Blue Gem Research (Pty) Ltd’s research approach for researching, forecasting and valuing equities is a fundamentally driven value-bias process. The analyst seeks to understand the business, its underlying profitability, its cash flows and its assets all modeled and, eventually, valued based on this understanding while bearing in mind management and their strategies, the market, industry and economy.
To gain a sound foundation in understanding Blue Gem Research (Pty) Ltd’s fundamental approach, it is strongly recommended that you watch the series on fundamental investing presented by our founder, Keith McLachlan, on JustOneLap.com (a free account at JustOneLap.com is needed to view these presentations). This is a progressive series, so it is also recommended that you watch it in the order that the links are displayed below:
- The Four Pillars of Fundamental Investing
- Profitability: The Aim of a Business
- Liquidity: A Critical Aspect of Business
- Solvency: Understanding Debt and Failure
- Management: The Qualitative Factors of Business
- Cost of Equity and WACC
- Overview of Valuation Models
- Valuations: Price Earnings (PE) Model (Theory)
- Valuations: Price Earnings (PE) Model (Case Study)
- Valuations: Price-to-Book (P/B) Model (Theory)
- Valuations: Price-to-Book (P/B) Model (Case Study)
- Valuations: EV/EBITDA Model (Theory)
- Valuations: EV/EBITDA Model (Case Study)
- Other Relative Valuation Models
- Valuations: Discounted Free Cash Flow (DCF) Model – What is Free Cash Flow? (Theory)
- Valuations: Discounted Free Cash Flow (DCF) Model – Forecasting Free Cash Flow (Theory)
- Valuations: Discounted Free Cash Flow (DCF) Model – Putting It All Together (Theory)
- Valuations: Discounted Free Cash Flow (DCF) Model (Case Study)
* Note: Dividend Discount (DD) Model has not yet been presented, though Blue Gem Research (Pty) Ltd does utilize it from time to time. See a basic explanation of the DD Model here.
While this webinar series is not entirely comprehensive, it does serve as a good foundation to our research approach and view of equities listed on the stock market.
Also consider these other useful presentations and articles:
- Small and Mid Cap Stock Analysis: Unique Approaches, Risks and Related Thoughts
- Build and Manage a Small Cap Portfolio
- Background investor educational resource
- Background small and mid cap specific articles
Blue Gem Research (Pty) Ltd utilizes what it calls a “Rule of Thumb” beta in its absolute valuation models for the stocks outside of the JSE Top 40 Index (i.e the small and mid caps stocks on the JSE). As the low liquidity of the small and mid caps listed on the JSE distort their respective beta’s (often artificially lowering them), Blue Gem Research (Pty) Ltd subjectively picks a beta from 1.2x to 1.5x for use in its Capital Asset Pricing Model (CAPM). CAPM builds the Cost of Equity, that drives the WACC and eventually is used in the DCF, DD and/or any other absolute valuation model.
Blue Gem Research (Pty) Ltd’s selection of a “Rule of Thumb” beta is subjective and aimed to, as best as possible, reflect the relative risk of the underlying business(es), its sector and the overall volatility/risk of the share. The selection of beta will range from and including 1.2x up to 1.5x (i.e. 1.2x is the “safest” share and 1.5x would be the “riskiest” one, relatively speaking).
This “Rule of Thumb” beta, though, can change from report to report, once again, depending on Blue Gem Research (Pty) Ltd’s subjective assessment of change in the underlying’s risk profile.
For example, as a resource company developing a mine moves from exploration into development and then eventually into mining and production, its risk profile would logically be expected to drop. In this example, it is likely that the “Rule of Thumb” beta selected would start at 1.5x (during the exploration phase of the company’s life) and, perhaps, drop to 1.3x as the company moves the mine into production and cash flows stabilize and the business “de-risks”.
Note that the use of “Rule of Thumb” beta’s is not common practice, but more or less unique to Blue Gem Research (Pty) Ltd. Despite this, it is our belief that this approach improves the accuracy and reliability of low liquidity stock analysis and valuation by circumventing statistical shortcomings created by these stocks’ low liquidity. Albeit, this does inject the element of research bias via the subjective selection of the “Rule of Thumb” beta based solely on the analysis(es) opinion.
Also note that the commonly accepted and arbitrary use of any “liquidity premium” (also known as the “small cap discount”) is not used by Blue Gem Research (Pty) Ltd. The use of a “Rule of Thumb” beta effectively captures the stock’s risk profile and, thus, the any further discounts applied to it solely for the sake of its being a smaller-than-average stock would be double counting. In essence, the correct application of the “Rule of Thumb” beta more astutely captures any small cap or liquidity effects with the valuation.
When reading and using Blue Gem Research (Pty) Ltd’s reports, you must take into account these above noted approaches, theories and methodologies and bear them in mind in forming your own opinion.
Terminology & Dictionary
Per the natural and accepted research process, Blue Gem Research (Pty) Ltd and its analysts may from time to time use certain financial shorthand, abbreviations or terminology within its reports. The following a list the more common financial shorthand, abbreviations and/or terminology with a brief explanation thereof:
- FY: “Financial Year”, for example, FY 13 represents the financial year that end during 2013.
- H1 or H2: This is shorthand for indicating the first or second half of a certain financial year. For example, H1:13 refers to the first six months of FY 13. H2:13 would refer to the second six months of the same financial year. This referencing system can be extended to refer to quarters as “Q”, for example, Q3:13 refers to the third quarter of FY 13.
- CY: “Calendar Year”, for example, CY 13 represents the calendar year 2013 (January to December).
- cps: “Cents per share”, for example, the dividend that Company ABC declared is 10cps.
- y/y: “Year on year”, for example, current year revenue growth of 10% y/y means that revenue grew by 10% when the current year is compared to the prior year.
- Fair value: Based off valuation or valuations, this is the subjective value of the stock at the time the report was written and/or published. This may differ, sometimes materially, from the ruling share price at the time or at any earlier or later date.
- 12m TP: “Twelve month Target Price” is the estimated fair value of the stock in approximately one calendar year’s time. The 12m TP tends to higher than the fair value due to the time value of money unwinding.
- Implied Return: This is the return implied by comparing the 12m TP to the share price of the relevant stock at the time of writing and/or publishing the report. For example, if the 12m TP is 110cps and the current share price is 100cps, then the implied return is 10% (=(110-100)/100). Assuming the company is not expected to declare a dividend over this period, then this is the total implied return. If the company in this example is expected to declare a dividend over this period, then this is the implied “price” return (i.e. from capital appreciation alone, excluding dividends). If the dividend in this example is expected to 10cps, then the implied “total” return (i.e. from capital appreciation and dividends, otherwise known as Total Return) is 20% (=(110+10-100)/100). It is key to understand that 12m TP is an estimate and in no way whatsoever should you take it as factual or any indication of where the share price will actually be in twelve months time from the date of writing and/or publishing the relevant report.
- SOTP: “Sum of the Parts” is simply reference to a valuation approach where different parts of a business are valued separately and the final valuation for the full business (or share) is the sum of these different parts fair values. For example, an investment holding company holds separate investments in unrelated businesses in totally different industries (or even countries!). The SOTP of this investment holding company would simply be the sum of each of its various investments’ fair values.
- c.: “circa”, for example, c.R100m is shorthand for ‘circa’ and implies a level of approximation or rounding in that the figure is not necessarily exactly R100,000,000.00. For legal and compliance reasons, where analysts are not certain on a number or have rounded it (for example, rounded forecast EPS of 12,34542124…cps to c.12,3cps), they would typically use ‘c.’ to indicate this. This allows the reader to apply his own judgement as to the riskiness of the number.
- Consider some further terminology here.