transition stage of a business cycle still usually generate a positive increase in earnings, albeit at a slower pace to the growth phase. Free cash flows in this stage begin to turn

positive and may make the company more appealing to an investment analyst in terms of the risk-reward trade off.

Finally in our three stage business cycle, there comes a point whereby companies mature for the long term. In this stage, new investment opportunities are low to nil and value to the company is mostly generated through existing operations.

In the Maturity stage, profits generally flatten out and reinvestment of earnings is minimal. Dividend issues are in fact popular amongst many established corporations throughout this stage of the cycle.

Globally, companies find themselves at different cycle points and may report positive or negative earnings accordingly. Only a thorough analysis of a company’s fundamentals and their stage in the business cycle may confirm the rejection or approval of investments in companies with negative earnings.

 

This article was issued by Mathieu Ganado, Junior Investment Manager at Calamatta Cuschieri. For more information visit, www.cc.com.mt .The information, views and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice.  

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