Lessons learned from Forge's flop

The damage is done … but there are important lessons to heed.

Summary: The Forge share price collapse this week is an important lessons for all investors, whether you hold stock in that company or not. Two key lessons are cash flow and the need for portfolio risk management.
Key take-out: At this point, the risk-reward in Forge doesn’t justify the investment at this juncture.
Key beneficiaries: general investors. Category: Shares.
Recommendation: Underperform.

Forge Group (FGE) shareholders have taken a bath this week, and they should use any bounce in the share price as a selling opportunity.

While some might think there is value in the stock after its 84% fall from grace to 68.5 cents on Thursday, the value may not necessarily go to investors.

Now we know how kangaroos caught in headlights feel. But I am not one to let a good crisis go to waste. There are some lessons shareholders should take away from the experience, and I’ll cover that after I list my three reasons why Forge shareholders should head for the exit.

I had downgraded the stock to “neutral” yesterday (see the end of Wednesday’s article for a background on the Forge crisis) as I wanted to talk to management before making a more dramatic move, but CEO David Simpson didn’t get back to me before the publishing deadline.

Three reasons to sell

  1. The first is based on my expectation that management will be wandering the wilderness for at least the next year. History has shown that big disappointers take several months to recover, and Forge will need some time to rebuild trust following the blow-up of the Diamantina and Angelas power station construction projects, which led to the crisis.

The sad thing is, Forge management has a solid past track record in running a tight ship, and it is this reputation that drew me to the stock. I was blindsided by Forge, and I apologise. I am sharing the pain too as I hold the stock in my portfolio, although I am in good company as the investment community had been taken with the stock as well.

Forge is widely held by institutional investors since fellow contractor Clough sold its 36% stake in the group back in March this year through a block trade at $6.05 a share.

There are media reports that a class action against Forge is brewing. We may have to wait for a court case to get further insights into what went wrong.

If there are doubts about management – as there must be given that it only took two projects in its vast order book to bring the group to its knees – then there is really little reason to stick with the stock.

  1. The second reason to bail now is the lack of a “Plan B”. If Australia and New Zealand Banking Group (ANZ) didn’t come to the rescue, Forge would either have to call in receivers or turn to “vulture” funds specialising in distressed funding. I am not sure which outcome I fear more.

The issue with the ANZ’s $60 million facility is that Forge only gets half now, and it has to prove itself to get the rest.

Forge needs nearly all of the $60 million to dig itself out of the power plant projects. The question is, where will it leave Forge if it cannot get access to the rest of the funds should more skeletons fall out of the closet?

Underperforming construction projects are hard to rectify, and the size and complexity of the projects (particularly Diamantina) means there is a good probability that something else will go wrong.

  1. The third reason to sell is because I believe any rally in the stock will be constrained by two factors. I suspect there is a long line of investors looking to get out, as they are overweight on the stock. The other constraint is the repayment of the ANZ debt.

The bank can decide anytime within the next three years to either take shares in Forge at 1 cent a share through the 11 million warrants it was issued, or it can ask for the difference between the value of the stock and warrant in cash. ANZ is likely to want most, if not all, in cash and this means Forge’s expected cash flows could cap the share price. If not cash flow, the stock overhang from ANZ taking shares will also weigh.

There is every chance Forge will redeem itself down the track. I just don’t see why investors need to hang on for the ride when the risk-reward doesn’t justify the investment at this juncture.

Look at the trading pattern of Newcrest Mining (NCM) and WorleyParsons (WOR) – companies with low management credibility. The only ones that are likely to be making money from Forge are ANZ and short-term stock traders.

This is why I am downgrading the stock to “underperform”.

Cash flow is king

There are two lessons from Forge. The first is cash flow and how Forge became a victim of its own success.

The group’s cash flow from operating activities had plunged around 80% in 2012-13 to $17.9 million due to large payments to suppliers and employees, as the group enjoyed record earnings.

Many analysts, including myself, didn’t think too much of it at that time due to Forge’s reputation and track record.

But the drop in cash gave it limited room to deal with problem projects, and led Forge to the liquidity crunch.

As WDS’ chief executive, Terry Chapman, said to Eureka Report this week, all good contractors should have good cash flow – even those with strong reputations. Lesson learnt.

Managing risk

The other thing that comes to mind is how to manage portfolio risk. I learnt the “2%-rule” from my days as a trader that I still apply to my super share portfolio.

The rule is simply this: every position cannot put at risk more than 2% of your total portfolio value. For instance, if you have a $500,000 share portfolio, you should immediately assume that a small cap stock will halve in value and the loss cannot be more than $10,000 (or 2% of your portfolio). This means you cannot buy more than $20,000 in any one small cap stock. 

You shouldn’t be hung up on the 2% number. These are just guides. Some prefer working with 5%, some less. It depends on your risk appetite and size of your portfolio. A small portfolio might need a different percentage number.

Also, as some small caps are riskier than others, you might need to assume more than a 50% loss before buying. Again, what value-at-risk figure you use depends on your personal circumstances.

The other important thing of this exercise is to force you to think about the downside risk for each stock. When investors get excited about a small cap, they often only think about how much money they can make – not how much they stand to lose.

I know I cannot retire early by applying this rule as my position size for small caps stocks will almost always be modest, but I know I won’t have to eat baked beans because of a Forge-like blow up.

Forge will no doubt cause some serious soul searching among investors and this development only reinforces our belief that stock analysis should start and end with management. There is more to the Forge story and we will keep updating readers on the Forge crisis in the coming days.

Forge Group is part of the Uncapped 100 list. Click here to view the full list.

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