For investors with an interest in small, speculative shares, this week's 40 per cent price crash at angling supplies retailer Fishing Republic (FISH), will have come as a shock. It's a reminder of just how unpredictable small-cap growth companies can be.
From a float price in June 2015 of 15p, Fishing Republic hit a high this year of 47p, but now it's back to just 22p. So how do you avoid that kind of investment rollercoaster?
Understanding what went wrong
In some ways Fishing Republic illustrates how early-stage roll-outs can catch the attention of investors. Ambitious expansion in new or niche markets can be a recipe for investment success. And in its interim results two months ago, there was no hint of a profit warning on the cards. But with the damage now done, Fishing Republic may recover quickly, but its share price could take much longer to win back confidence.
The backdrop to this story has been a sustained run in the overall performance of the AIM All-Share - the market where Fishing Republic is quoted. Over the past year, the index has risen by 26 per cent. For the large cap FTSE 350, the gain has been just 9 per cent.
But, of course, index valuations are only ever an average. Dig into the detail over any timeframe and you'll find big winners and losers. Fishing Republic had done well since its IPO, rising more than 160 per cent before its collapse. But that rising price had stretched its valuation. It looked expensive against what it earned and what it owned. Its forecast price-to-earnings (PE) ratio was a high 37x.
Balanced against its financial quality, that racy valuation looked vulnerable. Fishing Republic is a low margin business with below-average return on capital. In a good roll-out, these sorts of measures can improve over time because of economies of scale and better operational gearing. But in a small business, a setback that questions the credibility of the roll-out can have a serious impact on share price.
It's not all bad for smaller growth companies
Jim Slater, the late British investment legend, was attracted to firms like Fishing Republic, which could roll-out, or 'clone', their own activities. He saw retailers, restaurants and health clubs as cash cows that only had to refine and prove their formula once. But a key criteria in his investment rulebook was that he would never overpay for that growth - and that's an important lesson.
Slater's strategy focused on earnings growth, profitability, strong cashflow, low debt and signs of share price strength. It also included what's known as the PEG, or the 'price-earnings growth' factor.
The PEG measures whether the promise of growth comes at a reasonable price. It's calculated by dividing the forward price-to-earnings ratio of a share by the estimated future growth rate in earnings per share (EPS). Any share with a PEG over 1 would get short shrift from Slater. A score of 1 receives consideration and anything under 1 is worth a closer look.
At Stockopedia we track this investment strategy, and one of the interesting features is how few companies actually pass these rules at the moment. It really suggests that growth has got expensive in the UK market, which puts investors at risk of the kind of serious collapses seen at Fishing Republic.
A number of these companies have long fitted the Slater 'mould'. Stocks like VP (VP.), Inspired Energy (INSE), Elecosoft (ELCO), iomart (IOM) and IG Design (IGR) have routinely passed the rules over the past year.
There is no doubt that forecast PE ratios have increased, but these stocks continue to deliver strong earnings growth. So, their valuations haven't become detached from earnings. They also have the hallmarks of robust profitability and appeal in the market.
Crucially, though, while these shares have generally performed well over 12 months, they've not generally seen the sort of explosive price gains that attract floods of investors and stretch valuations.
Slater's take on the classic 'growth at a reasonable price' strategy usually picks up some of the most exciting companies in the market. But right now, the potentially vulnerable valuations of some growth stocks mean that this looks almost conservative in its approach.
While the numbers of companies passing the rules might be lower than normal, those shares should be better protected from the kinds of dramatic price corrections we've seen elsewhere.