Investing to avoid the next bubble

Shortly before the dot-com bubble burst in 2000, the information technology (IT) sector was all the rage with investors. At the same time the local construction sector was seen as backward and unattractive.

Now, seven years later, sentiments have changed. With the devastating effects of the dot-com bubble still a recent memory, investors remain wary of the IT sector. But the South African construction sector, on the back of 2010, has caught investors fancy in much the same way that IT companies captured investors in the late 1990s.
 
Gary Quinn, portfolio manager with Prudential Portfolio Managers (SA), has noticed that investors amend their valuation techniques depending on the cycle of a sector.

"At the top of a cycle investors tend to apply very loose valuation techniques, to the extend that some methods almost seem invented to help justify a running share price. But when an industry is depressed and investors are cautious, only conservative valuation techniques are used."

Valuations are key

Using the IT sector and the construction sector as an example, Quinn says during the dot-com boom, investors were happy to make investment decisions based on a company's market cap per subscriber.

"Take amazom.com as an example. Valuations were suddenly based on permutation on the number of subscribers or the company's Price/Earnings (P/E) ratio divided by the companys growth rate. In 1999 its price to sales was over 30. It currently is at 2.5 and still trades below its peak. At the same time companies in the construction sector were judged strictly by their book value. Murrray and Roberts traded at 0.75 times book value in 1999. It currently trades at five times book."

Quinn says lately, however, investors have been happy to pour money into the construction sector, based mainly on 2010 and the expected future size of the order book.

"The size of the order book is simply not a good reflection of the actual earnings that can be expected. The focus has shifted from earnings to the revenue line, which is a risky way of placing a value on a company," he explains.

Quinn has noticed a similar hype around junior mining companies. "Nobody is talking earnings in the junior mining space. Many investors are currently happy to pay for a business plan that looks good on paper and that is sold well by management."

A rush of new listings

Currently cautious of the construction and the junior mining sectors, Quinn explains that both are displaying traits very similar to those of the IT sector before the dot-com bubble burst.

Both sectors have seen a rush of new listings in recent months six construction companies and five junior mining companies. And according to Quinn, both are displaying a feature typical for speculative bubbles: a perceived scarcity factor and growth appeal.

Yet seven years ago, when Kroondal Platinum was listed as a junior platinum producer, investors were dismissive of its chances to succeed and were not keen to pay high valuations. It listed in late 1998, had positive earnings in 1998 and traded on a seven PE in 2000.

"But now that commodity prices have been doing well, investors are optimistically throwing their money at start-ups that have yet to prove themselves," says Quinn.

"The mining industry has a lot of attractive fundamentals and as a result investors are happy to fund start-up ventures. But it is dangerous to think that nothing can go wrong. Historically a rush of new listings has always been a sure indicator of a pending bubble." 

Buying on a hype

Quinn says the biggest inefficiency of the stock market is caused by euphoric funding of businesses at the wrong time. It is good for a company to list on a hype, but bad for investors, he says.

The dot-com bubble burst after investors over invested in new IT companies and consultancies that lacked substance. Soon margins became depressed, killing profitability and with that the industry.

He says the Telkom listing is a good example of a listing that came at the right time for investors, but at a bad time for the seller, (namely government). Telkom listed when the general sentiment towards fixed line businesses was very negative. As a result Telkom listed at R28 per share in 2003, but the share price now sits at R180.

Sectors to watch

Since Prudential is a value house, Quinn is constantly on the look out for undervalued assets where the share price is likely to rise over the longer-term to reflect their true value.

Quinn believes there is value in the TI sector. "There is little hype now and we havent seen new listings in a long time. This sector has also seen a lot of consolidation and mergers aimed at maximizing efficiencies. There are companies in this sector with low valuations that are set to enjoy margin expansion."  

One of the companies on Quinns radar screen is Datatec. One of the few survivors of the dot-com bubble and with a forward PE of 10, this is one of the stocks to watch, says Quinn.

Another favourite is Metrofile. A near casualty of the dot-com bubble, Metrofile is all that is left from what was previously in the MGX stable. Plagued by debt for a number of years, Quinn believes that Metrofile is slowly emerging from the rubble.