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When times get tough, profits matter

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When times get tough, profits matter.

Last year's market darling, the technology sector, has had a tough start to 2016 with those tech companies that do not make a profit feeling most of the pain. The tech stocks in the New Zealand share market have been no exception, with many share prices down heavily since the start of the year (although they did bounce towards the end of February). Why is the share market picking on these sorts of companies, seemingly indiscriminately?

We think the answer is that these companies are usually cash-flow negative and need to periodically tap the share market for more capital to top-up their cash levels until they can get their business models to a break-even situation (which might be years away, if at all!). When share markets become volatile, the ability to raise capital becomes significantly harder as providers of equity become more nervous and are reluctant to commit new equity and want a discount for the uncertainty.

The company that hit the headlines in February was Wynyard Group, a crime fighting and security software company. Wynyard got shareholder approval in December last year to raise $30m of new equity over the next 12 months at a minimum issue price of $2.00 per share. Share market volatility meant that the minimum $2.00 share price was no longer achievable by the end of January, and instead Wynyard was forced to conduct a rights issue at $0.85 to replenish its cash levels. The Wynyard share price is now half of what it was at the start of the year. Messy!

Our stock selection process means that we insist on companies having an earnings history and are forecast to be profitable going forward, to avoid this very scenario. While there is of course a viable place for software companies to be listed on stock exchanges, we favour investing in companies whose business models are proven and they generate rather than absorb cash.

 

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