Doctor's (investment) orders

It's no secret more companies float on the ASX in a bull market. In itself, perhaps it shouldn't be a concern, except to wonder whether less-than-stellar companies are simply riding the rising sharemarket to raise capital while there's money looking for a home.

Wonder no more. One piece of sharemarket analysis has made it official: almost 60% of listed entities are marginal (displaying unsatisfactory risk levels) or worse, they can be classed as distressed (exhibiting similar characteristics to failing companies.)

Stock researcher and fund manager Lincoln Indicators took a knife to the 1800-odd entities on the ASX with its fundamental financial analysis software Stock Doctor. Its ratings system found that only 30% were considered financially strong, and 6% were satisfactory.

The current state of the market is quite different to the one Stock Doctor analysed 10 years ago. In June 1998, 50% of the then 1200 listed entities were in strong or satisfactory financial health, while only 42% were considered in marginal or distressed financial health.

Stock Doctor only uses publicly available information. It bases its rating on quantitative data from the listed entity's latest interim or annual report. The "financial health score" is the first of nine steps Stock Doctor takes to recommend investment in a company. You can read more about this approach in Alan Kohler's discussion with Lincoln managing director Tim Lincoln. See The Lincoln formula.

The Melbourne-based Lincoln opened a managed fund in January 2005 to wholesale investors – and to retail investors in June this year – on the back of the success of the Stock Doctor software, which was introduced in 1996.

It would appear the theory behind the software, first propagated by academic Dr Merv Lincoln in 1984, has been vindicated by the Lincoln Australian Share Fund’s performance.

In the year to September 30, the fund posted a total return of 51.2% after fees, to lead the ungeared Australian large cap equities fund table compiled by research house Morningstar. The fund is too new to have the three and five-year performance figures many investors prefer to see before making decisions.

The $140 million fund slipped to second place on the Morningstar rankings the following month, the year to October 31. It was overtaken by another Melbourne fund manager, SG Hiscock’s $70 million SGH20 fund, whose 56.31% return after fees eclipsed Lincoln’s 49.38%. In the same period the S&P/ASX 300 Accumulation Index returned 30.46%.

As the Lincoln fund slipped in the rankings, management have also been rapidly trading out of many of the most widely held stocks in favour of lower-risk listings. The most recent entry for October's top 10 has few surprises, with familiar names featuring. But compared with the holdings only six months earlier, the investment team has clearly been doing some serious rethinking. Just two stocks – Bradken and CSL – have survived in the top 10 over the year. Changing holdings will mean trading costs and have tax repercussions.

nLincoln Australian Share Fund’s top 10
April 2007			October 2007
Sally Malay Mining	4.93%		BHP Billiton	13.45%
Monadelphous Group	4.74%		Westpac Banking Corp	7.02%
The Reject Shop	3.73%		QBE Insurance Group	4.89%
Seek	3.69%		Rio Tinto	4.78%
CSL	3.62%		CSL	4.27%
Bradken	3.58%		St George Bank	4.21%
Zinifex	3.54%		Bradken	3.58%
SMS Management	3.31%		Leighton Holdings	3.57%
Cabcharge Australia	3.23%		Orica	3.56%
JB Hi-Fi	3.14%		Oxiana	3.40%
Total	37.51%			52.73%

Of course, the fund is not run with Stock Doctor alone. The software could favour any number of stocks if they pass the financial health hurdle, but the Lincoln Australian Share Fund only holds 30 stocks currently. Its research covers all stocks, but the managed fund has a preference for large caps because they are easier to trade often and so provide better access to liquidity.

While Stock Doctor's quantitative measures help select stocks at the fundamental level, the fund's investment team brings the bigger picture – the top-down view – to the table. It also does further qualitative analysis of the stocks and companies.

Lincoln’s director of Stock Doctor research, Elio D'Amato, uses the materials sector as an example of how Stock Doctor helps sift through investment offerings. Within the Lincoln managed fund, the largest exposure by sector is its 30% allocation to materials. D'Amato says although resources has been one of the best-performing sectors in recent years, it is also one of the unhealthiest, loaded with a lot of small, unprofitable stocks.

Consistent with Tim Treadgold's argument that only three of the 38 upcoming mining IPOs were worth investing in (see Standouts in the ASX class of 38), D'Amato says the Stock Doctor has given a tick to just 11 of the 190 companies that have listed in the materials sector in the past three years.

Similarly, the energy sector has boomed in recent years. Not surprisingly, so have the listings. The Stock Doctor gave its investment grade rating to just eight of the 91 companies that have listed in the past three years.

The rush to list is what one would expect in a booming sector, D'Amato says, but much like the "opportunism" the market saw with the number of dot-com listings in the dot-com boom, it can be a minefield for the unwary.

Unfortunately, Stock Doctor cannot save the unwary from a dodgy company in the IPO stage, as its accounting ratios require the data of an interim or annual report.

D'Amato says information provided in a product disclosure statement prior to listing usually paints a rosier picture than the truth. On the other hand, information contained in reports to the ASX is much more rigorous, with more stringent requirements, and of course has the financial figures to feed Lincoln's number crunching formulas.

The four primary financial measures Stock Doctor analyses are:

• Level of operating cash flow.
• Level of gearing or debt.
• Total cash balance in the bank – ready for the unexpected, necessary expenses.
• Overall growth in earnings or profitability.

Once a company is listed, however, Lincoln boasts it has a record of 95% accuracy in predicting whether a company will fail, an early warning that gives investors time to bale out safely.

D'Amato points to two high-profile stocks that were popular with investors for a time, but were never investment grade, according to Stock Doctor. Wine producer Evans & Tate and biotech company Chemeq were quite large companies by market capitalisation in their hey day, with successful capital raisings as listed entities. But their financials never persuaded the Stock Doctor.

Its graphs of the two companies show they were both consistently distressed or in marginal financial health for their entire listed lives – five years and three and a half years respectively – until they went into administration.

D'Amato says both were heavily geared, returning time and again to the market for more capital, "but eventually the well dried up".