Should losses cause worry?

The Star Online
Wednesday May 19, 2010
Should losses cause worry?

PERSONAL INVESTING
By OOI KOK HWA

MANY long-term investors always look for companies that can provide consistent growth in earnings and, more importantly, stable growth in earnings. They dislike companies that appear to be “accident-prone” and have “extraordinary” losses every year or every few years.

Given that they will hold on to their investments for a very long period of time, their key returns from the companies will be highly dependent on the dividend payments.

If a company always shows high “extraordinary” losses every few years, long-term investors may not want to invest in this company since it cannot pay stable dividend payments. Nevertheless, some may still buy the company for trading rather than for long-term investment.

An earnings surprise occurs when there is a material difference between expected and actual financial results. In this article, we will look into earnings surprise as a result of unexpected huge losses incurred.

There are two main types of “extraordinary” losses:

• one is related to the recurring items or due to their normal business operations; 
• the other to non-recurring items.

Charles W. Mulford and Eugene E. Comiskey, in their book entitled Financial Warnings, defined non-recurring items as revenues or gains and expenses or losses that are not reasonably consistent contributors to financial results, either in terms of their presence or their amount. Examples of non-recurring items are

• gains and losses on asset sales, 
• foreign currency and debt retirement gains and losses, 
• foreign currency gains and losses as well as 
• the costs incurred in restructuring activities.

In 2009, as a result of low asset prices, a lot of companies reported high impairment losses on their assets. Even though high losses incurred from non-recurring items can affect the dividend payments and write off a portion of shareholders’ funds, most analysts will exclude the above losses in their earnings forecast as they are more concerned with the losses from their normal business operations.

In the computation of intrinsic value, analysts will look into the earnings power of the companies – the companies’ abilities to generate future earnings.

Analysts are less concerned with non-recurring items as the companies are not expected to incur this type of losses every year. For example, if a company incurs huge losses due to the disposal of certain assets, analysts are less worried as the company will not dispose of its assets every year. Furthermore, asset disposal is not part of its normal business operations.

Companies cannot avoid incurring losses from non-recurring items, which might be due to

• changes in economic situation or 
• changes in business cycles, 
• changes in accounting treatments or 
• some unforeseen events.

However, based on our analysis, companies that tend to show frequent losses from non-recurring items in almost every financial year are normally fundamentally unhealthy. The quality of their management is almost always in doubt.

Some companies may claim that they cannot avoid incurring these losses. However, they are unable to provide a satisfactory explanation on why their competitors do not seem to be similarly affected but are instead able to show consistent growth in earnings despite difficult business cycles or environment.

As mentioned earlier, analysts are more concerned with the losses incurred as a result of the normal business operations. If a company incurs high losses due to

• cost overrun on certain projects, 
• sharp drop in revenue or
• sudden increase in operating costs, 

analysts need to determine whether the above phenomenon is due to

• the overall country economic situation, 
• industry specific or 
• only unique to that particular company.

If it seems to be the only one that shows losses while its competitors have been performing well, we need to investigate the causes behind these losses and the effect on the bottomline of the company.

It is very important to take note of the subsequent corrective actions suggested by the companies to overcome the issues involved. Besides, we need to check the possibility of the company repeating the same mistake in the near future.

In short, besides focusing on generating higher sales and profits, the company needs to pay attention to risk management on cost control and take the necessary steps to hedge against business risks.

Companies need to understand that investors look for stability and predictability in future earnings.

● Ooi Kok Hwa is an investment adviser and managing partner of MRR Consulting.