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 MARKET REPORTS |
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Stocks
Stock of the week – Babcock & Brown
August 25, 2008
Tim Morris, wise-owl.com analyst
Company: Babcock and Brown
Code: BNB
Recommendation: Avoid
Market Cap: $800m
After we advised our clients to sell out of investment bank Babcock and Brown at $26 back in November last year, other less informed investors in the company learned one of the hardest lessons when it comes to the stock market – the importance of profit taking.
When to sell is often the hardest decision for investors. The notion of ‘buy low, sell high’ seems a logical strategy to follow, however often when stocks are at record highs, a bright outlook can blind the investor’s propensity to sell.
For a stock to be near record highs, the outlook must be positive in some form or another. Therefore in making a decision to sell, we use a combination of fundamental analysis and risk management strategies. Our fundamental analysis follows a ‘bottom up’ approach, taking into account the company’s internal growth prospects followed by a consideration of the macroeconomic forces that impact its industry. Our risk management strategy incorporates mechanisms that protects profits and mitigates losses in the event that our recommendation turns sour. In the world of investing, ‘bad apples’ are a reality. Even the world’s greatest fund managers have picked their share of losers. The key to success is therefore identifying these underperformers early on and holding onto your winners for maximum profit.
Babcock and Brown, which has made a lot of headlines over the last week, provides a great example of how this strategy should be employed. In the past we had been fans of the company, generating handsome returns for members along the way. Our last ‘buy’ recommendation for Babcock was made on August 19th last year during the initial US Sub Prime induced market rout, when the stock was trading at $18.80. As the stock went onto record highs, the market became absorbed with the company’s track record of success. However we identified severe macroeconomic headwinds that posed a threat to the company’s debt reliant business model. While Babcock’s creative use of debt generated solid earnings in an environment of cheap and readily available credit, the supply and cost of this ‘lifeblood’ was changing. In November last year the cost of debt was increasing as credit spreads widened around the world and its availability was becoming tighter.
While management had garnished a positive track record for delivering growth, we suspected that repeating past performances would become increasingly difficult. Combined with the fact that it was trading at a PE premium to its peers at the time, our fundamental analysis suggested that the downside risks for the share price were high. Therefore sitting on considerable gains we sought to protect our members profits by initiating a ‘profit stop’ mechanism at $26. Effectively this told our members to sell the stock if it traded below $26, and as such prices for BNB are now a distant memory, we are satisfied with the 38% gain secured for members.
So where to now for Babcock?
The board has been restructured following last week’s half year results which confirmed that profitability has been severely impacted by the credit rout with net profit falling 36% to $161m. However it is the company’s weak balance sheet which has triggered the loss of confidence in the stock.
Babcock is aiming to trade its way out of trouble via asset sales, but doing so is set to be a challenge. The credit crunch appears to have triggered a bout of asset price deflation in areas such as real estate and infrastructure. The supply of distressed assets up for sale around the world has increased as companies attempt to reduce gearing. Potential buyers have been limited by the higher cost of debt, and this limited availability.
Babcock’s asset sales are designed to reduce the $11.5bn worth of liabilities on its balance sheet. With assets of $14.1bn, it would only take a 19% fall in their average value for shareholders equity in the company to be wiped out. This is not a good proposition for shareholders in the current climate of asset price deflation.
After staging an equally dramatic sell off in June, the stock has more than halved during August, falling below $2. In future years we may well look back at this price as a standout bargain, however while uncertainty over the company’s future remains so great we are happy to continue avoiding the stock in the near term. For investors, the risks remain high, and the stock is now better suited to short term traders interested in taking advantage of short term price volatility which we expect to remain high. Trading tactics are another ball game altogether, suitable for advanced investors.
Tim Morris is an analyst at wise-owl.com, one of Australia's leading independent stockmarket research houses. Click here for your complimentary report.
Please note that CompareShares.com.au simply publishes analyst reports on this page. The publication of these reports does not in any way constitute a recommendation on the part of CompareShares.com.au. You should seek professional advice before making any investment decisions.
More articles from this edition of CompareShares:
Share tips: Broker Stock Recommendations 25 August – 6 to BUY, 6 to SELL and 6 to HOLD
Investing: Dividend Reinvestment Plans: Not as good as they once were
Expert Panel - CFDs: Does taking the emotion out of trading lead to fatter profits?
CFDs: Top Ten CFD stocks for the week
Stocks: Stock of the week – Babcock & Brown
Your Money: $50 to a $20 million empire
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