Avoiding the traps in the stock market billabong

Financial journalist
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The share market is a great place to generate wealth, as profitable companies pay a stream of growing, tax-advantaged dividends, and compound the growth of their retained earnings to produce capital gain.

Of course, it is also possible to make a capital loss.

Take surfwear group Billabong. It was floated in August 2000 at $3.15 a share, raising $295 million. Seven years later, when Billabong’s shares touched $18.51, the company was worth $4 billion.

Last month, the shares hit a record low of 13 cents. It last traded at 40 cents.

A company’s price on the stock market at any time, or point in its history, is a record of transactions. There is no ‘price’ without a transaction: at any time, there are the bids (the prices that buyers are prepared to pay) and asks (the prices that sellers are prepared to accept).

In May 2007, there was a buyer willing to pay $18.51 for Billabong. And in June 2013, there was a seller willing to accept 13 cents. Let’s hope it was not the same person, because that 99.3% potential loss is about as bad as it gets on the stock market.

Diversification benefits

Sometimes, shares blow up spectacularly, like Billabong. That’s why share investors are told to build a diversified portfolio, because the risk of having too few exposures is that a downturn, such as Billabong’s, can virtually wreck your share portfolio.

Billabong is a great case study of a stock success story gone badly wrong.

It is clear in hindsight that Billabong did a great job in creating wealth on the rise from $3.15 at issue, to $18.51. It is equally clear that along the way, the stock should have been sold. Down that horrible slide from $18.51, Billabong gave investors plenty of opportunity to sell.

Billabong was a growth story in the 2000s and the stock market loved the notion of the Australian brand going global. By 2011, it had 639 stores around the world and it had swelled into a vertically integrated manufacturer and retailer of surf, skate and ski gear and various accessories. Over 2009 and 2010, the company went on a massive spending spree in surf, snow and skate brands, picking up the likes of DaKine, Swell, RVCA, Jetty Surf, Rush, Surf Dive’n’Ski and West 49.

Late in 2011, however, Billabong’s growth story began to hit difficulties. In December of that year, it forecast a huge decline in earnings for the first half of the financial year, based on a sales slump across the globe, which it blamed on an unseasonably warm winter in the northern hemisphere and a cooler start to the summer.

In 2011-12, Billabong reported a loss for the first time since it floated in 2000.

Dividend decline

Although Billabong was never really a dividend story, investors who focused on the dividends would have noticed that the annual dividend grew consistently until 2007-08, when the company paid shareholders 55.5 cents a share. The following year it was 45 cents; in 2009-10 it was 36 cents; then 29 cents in 2010-11, and just three cents in 2011-12. There was no interim dividend for the December 2012 half, and no final dividend is expected either.

The big problem for investors was that most brokers didn’t start to call the stock as a sell until mid-2012, when the shares were trading at about $1.10. Even then, many of them still rated Billabong as a buy.

Brokers were still gun-shy from the GFC, when 50% to 80% price falls were reasonably common among the top Australian stocks. If this happened to a stock in a normal market environment, the fall would be a screaming red flag that something wrong was afoot.

The point is that Billabong shareholders did not really know that their company was in big trouble.

This is a big problem for share investors – they won’t be told when to sell a stock that has hit the skids.

Stick to your game plan

You can’t rely on your stockbroker to make sell calls. Stockbrokers talk about ‘underweighting’ a stock, ‘lightening’ it, ‘reducing’ it or even ‘trimming’ it, but for a variety of reasons, they rarely bring themselves to say ‘sell’.

But investors should always be thinking about selling their shares, or more correctly, when they should sell a stock. A stock should be sold when it delivers the return you expected when you bought it, or if the company’s ‘story’ or business environment changes and the risk of holding it increases.

Even Warren Buffett has bought the occasional dog. It’s an occupational hazard of the share market. The trick to share market investment is quite simply to have fewer dogs than success stories in your portfolio – and to expel the dogs when you realise that they are dogs.

Of course, if you’ve chosen a share carefully for the purpose of long-term capital appreciation, a temporary fall in price is not necessarily a cause for alarm. But you must monitor your portfolio constantly for signs that a depressed price may be turning into a more permanent state. When you’ve come to the conclusion that a share in your portfolio is in financial difficulty – and likely to fall in price – it’s time to sell it, and employ a better one in its place.

Helpful aids

There are tools you can use to monitor the health of your stocks.

For example, Lincoln Indicators’ Stock Doctor fundamental research software tracks the financial health of more than 2000 ASX-listed companies (based on the most recent half and full-year reported result) and assesses each company’s financial health and level of financial risk.

The system gives early warning of both improving and deteriorating fundamentals: for instance, Billabong was Stock Doctor ‘star stock’ until it was removed in 2006 (at $15.30) because its return on assets (ROA) was falling.

In 2008, Billabong hit the next level of warning on the Stock Doctor system – a rating of ‘marginal’ – when earnings for the December 2007 half fell by 2%. Finally in mid-2011, when operating cash flow dropped significantly, the stock triggered a ‘distressed’ rating.

Other handy tools include the StocksInValue and Skaffold systems, both of which calculate an ‘intrinsic value’ for a stock, derived from its return on equity (profitability) and other fundamental financial measurements, and its inherent business or investment risk.

The intrinsic value is calculated from formulas that take into account the financial fundamentals: equity, profitability, cash flow, debt and assets – as well as the amount of risk involved in buying the stock. When a company’s share price rises above its intrinsic value, it is most likely a sell.

The bottom line is that investors should always be open to the possibility of selling any stock. In the SMSF context, the major banks are a different situation, because a lot of people are holding them for the very strong dividend yields they generate. But when you are managing your own share portfolio, you have to think like a professional investor, and constantly assess your stocks on the grounds of whether they are still doing the job for which you bought them.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

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