Avoiding investment pitfalls

by **Cals** Mon 08 Jun 2015, 03:31

Avoiding investment pitfalls

Saturday, 6 June 2015
By: RISEN JAYASELAN

THE rather spectacular crash of the shares of K-One Technology Bhd should serve as a reminder to investors of the risks involved when investing in small companies that do not have a sound profit track record.
What is particularly disconcerting about K-One is the significant number of institutional funds who must have been captivated by the sales pitches by this company and its promoters, which apparently included some of the big investment banks in the country.
A research reported dated Jan 22 by Kenanga Research opined that K-One had “resilient earnings prospects in FY2015”, after being awarded new orders worth around RM20mil from a “world renowned multinational corporation” to manufacture high-end communication accessories.
On May 27, K-One announced that its net profit for the first quarter ended March 31, dipped by a massive 84% year-on-year, to RM520,000 compared with RM3.24mil previously. Kenanga had forecast a net profit of RM21.6mil for FY2015. At that time K-One’s share price was 51 sen, and based on Kenanga’s forward projection, the stock was seemingly attractive at a FY2015 price earnings multiple of 8.9 times.
K-One’s shares have dipped by more than 50% since its first quarter result announcement.
Clearly, this isn’t the first time a small company has failed to deliver on its promises and it sure isn’t going to be the last.
To be sure, K-One has since explained its poor Q1 earnings on the basis that its business is cyclical and that things should pick up with earnings peaking in the fourth quarter. But going by K-One’s share price, investors aren’t convinced. What is worrisome is when funds begin to believe the spiel of some of these small companies and start placing significant bets on them.
True, some of them do seem to show a significant rise in profitability but there is the concern if their profitability can be sustained and more ominously, can these profits really be trusted? In other words, could there be cases of fudging of numbers? Although many readers would go aghast at such a suggestion the truth is that this has happened before.
Consider the past cases of Megan Media Holdings Bhd, SCAN Associates Bhd and DIS Technology Holdings Bhd.
Fraud and accounting irregularities aside, it is never easy for small companies to achieve phenomenal growth, although that what’s most investors are chasing: investing early in a company that would become a huge success.
One of the reasons why these small companies tend to not meet their potential or promises is that they aren’t able to withstand the competition in the market place. This seems to be the case especially with technology or software related firms, as the experience of a number of ACE Market companies has shown.
In this context, the philosophy of one savvy manager from a private equity fund comes to mind: he says he always seeks out companies which have an entrenched place in the sectors they operate in or are showing sure signs of becoming that way. He avoids companies that are generic manufacturers or service providers because they are subject to the onslaught of intense competition.
That’s not to say that larger more established companies don’t disappoint. Just look at the performances of AirAsia X Bhd (AAX) and Felda Global Venture Holdings Bhd, from the point of their recent listings. These were established companies that have also failed to deliver on their promises, causing huge losses to investors who bought their shares.
Another notable development this week was the planned takeover of Cocaoland Holdings Bhd. Here also investors ought to thread with care. That’s because while the offeror, Hong-Kong listed First Pacific Company Ltd, has stated a price at which it intends to buy out Cocoaland, there is little assurance that this deal will go through or be firmed up at that price. First Pacific has yet to conduct a due diligence on Cocoaland.
As we have seen in other attempted buyout cases before, a due diligence exercise could lead to the deal falling through or the offer price being lowered in the end.
For example, in 2011 a proposed buyout offer of Latexx Partners Bhd by Navis Asia VI Management Co and Mettiz Ltd failed to materialise, leading to losses for investors betting that the deal would be done. Notably, Latexx had announced that the buyers were planning to pay RM3.10 per share, leading investors to chase up the stock close to those levels.
In 2012, ACE Market-listed Ingenuity Solutions Bhd (Ingens) announced it had received an offer from a company called Ninetology Marketing Sdn Bhd to acquire a 39.44% stake in the company at 55 sen a piece.
Had this RM117.9mil deal gone through, it would have triggered a mandatory general offer to acquire all the remaining shares Ninetology had not already owned in Ingens. Ingens’ shares then rose to around 46 sen from 12.5 sen on speculation of the takeover bid.
Alas, the general offer did not materialise because the major shareholder of Ingens, Chin Boon Long, said he did not want to accept that offer because he saw more value in Ingens. This was despite the fact that the offer valued Ingens at six times more than what it was trading at just a month before.
In Cocoaland’s case, it is clear that investors have generally wised up to these risks as it shares, post First Pacific’s announcement have not reached the RM2.70 indicative offer price as investors are weighing the risk that the deal will not materialise.