How To Buy A Falling Knife

Published in Investing on 1 June 2012

This Fool has spotted some good opportunities in recent bad news.

Warren Buffett is known for his ability to see through bad news and identify the underlying quality of good companies. As my Foolish colleague Malcolm Wheatley recently pointed out, following Buffett's advice is a good way to make money. Take this quote:

"The best thing that happens to us is when a great company gets into temporary trouble... We want to buy them when they're on the operating table."

Indeed, Buffett recently followed his own advice and nearly doubled his stake in a major British FTSE 100 business that's currently going through a rough patch. If you'd like to know more about this deal, you can find all the details in this free Motley Fool report, "The One UK Share That Warren Buffett Loves".

Buying opportunities?

For the rest of us, the current market distress has made almost everything seem cheaper, but I've come across three companies that have had their own particular problems to contend with recently -- and have been severely punished by the markets as a result.

Are they good investments? I reckon two of them might be excellent -- so read on to see what you think.

Cape

Over the past 10 years, FTSE 250 newcomer Cape (LSE: CIU) has developed a substantial engineering business, providing insulation, coating and access services to the global energy industry. The CEO who oversaw this growth, Martin May, left the company at the end of March and just over a month later, some more bad news followed.

Cape has operations all over the world, and the particular source of the trouble was its Arzew Project in Algeria. The company had already identified delays in the project in its results statement in March, but its 16 May update painted an altogether bleaker picture. It revealed that an audit initiated by the company's acting CEO had found that the extra resources required to deliver the work on time were going to result in a "significant loss" on the project.

The result was that Cape plans to recognise a one-off charge of £14m to cover losses on Arzew, which will reduce its forecast profits for the year by about 20%.

This was enough to slash Cape's share price by 30% in a day, taking it from about 325p down to just over 200p. However, Cape is generally popular with investors, and its share price has already begun to recover.

Is it a buy?

Since then, Cape has also managed to appoint a new CEO. Joe Oatley was previously the CEO of Hamworthy, a similar company that he recently led to a successful takeover. News of Oatley's appointment on 30 May triggered an 8% rise in the company's share price, suggesting that he is well regarded.

I think that the Cape story remains intact. Drastic manpower and management changes have been put in place in Algeria, and I suspect the company will have learned from the experience. I'd be happy to buy shares in Cape, and I suspect that within a year or so this episode will have been forgotten.

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Hargreaves Services

Hargreaves Services (LSE: HSP) mines, imports, trades and transports coal -- and is one of the biggest suppliers to coal power generator Drax Group (LSE: DRX).

Back in February, I wrote a glowing review of Hargreaves' interim results, which suggested that it was on course to deliver a substantial increase in pre-tax profits for the sixth consecutive year.

Recently, Hargreaves lost a third of its value in one day, as its shares tumbled from around 1,050p to 725p.

How could I have been so wrong?

Hargreaves' recent fall was triggered by an unusual problem in its main Maltby mine, where it had been preparing a new coal face to go into production for the next financial year. The problems started when Hargreaves encountered "unusual geological conditions […] that resulted in increasing ingress of water, oil, gas and other hydrocarbons".

The result will be a 12-16 week gap between completing production on the old coal face and starting production on the new one. Hargreaves estimates that this will wipe £12m to £16m off the group's profits for the 2012-13 financial year, although this year's results should be unaffected.

Although it's possible that further investigation will show the problem to be more extensive than Hargreaves expects, I think this is just freak bad luck and I believe the company's underlying business is just as attractive as it was before -- presenting a very attractive buying opportunity.

Lamprell

Before any angry Fools rush for the comment box, I've included Lamprell as an example of a falling knife that could cut you badly. FTSE 250-listed Lamprell (LSE: LAM) is an engineering contractor that builds and refurbishes oil rigs.

Following the announcement of a new contract award on 1 May, Lamprell's shares peaked at over 360p on 2 May and 3 May, on which days two of Lamprell's hard-working senior managers, Scott Doak and Kevin Isles, each sold about 42% of their shares in the company, netting themselves £726,000 and £902,500 respectively.

Ill-gotten gains?

Imagine the market's surprise, therefore, when a fortnight later Lamprell issued a trading update revealing that the year to date had seen progressive delays in the delivery of key equipment, project awards and client deliverables, which in turn had caused "a delay in revenue generation and led to the significant underutilisation of resources including personnel". It also now expects to incur extra costs on another project.

Lamprell then said that it expects this sorry tale of poor management to result in the company making a loss in the first half of the year, although things are expected to improve in the second half.

As a result of this news, Lamprell shares were sold off like hot cakes, resulting in a colossal 65% one-day fall in the company's share price.

Despite denials, it's hard not to conclude that Lamprell's two big sellers saw this coming and decided to cash in first. Trading at about 100p, Lamprell's shares now look quite cheap on paper, but I wouldn't trust the management with my money.

What next?

I think that Cape and Hargreaves Services are good companies at attractive prices. However, bad news sometimes comes in clusters and there is always the possibility of further bad news before all of the problems are properly resolved. That's where the risk lies in these opportunities -- so it's down to you to make the final decision.

Meanwhile, if you'd like to know what some of the Fool's expert stock analysts are recommending for the year ahead, I'd recommend you check out this free report, "Top Sectors Of 2012", which includes details of several resource shares.

He avoided techs in the dotcom bubble and banks in the credit boom. But just where is dividend expert Neil Woodford investing today? All is revealed in this free Motley Fool report -- "8 Shares Held By Britain's Super Investor".

Further investment opportunities:

> Roland does not own any of the shares mentioned in this article.

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Comments

The opinions expressed here are those of the individual writers and are not representative of The Motley Fool. If you spot any comments that are unsuitable hit the flag to alert our moderators.

Cisk999 01 Jun 2012 , 3:36pm

Lamprell's management should be kicked into touch. To issue rosy announcements just weeks ago, then to dump the recent bombshell, and allow senior managers to offload stock - is clearly not good form. And then to wait until now to warn of delays that they saw coming....

I read somewhere that the Board said that they didn't need to approve the share sales - well if not, then they should have had a process in place to make them approve the sales. And these guys must be fairly senior to have had £1m+ holdings each.

Hopefully the FSA will investigate this incident - however, I fear (and probably in common with many Fools here) that the FSA won't find any evidence of wrong-doing and just sweep the matter away.

I don't hold any Lamprell but do hold Hargreaves - Roland I echo your view that this is a quality company and has just been unlucky. Let's hope that there is some good luck to come through.

As for Cape, they've had two disappointments in a row. The odds favour a third, and with a new CEO he's bound to want to 'clear the decks' and get all the bad news out. I also think it's a quality company underneath, but clearly has poor controls and / or supervision of 'live' projects. I would rather wait until he's conducted a thorough review first.

jaizan 01 Jun 2012 , 10:16pm

I also find it difficult to trust Lamprell after this.

Also, we need penalties for this kind of behaviour.

JapanStocksMan 05 Jun 2012 , 4:38am

Sure, this smells like a fish left behind a cupboard for two weeks.

However, if you recall cases where stocks have plunged on dodgy insider buying or selling (Apple is probably the most famous), you know that the market forgets about this kind of thing fairly quickly, and then people start to focus on the value. Lamprell is worth much more than a quarter of a billion pounds.

Jan
http://www.smartjapanesestocks.com/

sopavest 08 Jun 2012 , 1:01pm

@JapanStocksMan

I take your point re. Lamprell and the market's short memory, but Lamprell is down another 25% today following another profit warning:

http://www.investegate.co.uk/Article.aspx?id=201206071635069368E

It tried to slip the warning out without anyone noticing it by publishing it late in the day yesterday, but to no avail.

I suspect Lamprell will recover or be taken over in due course, - but its management's lack of foresight and transparency puts me off at the moment.

Cheers, Roland (article author)

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