THE
R
R
E
E
D
D
H
H
O
O
T
T
VALUE INVESTOR
GUIDE TO
ULTIMATE
STOCK
MARKET
SUCCESS
* The Red Hot Value Investor’s Guide to Ultimate Stock Market Success *
*
2
*
THE RED HOT VALUE INVESTOR
GUIDE TO
U L T I M A T E
S T O C K
M A R K E T
S U C C E S S
© Copyright 2001 Fleet Street Publications Ltd. All rights reserved. No part of this book may be
reproduced by any means or for any reason without the expressed written consent of the publisher.

* The Red Hot Value Investor’s Guide to Ultimate Stock Market Success *
*
3
*
CONTENTS
Introduction
5

Your advantage over the “P
rofessional”
5

Why Penny Shares?
5

Potential problems with Penny Shares
6
Chapter One: Filter Out The Losers
8

Introduction
8
Part One: The non
-
financials
8
1. Management is crucial
8
2. Never back those who break their promises
9

3. Listen to what a company’s rivals are saying
10
4. Let the trend be your friend
10
5. Avoid companies that change advisers or directors frequently
10
6. Listen closely
–
what is said is often not what is meant
11
7. The Mission Statement
11
8. Market and industry charac
teristics
11
Conclusion
12
Part Two: The Financials
12
1. Do not be obsessed by litigation, but do not ignore it
13
2. Are the company’s accounting policies both reasonable and normal?
13
3. Is the company really gro
wing and adding value for shareholders?
14
4. Cash is King
&
Tax
is unavo

idable
15
5. Do not ignore the Balance Sheet either
15
Chapter Two: Valuation, The Final Filter
17

Back to valuation
17

Assessing the true value of a company
18
Chapter Three: Special situations
21
Chapter Four: Stop
-
loss, profit taking and top slicing
22

The point of setting stop losses
22

Top Slicing
23

Summary
24
Conclusion
25


One last piece of advice
25
All gains exclude dividend payments and dealing costs. We do try to research all our recommendations and articles
thoroughly, but we disclaim’ all liability for any inaccuracies or omissions found in this publication. Do remember that shar
es
are, by
their very nature, speculative, and that generally investments in smaller companies have a higher risk factor, so you
should never invest more than you can safely afford as you may not get back the full amount invested. It can also be more
difficult to sel
l or realise such an investment. The past is not necessarily a guide to future performance. Before investing,
readers should seek professional advice from a stockbroker or independent financial adviser.
* The Red Hot Value Investor’s Guide to Ultimate Stock Market Success *
*
4
*
INTRODUCING
THE RED HOT VALUE INVESTOR
EDITOR
JACQUES MAGLIOLO …
Jacques Magliolo, the
editor of The
Red Hot Value Investor,
is exceptionally well placed to
assess the volatile South African market. He was a head of research and a director of
a leading
Johannesburg
-
based stockbroking firm, where
he specialized in global investment strategies to
assess how these affect local companies. His investment philosophy and the

strategy that he
developed was to target Institutional a
nd private clients through a co
ordinated approach to
research. This includ
ed global market economic, business and political research, specific
company analysis and identifying anomalies and market trends. More specifically, research was
conducted in the following way:
A. Strategic Research
1.
Conduct global market research to iden
tify global trends.
2.
Determine how those trends affect South Africa, i.e. political, business and economic.
3.
Identify sectors that would be most affected by these trends.
B. Company Analysis
1.
Conduct industrial and financial analysis on companies identified
through global market
analysis.
2.
Recommend shares to clients.
C. Update these companies through information documents.
D. Use company analysis to complete portfolio and asset allocations.
E. Use information database to detect anomalies between equities and
warrants.
Author of
Share Analysis and Company Forecasting
and

The Business Plan: A Manual for
South African Entrepreneurs
, he has contributed to, among others, the
Financial Mail, Business
Day and the UK
-
based Petroleum Economist
and
The Daily Mail.
He
has also been a columnist
for
the Mail & Guardian and The Star.
Born in Morocco, Jacques moved to South Africa 30 years ago and began his career for the
Financial Mail in 1987, before moving into stockbroking in 1990. As investment strategist, he
has also
been involved in the development of complex investment models to identify market
anomalies in both equities and warrants.
* The Red Hot Value Investor’s Guide to Ultimate Stock Market Success *
*
5
*
Introduction
Any fool can make some money from buying shares but, follow a few simple rules and take advice from
the right quarter
s, and you can make serious amounts of money. The aim of this booklet is to guide you
towards those serious rewards. Remember that there is a significant difference between a gambling
-
type
share purchase and creating wealth over time through proper share s

election.
It might seem foolish or naive to suggest that absolutely anyone can make money from shares. Yet
history shows that over the long term equities outperform all other forms of investment. So, if you are
happy to pay fat management fees to a City f
und manager you can entrust your cash to him and he will
deliver you an annual gain that will, to a greater or lesser degree, match the average return of the JSE
Securities All Share Index. Over the past few years that return has been a creditable, if not
outstanding
13.6% over the last year.
Our philosophy at the
Red Hot Value Investor
is that passive investment is a short
-
sighted policy,
because there are so many advantages that you, the private investor, holds over the institutional fund
manager, the so
-
called “professionals.”
Your advantage over the “P
rofessional”
1.
Your biggest asset is that you can concentrate your firepower on the handful of shares
that you expect to deliver the greatest returns.
The fund manager would like to do so, but is
forced to
invest in a multitude of complex financial instruments, like derivatives, and in a host of
conglomerates that have dozens of listed subsidiaries (come offshore). The reason is that, if he
were to put all his cash into just a few stocks, he might well end
up owning them entirely. In other
words, he is forced to invest in companies that he has only limited faith. This argument, that a

concentrated portfolio is actually less risky than a diversified one, has been expounded, and put
into practice over many yea
rs, by the greatest living investor, Warren Buffett.
2.
Your second biggest advantage is speed.
The fund manager is controlling millions of Rands
and so
-
especially when dealing in relatively illiquid smaller company shares
-
it’s extremely
difficult for him
to buy or sell enough shares to make a significant difference to the shape and
balance of his portfolio. Remember that portfolio managers’ remuneration is largely dependent on
the increasing value of his portfolio. For the private individual, selling or b
uying a holding that may
be significant to you, but is almost insignif
icant to the wider market, should present no such
problems. You, and I, can move in or out of a position almost immediately with no problems.
Why Penny Shares?
Why should I invest in
shares in smaller companies, those (for the purposes of
Red Hot Value Investor)
with a market share price of less than R10 a share?
1.
Firstly, the academic evidence is that smaller, younger and more entrepreneurial companies are
expected to deliver rapid pr
ofits growth and this will inevitably, over the long run, come to be
reflected in the performance of their shares. The most authoritative academic research on this
subject comes from the London Business School which showed that

-
except in the depths of
re
cession
-
the universe of smaller companies outperform their larger counterparts every year.
* The Red Hot Value Investor’s Guide to Ultimate Stock Market Success *
*
6
*
The star small caps do even better and
-
every year
-
will be found at the top of the performance
league tables for quoted shares.
Instinctively, many of us who ha
ve worked for large bureaucratic organizations will agree that
smaller companies are better focused, more efficient and organized than their larger
counterparts, where decision making seems to take an eternity and where length of service often
counts for m
ore than current performance.
2.
“Professional” analysts in the broking community often overlook smaller companies as these do
not generate sufficient brokerage. Many of the smaller cap stocks trade infrequently and have low
share prices. In South Africa b
rokerage is calculated on a percentage basis, so the lower the
price the lower the commission
–
to the point where many of the larger stockbrokers have set

minimum limits. For instance, if a stockbroker sold 100,000 De Beers shares at the current price
of
R305 a share, the broker would earn about R61,000 (brokerage at 0.2% of value of
transaction), but if he sold one million share in micro
-
lender Unifer at a price of 81 cents a share,
he would earn only R1,620.0 The “professionals” would rather write a leng
thy note on Anglo or
Dimension Data
-
even if their research created little added value
-
because that report would
probably generate far more commission income than from spending the same amount of time
discovering the joys of, and the potential value in,
smaller companies.
That is how some smaller company shares with dynamic growth prospects can remain unnoticed.
Trading in such shares may be minimal until the company makes a formal stockmarket announcement
when, belatedly, investors pile in causing the
shares to soar in value. Even when a formal results
announcement is made the market may not always realise its full impact so there is often time to buy the
stock after its initial re
-
rating and still make significant gains.
That is not to say that making
money from penny shares is easy, because commensurate with higher
rewards, the Penny Share sector also comes with higher risks. It is the aim of the system of share
selection methodology outlined in this booklet and for
Red Hot Value Investor
is to steer

you away from
those risks. Never forget there are risks.
Potential problems with Penny Shares
1.
The principal danger (as well as the main attraction) is the potential gearing of Penny Shares to
just one event. For instance, if Comparex wins or loses the ne
xt big order for e
-
commerce
technology it could make a difference of, say 5%, to its share price. For a smaller Info Tech
company operating in the same or similar sphere, just as the potential upside of a big contract
win is enormous, the potential downsid
e from a big contract loss could be devastating. Careless
stock selection, when choosing between JSE Industrial 40 companies, is unlikely to lose you (or
make you) significant amounts of money in relatively few weeks. The same is not always true for
Penny
Shares.
2.
The second potential problem with Penny Shares is one of marketability, which itself adds to the
risk of this game. Not only can the difference between the buying and selling prices (the spread)
be large in percentage terms, but also if there is
little trading in the shares the price can move
sharply on even the smallest trades. This is particularly true for some of the more illiquid stocks
on the Development Capital Market (DCM) and, especially, on the Venture Capital Market
(VCM).
* The Red Hot Value Investor’s Guide to Ultimate Stock Market Success *
*
7
*
For instance

, in 1998 news that VCM listed company Whetstone had developed (and had approved and
sold to a US company) a new petrol additive that could become the answer to world emmision problems,
sent the company share price soaring. In a matter of week the price ha
d risen from 140 cents to over 470
cents. When news broke that the contract had fallen through, the share fell all the way to 15 cents. As a
result of the higher risks associated with Penny Shares, it would be suicidal to invest all your cash in just
one
stock, as nothing in life is absolutely guaranteed
-
even the greatest investors get it wrong
occasionally.
At
Red Hot Value Investor
we believe that you should build up a portfolio of between 10 and 15 smaller
company shares that mirror your own risk rew
ard profile. If you feel you wish to invest in another
company outside your existing portfolio, you should perhaps consider realising your gains on one of your
current investments as excessive diversification carries its own risks. You should always consid
er
banking substantial gains, because every growth stock will, one day, mature to a stage where its rate of
growth will start to decline. The successful Penny Share investor can have no room for sentimental
attachments to a particular share, even if it has
served him exceptionally well in the past.
Following the
Red Hot Value Investor’
system for spotting growth opportunities is a good start on the
journey to making big gains from smaller company shares. Our monthly publication should assist you on
your tr
avels since it will contain analysis, available nowhere else, as well as the distilled insights, views
and suggestions of hundreds of contacts from the markets, industry, political connections and business

dealings.
It was one of my industry contacts in 1
997 that pointed out former IT giant Computer Configuration
Holdings (CCH) as a possible recommendation. On approaching the CEO, I discovered that they had
publicly announced a successfully acquisition that would make a significant difference over the shor
t
time. Analysts ignored this newly listed, 200 cents a share company, but to their detriment. With 12
months the company had seen its share rise to 4700 cents. The reverse happened in 1999, when the
company had grown too fast. I recommended that investors
“take profits.” Shortly after this, the company
was swallowed up by another IT company and practically disappeared from sight.
Not every Penny Share will be a winner like CCH and on that basis you should never invest money on
the stockmarket that you can
not afford to lose. There are literally hundreds of stocks out there that offer
the potential for making similar gains. By using
Red Hot Value Investor’
proven method and by gaining
the best possible sources of information you can dramatically increase you
r chances of picking the next
CCH and start creating your own wealth building portfolio.
* The Red Hot Value Investor’s Guide to Ultimate Stock Market Success *
*
8
*
Chapter One: Filter Out The Losers
Introduction
There are over 500 Penny Shares quoted on the JSE Securities Exchange, in which you could invest
and each week var
ious contacts will suggest looking at over 30 shares that have some potential.
It may sound perverse, but the way to spot the winners from a given universe of stocks is by eliminating

all the obvious losers. That’s Warren Buffett’s strategy: he will alway
s look at the downside of any
prospective investment and, if it looks too risky, he will walk away, however tempting the upside. As the
great man puts it:
“Rule number one of investment is not to lose money Rule number two is to remember
rule number one.”
The
Red Hot Value Investor
filter method of share selection comes in two parts:

Non
-
financial:
Even the semi
-
numerates who run local government departments might
understand.

Financial
: This requires some understanding of balance sheets, cash flow state
ments and
profit & loss accounts.

Both filters are based on common sense and experience. These are qualities that should
always be the basis for all investment decisions, but are too often ignored in the hype one
hears from certain stockbrokers and read a
bout
-
all too often
-

in the mainstream press.
Part One, the non
-
financials
“Despite my appreciation of structural models in forecasting, I do not believe in
mechanical model
-
based forecasting, estimating the model and letting it make the forecast
witho
ut intervention of the forecaster.” (Laurence Meyer, Member of the Board of the US
Federal Reserve, 1998)
A well
-
known analyst some years ago produced a lengthy tome studying common features among
corporate post
-
mortems. Like most people who read that p
ublication, we now look nervously when we
see a finance director wearing a bow
-
tie and grow even more jittery if, contained within an unusually
designed annual report, is a picture of a fountain gushing in the atrium of the company’s headquarters
building.
Despite this, Red Hot’s actual filter criteria are rather more straightforward.
1. Management is crucial

Firstly they must be committed in a financial sense to growing the business and so rewarding
shareholders, rather than to rewarding themselves. In 1
990, a group of directors formed a retail
company called Rusfurn, which incorporated a number of large mass discounters (Dion, now part

of Massmart) and furniture groups. After a lengthy discussion with the CEO and financial director I
discovered that “if
Rusfurn reaches …eps ….the directors gain an additional ….million shares.” A
quick analysis suggested that the additional shares would significantly dilute earnings in the
* The Red Hot Value Investor’s Guide to Ultimate Stock Market Success *
*
9
*
following financial year
–
to the detriment of the shareholder. I recommended that i
nvestors bail out
at 120 cents a share and, within six months, the share had crashed to less than 10 cents, the
company ultimately sold piece meal.

However, it is always heartening to see that the board has a significant stake of, say, more than
5% in
any smaller company as that gives them a real incentive to drive the share price forward. On
the other hand, too great a stake and there is a danger that the firm may be run as a comfortable
“family” firm, not one with an ethos of maximising earnings grow
th. There is often also the potential
that the directors listed the company to maximize their personal wealth (push the share price up),
before selling the company to the highest bidder.

It is equally disheartening to see senior managers, whose pay levels
and annual remuneration
increases, bear little relationship to the company’s record of adding value for shareholders. Always
check that a company’s senior managers are demonstrating real financial commitment to the
company, rather than to themselves, by t
aking home pay commensurate to the size of the

business and pay rises commensurate with its success. Notes in the annual reports about “material
transactions” with other companies in which a director has an interest are often signs that
managers are toppin
g up their salaries via the back door. If this is the case, we would rather invest
elsewhere.

Finally it is always worth noting recent share purchases or selling by directors. If the top men are
lightening their equity holdings, that cannot be seen as a v
ote of confidence and perhaps you
should follow suit. The reverse is also true. There are several internet sites that provide free
access to main shareholder structures, the best of these is www.bfanet.com.

As important as the management’s financial inter
est in maximising shareholder value, is its ability
to deliver that value. It seems heartless, but you should rarely give a failed chief executive a
second chance
-
it pays to back proven winners, rather than even those who have failed once
before. Jeff Li
ebsman is an example of a failed businessman who made a strong comeback. In the
early 1990s he wielded significant power in a conglomerate called W&A, only to see the group fall
apart. However, by late 1997 he had re
-
grouped
–
with new investors and consul
tants
–
he had set
up Corpgro and a host of other listed entities. What I’m trying to say is, who you follow is

dependent on the amount of knowledge you have on the person, the type of venture he is pursuing
and who his backers are. These must form a major
part of your decision making process.

A UK survey published in October 1996 by the business information group CCN showed the extent
of serial failure among company directors. More than a fifth of those who had steered one vessel
onto the rocks had also m
anaged to send another ship to the ocean floor. There are currently more
than 4,000 company directors in Britain who have already been involved in 10 or more company
failures. While figures are not available for South Africa, I can state that personal rese
arch shows
that 33% of all companies in South Africa head for bankruptcy every year.

Ask yourself: whatever the odds, should you risk your wealth, your portfolio of shares to someone
who has already failed?
2. Never back those who break their promises

J
ust as perennial losers should be shunned, so too should those vehicles that persistently fail to
meet expectations. The Stock Market will not tolerate “promises of profits tomorrow” forever, and a
* The Red Hot Value Investor’s Guide to Ultimate Stock Market Success *
*
10
*
record of issuing profits warnings will inevitably see the
shares de
-
rated, and unlikely to be re
-
rated

even if the profits warnings cease. The market adage is that profits warnings usually come in
threes. Sadly it is often in fours or fives.

The bottom line is that well
-
managed firms in growth industries do not
issue regular profits
warnings, either overtly through the Stock Exchange or covertly by telling brokers to cut their
forecasts.
3. Listen to what a company’s rivals are saying

Before investing in a particular company check what its rivals are saying ab
out their current trading
and prospects. If the company you are thinking of backing seems to be singing from a completely
different hymn sheet than those of its competitors, it is not one that should pass the filter test.
Experience and common sense should
always tell you that if something sounds too good to be
true, it probably is not true.
4. Let the trend be your friend

It is usually better to invest in shares that are on an upward trend than one that is on the reverse,
as the sensible investor should
let the trend be his friend. A share may look cheap, but if its price is
on a persistent downward path that often means that someone, somewhere, knows something
bad. If you were aware of that inside information, the chances are that you would not think the
share was still cheap.

If you still think a particular stock looks cheap after it has started to fall, wait until it stops falling and
has instead risen for a couple of days before buying. If you buy falling shares in the hope “surely
they cannot go any

lower” or if you buy shares that fail the normal
Red Hot Value Investor
filters
just because they “look cheap” you will quite possibly get badly burnt. This is the Stock Market
equivalent of the old adage: “Never catch a falling knife.” In the investment w
orld that can be a very
useful phrase to remember.

Having said that, you should also not chase a price up. If
Red Hot Value Investor
tips a stock at 10
cents it is due to our belief that you can reasonably expect to make a 30% return on that within six
mo
nths, and possibly considerably more. However, traders have large research departments, with
analysts who monitor all share recommenda
tions (especially those made by someone with a
record of success) very carefully and will respond to such tips by marking
the shares up. So, if by
the time you come to buy, the shares are already trading at 14 cents, any subsequent purchaser
will already have lost most, if not all, of the subsequent upside. But if you and other sensible
investors hold off from buying immedia
tely, the traders will call the price lower in order to drum up
business. Thus, it often pays to be patient and wait a few days or weeks in order to make your
purchase.
5. Avoid companies that change advisers or directors frequently

To lose one non
-
execu
tive director or one key adviser is acceptable, to lose two is careless and to

lose more is terrifying.

An unexplained resignation by a non
-
executive director, or change of sponsoring stockbroker or
merchant bank is always worth investigating. When these
supposedly impartial directors or
* The Red Hot Value Investor’s Guide to Ultimate Stock Market Success *
*
11
*
advisers, whose supposed role is to protect shareholders interests, quit without explanation, we
start to become concerned. Those who sold their shares in Wooltru when Colin Hall resigned as
executive chairman, were consid
erably better off than those who ignored the warning signal.

Unless both the company and the departing non
-
exec or adviser can give a cogent and plausible
reason for the parting of ways, the company does not merit your financial support.

When there is a
series of boardroom resignations or a repeated changing of advisers or brokers
you should become extremely concerned. At best, it may suggest that the company’s senior
management find it hard to maintain decent business relationships. At worst, it suggests
rather
more serious problems. Either way, the company involved is not one in which you should invest.
6
.
Listen closely

–
what is said is often not what is meant

In 1996, a colleague (a stockbroker) and I interviewed the directors of a Cape Town based
Food
listed company. The directors said that “everything is positive,” and “we expect a 25% earnings
growth rate this year.” Despite their attempts at conveying a positive message, they seemed
uneasy. After the discussion, my colleague turned to me and sai
d that he was going back to the
office to advice clients to continue to accumulate the share. He then asked me for my advice.

This is what I said: “I believe that they (the company) is about to be de
-
listed, with head office
using this company to reverse
list another operation, possibly the Johannesburg
-
based holding
company.” He looked at me, slightly confused and, shaking his head, asked me how I had
concluded that scenario. I pointed out that the directors had avoided any question relating to head
offi
ce and had not provided a reasonable explanation as to how Head office would expand all its
food operations into Africa. They would need a listed vehicle to fund such a venture!

Within three weeks of my statement to my colleague, the holding company annou
nced a de
-
listing
of the Cape Town firm. I had proved myself to our institutional clients, yet all it took was gut feel
and listening closely. In other words, try to know that people often say more by not speaking at all.

If you are “listening” you can get
an investment edge.
7. The Mission Statement

A mission statement is necessary for a company to give focus to their strategy. Essentially, a
Statement enables business to bring people together with a focused, common ideology and
direction. In addition,
the company can make sure that the whole strategic planning process is
integrated throughout the entire group.

However, if the mission statement is too broad, it results in blue sky type planning, which should be
restricted to Boardroom brainstorming sess
ions. A statement that is too narrow results in channel
vision and foregone opportunities. This implies that a brief look at a company’s statement should
give the investor an understanding of the general direction that the firm should be taking. If not,
wh
y invest in a company that cannot even keep to its own agenda.
8. Market and industry characteristics

Another non
-
mathematical method of determining whether a company has a suitable strategy is an
investigation of the opportunities and threats that the c
ompany faces in the environmental factors
* The Red Hot Value Investor’s Guide to Ultimate Stock Market Success *
*
12
*
within which it operates; including, politics, economics, finance, global threats and opportunities,
technology, social change and labour issues.


The dilemma strategists face is what factors to include and exclud
e when setting up key criterion
for decision making. One approach is to identify key characteristics of the environment arising out
of product life cycle and other major factors that affect business. Some key filters include
characteristics of the markets,
competitors, market fragmentation, entrepreneurial flare of
management and possible synergies arising out of a takeover, acquisition, merger etc. Stated
differently, a company, market or share is considered attractive if its potential for providing a
sign
ificant contribution to objectives (mission statement) can be met, i.e. earnings growth, cash
flow, return on investment or assets, dividend income or capital growth.
Conclusion

Thus, even before analysing the financial statements of a company by refer
ring to its last published
Annual Report and any formal Stock Exchange announcements made in the past couple of years,
someone using the
Red Hot Value Investor’
filter
-
system should be able to eliminate at least half, if
not more, of the 500 smaller compan
y shares on offer as being unsuitable for his or her portfolio.

Remember: unless a company’s managers have a record of success and show financial
commitment and confidence in the business; unless those managers have a record of meeting
expectations and th
ere is a record of boardroom continuity and of stable relationships with their
advisers; unless the company makes promises that appear realistic in relation to those of its rivals;

and unless the share price is, at worst, stable, then the company has faile
d the
Red Hot Value
Investor’
non
-
financial filters.

As such it does not merit a place in your investment portfolio.
Part Two: The Financials
The non
-
financial filters will probably have already weeded out at least 33% of the three dozen or so
compani
es that financial and other contacts suggest that we investigate every week, and so it is only at
this stage that the company’s Annual Report truly comes into its own as one attempts to gauge the
financial health and prospects of the business. As before, t
here are a number of filters that should be
enough to eliminate all but a few potential candidates for investment.
It might be surprising, but it is always worth starting corporate detective work at the back, rather than the
front, of a company’s annual r
eport. At the beginning, there should be a statement from both the
chairman and CEO outlining the events of the past year and putting as positive a spin as is possible on
the company’s prospects. Reading between the lines of his statement can unearth a few
concerns, but
the first third of an annual report normally contains nothing more than merely a restatement of a handful
of corporate clichés and a collection of glossy photos of fat
-
cat executives. In other words, the content is
unlikely to be either part

icularly useful or especially aesthetically pleasing.
In the middle of an annual report are the Income Statement, Balance Sheet and Cash Flow Statement.
More is outlined later.
* The Red Hot Value Investor’s Guide to Ultimate Stock Market Success *
*
13
*
However, it is the final section, the notes to the accounts, that is often
most illuminating since it contains
details of the accounting policies used in the preparation of the annual report; details of litigation that the
company might face in future; directors’ remuneration and share option packages and other such
nuggets. In o
ther words, the notes to the accounts can be crucial.
1. Do not be obsessed by litigation, but do not ignore it

Nearly all companies, especially those doing business in litigation
-
obsessed places such as the USA,
will find themselves involved in a legal
case sooner or later. So, just because the company admits
that it is being sued in its report and accounts, that is not necessarily a reason not to invest in it.
However, smaller companies can be seriously damaged by just one large and costly legal case so
be
careful.

Normally, the directors will give their view on any outstanding litigation claiming, hopefully, that it is
not “significant” in the context of their overall business or is, in their opinion, ”unlikely to succeed.”
Since the successful Penny S
hare investor is, like Warren Buffett, prudent, unless both of the above
caveats are contained with reference to outstanding legal matters, it is probably safer to walk away


Equally, if you subsequently discover that a company has “neglected” to mention i
ts potential legal
liabilities in a public document, it raises such serious concerns about the trustworthiness of its
directors that you should always walk away
2. Are the company’s accounting policies both reasonable and normal?

In the Notes section of
an annual report the company must explain how it treats accounting issues
such as depreciation of assets, capitalisation of interest payments, and research and development
spending. Such matters are crucial as these affect headline profits. You will also f
ind a schedule of
values for its underlying assets in the notes section
–
more later about these values.

Depreciation refers to the amount set against stated profits to cover the reduction in value of fixed
assets over time, effectively wear
-
and
-
tear. Cap
italisation of interest refers to the accounting practice
where certain interest costs are not written off against profits, but are added to the balance sheet as
an asset and depreciated in subsequent years.

The effect on stated profits can be significan
t. For instance, if a company writes down the value of a
piece of machinery over twenty years, whereas its rivals write it off over ten years, the first company
would (because it had a lower annual depreciation charge over the first decade) report higher p

rofits
than its competitors.

Similarly, by capitalising an unusually high amount of interest costs in a particular year, a company
can flatter its profits artificially even if, in subsequent years, its profits will be reduced because it has a
greater asse
t base to depreciate.

Some companies also choose to capitalise research spending rather than writing it off against profits.
They claim that this is because such spending will have the long
-
term effect of growing their
business. But the most obvious effec
t of such a policy is to flatter both the Income Statement (by
“reducing” costs) and the balance sheet (by “increasing” net, albeit intangible, assets).
* The Red Hot Value Investor’s Guide to Ultimate Stock Market Success *
*
14
*

Capitalisation of interest, for instance, is not per se a necessary cause for concern. For instance,
w
hen building a nursing home, the interest bill prior to opening is a cost, just like labour or bricks,
necessary to create the completed final asset. Since the value of that asset is effectively its
replacement cost, capitalising interest is probably not u
nfair.

However, it may become a concern if the policy adopted is noticeably different from that of the
company’s competitors. Certain nursing home operators, for instance, used to capitalise interest
costs until the homes they had built were three quarter

s full. The mere fact that those operators were
adopting policies that flattered their profits and that their peers refused to adopt, should have been a
cause for concern for potential investors.

Occasionally it is not even necessary to check out the poli
cies adopted by rivals. Gut instinct will do!
If, for instance, a company says it depreciates its car fleet over more than five years it is blindingly
obvious that, since those cars will need to be replaced before the half
-
decade is out, the sole purpose
o
f adopting such an unrealistic policy is to flatter profits and earnings per share.

The point about aggressive accounting policies is that, while they may flatter earnings for a certain
time, they do nothing to change the underlying trading position of t
he company concerned. Sooner or
later that will become apparent. When an economy is on the verge of entering a recession, or at least
an economic slowdown, it becomes more difficult for the aggressive accounting firms to paper over
the cracks, and the chic
kens will inevitably start coming home to roost.
3. Is the company really growing and adding value for shareholders?

Moving from the back of the accounts to the middle, one should start with the Income Statement,
which should show the company’s turnover
(revenue in the case of finance houses, banks and
private equity firms), Operating Profit Befiore Interest & Tax, interest paid or received, Tax paid, Net
taxed profits, extraordinary costs, attributable profits and dividends. These figures are stated for
both
the current and previous years. In the case of a holding company (ie a company with subsidiaries),
there will be a second set of figures, one for “company” and one for “group”. The group figures are

used to assess the whole organization, while the fi
gures for “company” will show you whether the
holding company is a trading one, or simply a means to maintain a strategic overview of the whole
organization. Remember to use one set of figures constantly, or you could end up double counting
profits or debt
–
whichever, you will get a distorted picture of the group’s financial perfromance.

The Income Statement is not a snapshot picture of the company’s position at the year
-
end, but a
record of its achievements over the previous trading period.

The key test
for
Red Hot Value Investor
and other potential investors is whether the company
appears to be growing in a sustainable manner and in a way that creates extra value for its
shareholders. Thus we would hope to see that it had achieved steady turnover growth
without having
to sacrifice its operating margins
-
in other words that the company was not cutting prices merely to
shift stock. The operating margin is calculated by dividing Turnover (as a percentage) by Operating
Profit before interest & tax.

More
importantly,
Red Hot Value Investor
will only recommend shares in those companies with a

consistent record of generating steady growth in earnings per share (EPS). Earnings per share is the
net profit of a company after paying all costs, including interest
and tax, divided by the number of
shares in issue, and is a far more useful indicator of growth than pre
-
tax profits. In South Africa,
* The Red Hot Value Investor’s Guide to Ultimate Stock Market Success *
*
15
*
accounting firms have added what is today referred to as Headline Earnings per share (HEPS), and
is the attributable pro
fits before extraordinary costs divided by the number of shares in issue. The
reason for this calculation is that, if a company sells an asset (an extraordinary profit), it could
positively distort EPS for that year. HEPS excludes ythat profit. Of course,
if the extraordinary item
was a loss, the opposite would be true. HEPS thus is the sustainable growth in a company’s
earnings, excluding extraordinary profits or losses.

In addition, many companies can grow headline profits by issuing new shares in order
to acquire
assets or indeed other companies, but add nothing for shareholders in doing so. For instance, if
company A acquires company B by issuing fresh equity in a deal that increases its number of shares
in issue by 10%, and the deal increases pre
-
tax p
rofits by only
5%,
the transaction will look good at
the pre

-
tax level but will not enhance EPS. It will, in fact, have a dilution effect on earnings.

Unless a company has a consistent record of growing sales without comprising margins and of
adding to HE
PS, it fails this particular
Red Hot Value Investor
filter.
4.
Cash is King & Tax is unavoidable

Newspaper share tipsters and, all too often, professional investment analysts seem to be extremely
obsessed by a company’s HEPS growth. While important, it must never to the be
all and end all of
industrial analysis, because no business can survive without cash.

One should therefore always be extremely nervous if a company is failing to generate cash at an
operational level, something that will be apparent if one reads the Cash
Flow Statement in its Annual
Report. In the long run, companies must generate cash from trading, because they cannot survive
forever from just running down stock levels or from squeezing debtors while pushing creditors for
more generous terms. A well
-
run b
usiness in a growth market can live with high borrowings if it has
had to invest heavily, but if it is failing to generate cash, you should be extremely nervous.

As a general rule if cash flow generated from operations falls well below operating profits,
then
Red

Hot Value Investor
would rather stay well clear.

A
s
a fourth
lesson
, look for companies that can c
ontrol
its
taxes
.
One of the least understood costs in
an investment portfolio is tax. In the real world, most of us have to pay tax, and many times our
investment plans incre
ase our tax burden. Each time
a co
m
p
a
ny
receive
s
an interest payment, the
Receiver of Revenue wants his cut
.
R
emember,
when analysing a company, always use the
maximum tax payable.

5. Do not ignore the Balance Sheet either

The final part of the mid
-
section of a company report is the Balance Sheet, a statement of what the
company owns (its assets) and owes (its liabilities)
at the period end. As such, the balance sheet can
be slightly misleading. For instance, at the end of December, a typical retailer should have lower
borrowings and more cash than at the end of November, due to having just completed its most busy
trading pe
riod of the year. In the period before the Christmas season most retailers would have high
borrowings, to support high stock levels, but little cash. Not surprisingly, most retailers have an end
-
December year
-
end in order to make their balance sheets look
as healthy as possible in the annual
report.
* The Red Hot Value Investor’s Guide to Ultimate Stock Market Success *
*
16
*

Having said that, balance sheets can be misleading due to timing and strange accounting policies
that relate to items such as capitalisation of research spending. Analysts use the Balance Sheet as
an indicatio
n of the financial strength of a company.

The most commonly quoted Balance Sheet ratio is gearing, which is a company’s total debt (long
and short term loans and bank overdrafts, but less cash) expressed as a percentage of its net assets.

If a company’s g
earing is high (say heading towards three figures) one might wonder whether it has
the organic resources to invest in new plant for expansion, whether it can afford to increase its
dividend or, indeed, whether it has any prospects of ever repaying its debt
s.

This is perhaps a little simplistic. Some companies (such as the pharmaceuticals giants) actually
have very few tangible assets and so can look highly geared. But since they are highly cash
generative and their interest payments are normally many times
covered by profits before interest
and tax (PBIT) they do have real scope to invest, repay debt and still reward shareholders. In
addition, a company’s annual report is usually released three months after its year end and, thus, any
ratio could be signifi
cantly outdated. Use the Balance Sheet as a barometre and feel free to
telephone the company secretary and quiz him on the ratios.

When an economy is expected to slowdown and interest rates are expected to rise, it pays to be
cautious when assessing an
investment opportunity, particularly if a company’s gearing looks high in
both absolute terms and relative to that of its competitors. It is unlikely to be a prudent investment for
someone keen to follow Warren Buffett’s first rule.
* The Red Hot Value Investor’s Guide to Ultimate Stock Market Success *
*
17
*
Chapter Two: Valuati
on, The Final Filter
It is the Red Hot first rule of investment that a bad stock that fails to pass the investment
criteria is never a buy, whatever its share price.
The

Red Hot Value Investor
filter system should by now have weeded out those stocks th
at will never
outperform the market by enough to make them a satisfactory home for your money.
Probably around 75% of South Africa’s Penny Shares will have failed to pass the Filter system, and
merely by avoiding those laggards the portfolio of a good fu
nd manager will outperform the universe as a
whole. The key to making big gains is by buying quality shares when their valuation is right.
It cannot be said often enough that there really is no such thing as a “trading buy” although that is
something few
brokers seem to understand. Sure, you may get lucky trading in and out of fundamen
tally
dud stocks, making a quick turn here and there for a while. But dud stocks with poor managers or with a
negative Cash Flow will inevitably come up with a shock profits
warning, unexpectedly large losses, or
unforeseen management upheaval. When that happens, the enormous losses taken by the short
-
term
trader or speculator with a position in the stock will more than offset the small trading turns he will have
made elsewhe
re.
Thus
Red Hot Value Investor
seeks, instead, to focus on buying into quality growth stocks when the
timing and the price is right. That does not mean that we expect to see massive gains overnight or even
next week. It may take months or even over a yea
r before the market realises a company’s full potential.
When that happens, the excitement and the profits for those who became involved when we suggested
will make it well worth the wait. Although
Red Hot Value Investor

highlights only those stocks that i
t
expects to see make significant gains on a six months perspective the successful investor must be
prepared to be patient.
Back to valuation

Over time there have been well known investment gurus, here and in the UK. Perhaps the best
known investor in Bri
tain today is Jim Slater, for whom it is hard not to have the greatest of respect.
Slater’s proven methodology is based on the principle that a share looks cheap if the prospective
Price Earnings ratio (that is to say the share price divided by the predict
ed earnings per share for the
current year) divided by the rate at which its earnings will grow in the current year is less than a
certain multiple. Greg Blank stands out as one of the most influential investors in South Africa today.
His involvement in th
e small cap market during the late 1990s has rejuvenated that sector, seeing
companies like DNA, Corpgro and Iota come strongly to the fore. Speaking to him recently, I asked
him what his investment philosophy is and he simply said that he buys “only under
valued” situations.

The trouble with such a rigid filters is that especially in bull markets, it can leave one with an
exceptionally narrow universe of potential stock rec
ommendations, unless that multiple (known as the
Price Earnings Growth or PEG Multi
ple) is exceedingly generous. In the early 1990s one could find
plenty of good growth stocks trading on PEGs of around 1. Slater has recently been tipping shares on
PEGs of around 1.5.

That is not to say that the PEG theory is not valid, but only if used
loosely to eliminate those shares

that appear to he grossly overvalued.
* The Red Hot Value Investor’s Guide to Ultimate Stock Market Success *
*
18
*

Those quality stocks that appear to he sitting on generous PEG multiples of well over 1.5 are worth
monitoring, because
-
should their share price retreat over time or they are dragg
ed down with the
rubbish during an overall market correction
-
they could well come back into buying range.

However, that is for the long term. In the more immediate term, it is the job of
Red Hot Value Investor
to identify those stocks which have passed
more rigorous filter checks, which offer the potential for
delivering significant and sustainable long
-
term earnings growth, and whose value is not yet
discounted in its share price.

By using the proven filter methodology and buying only on sensible valu
ations there is no reason why
the winning streak should come to an end.
Assessing the true value of a company

As stated earlier, another form of valuation can be conducted by assessing the true value of a group.

At the back of the annual report you will f
ind a schedule of subsidiary and associate companies
valuations. These can be used to re
-
value a company and to assess that value relative to its share
price. If the share is trading at less than the re
-
calculated value, the market has valued the company
a
t a discount to its underlying assets and, if higher, at a premium to underlying assets.

Once the assessment has been completed, the question is to to assess the reasons for such a
discount or premium. Usually, the assets are undervalued because such valu
ations was done years
ago. Another problem is that a Balance Sheet is a snapshot in time, but values change constantly.

Here is how you go about re
-
valuing a company.
Step 1: Re
-
value the group’s listed assets.
Take a holding company’s percentage stake
in its
underlying companies and calculate the value of its investment at the current share price. Repeat this for
all its listed divisions and add these to get a total value.
Step 2: Re
-
value the group’s unlisted assets
. The value of subsidiaries and ass

ociates will either be
at book value or directors’ market value. A list of the holding company’s percentage holding in those
companies is also stated here. Now, look at the values and consider if these are realistic
–
were they
valued recently or years ago
? If you believe these are realistic, use the figures. If not, take the
attributable profit of these underlying assets and multiply that number by the sector price earnings (if a
media company, use the Media Index and so on). This will give you a realistic
value for this entity.
Repeat the exercise for all underlying assets and total these up.
Step 3: Re
-
value the group’s net cash to debt.
Take the last annual report (final or interim) and work
out net cash to debt.
Step 4: Work out the total shares in is
sue.
Add up all the shares, including ordinary shares, N shares,
Preference shares and debentures.
Step 5: Calculation of True Net Worth of a company.
Add the values in step 1, 2 and 3 and divide this
by the value in Step 4. The figure is the re
-
calculat
ed value of the company per share. If this is higher
than the share price, the share is trading at a discount, if lower
–
the share is at a premium.
The following is a fictitious example: Recalculation of International Finance Ltd [IF]

* The Red Hot Value Investor’s Guide to Ultimate Stock Market Success *
*
19
*
A
Net Worth Calcu
lation [ (1+2+3) ÷ 4 ]
(R)
56.17
B
Share Price (live)
(R)
32.00
C
Premium/(Discount) [ (B ÷ A) expressed as % ]
(%)
(43.03)
1. International Finance Ltd’s
Listed Investments
IF’s listed
divisions
Listed entities’
Issued Share
capital
Held by
International
Finance Ltd
Share Price of
listed entity
Actual

Value
% of
Total
Net Worth
Value of
entity
million
%
million
Rands
R’million
%
R/share
Banco de Brazil
500
75.00
375
12.00
4,500
45.8
25.7
Columbia White
200
10.00
20
5.00
100
1.0
0.6
Total Listed

-
-
-
-
4,600
46.8
26.3
2. International Finance Ltd’s
Unlisted Investments
IF’s unlisted
investments
% Held by
International
Finance Ltd
Division’s
Total
Earnings
(Rm)
Division’s
Attributable
earnings
(Rm
Estimated
Price:Earnings
(tim
es)
Estimated
Value (R'm)
% of
Total

Net Worth
Value of
entity
(R/share)
Printers Co.
100
200
140
20
2,800
28.5
16.0
FreeTown News
50
120
84
35
2,940
29.9
16.8
Total Unlisted
5,740
58.4
32.8
3. International Finance Ltd’s
Other Investments, Net c
ash to debt position
Estimated
Value (R'm)
% of

Total
Net Worth
Value of
entity
(R/share)
Debt (net of cash)
-
110
-
1.4
-
0.78
Net other working capital
-
400
-
4.1
-
2.3
Total
-
510
-
5.2
-
2.9
4. International Finance Ltd
Share Capital
1. Ordinary share
s in issue

100,000,000
2. Preference shares
50,000,000
3. N
-
Shares
25,000,000
TOTAL SHARES IN ISSUE
175,000,000
VALUE OF
INTERNATIONAL FINANCE LTD

Total [1+2+3]
R9,830 million

Per Share [ (1+2+3) ÷ 4]
R56.17
* The Red Hot Value Investor’s Guide to Ultimate Stock Market Success *
*
20
*
Explanation of example

Internati
onal Finance Ltd has a current share price of R32.00, but a re
-
calculated Net Worth of
R56.17, which means that the company’s share is trading at a 43.03% discount to its true worth.

In calculating its true worth, current updated market values for its lis

ted entities were used, while a
realistic price earnings ratio for unlisted divisions was assessed and used to calculate net worth.

The net worth
was thus as follows:
1.
Listed Investments
R4,600 million
2.
Unlisted Investments
R5,740
million
3.
Other Investments, Net cash to debt position
(R510 million)
TOTAL VALUE (addition of 1,2 & 3)
R9,830 million

Calculation of Premium/Discount
was thus:
1.
Total Value
R9,830 million
2. Total issued s
hare capital
175 million
3. Total Value per share (1 ÷ 2)
R56.17
Premium/Discount Rating (R56.17 ÷ share price of R32)
(43.03%)


The model also identified that the unlisted entities represent R32.80 of the net worth of Internat
ional
Finance Ltd. This is slightly more than the value of International Finance Ltd’s share price.
* The Red Hot Value Investor’s Guide to Ultimate Stock Market Success *
*
21
*
Chapter Three: Special situations
Too many investors look for Special Situations
–
trying to identify the next Big Thing
–
often resulting i
n a specific industry becoming popular. That popularity will always be
temporary and, when lost, investors won’t return for many years. Templeton Value
Investing saying.
Both Jim Slater and Warren Buffet are notoriously wary of what might be termed spec
ial situations
-
those stocks that fail all conventional valuation methods, especially rigid systems such as the PEG
theorem. Generally
Red Hot Value Investor
would be inclined to agree that sectors, like bio
-
technology,
e
-
commerce and software development
, are unnecessarily risky. Why risk your hard

-
earned cash on
what could ultimately be a gamble, when you can be fairly sure of making excellent returns from
relatively low risk
-
, and certainly low downside
-
investments elsewhere?
It is a valid question
. The answer is to invest only when you feel you are in possession of specific
information that gives your investment strategy an edge over the wider market. At
Red Hot Value
Investor
we have excellent connections in the hi
-
tech and biotech worlds and in o
il exploration, another
sector where conventional investment criteria such as PE ratios or operating margins mean absolutely
nothing. Of course, such investments will always be subject to unusual risks. As such, all investment
recommendations will always b
e flagged as being only for speculative investors, for those seeking some
real excitement, thrills with the risk of spills, for a small portion of their portfolio.
Perhaps the most obvious example of a special situation is the shell, a company best define
d as a trivial
business
-
or more often than not a previously viable business that has collapsed
-
which is then taken
over and transformed into something more significant.

Essentially, a shell’s only assets are likely to be its stockmarket quotation, it
s shareholder list, possibly
some inherited tax losses, and the intangible value of a new, dynamic management team that has been
brought in to create shareholder value. By far the greatest gains come from investing in a shell during its
early stages, befor
e it becomes “just another company”, and as the wider market slowly comes to realise
the transformation that is taking place.
There are of course various approaches to investing in shells. One could merely trawl through various
directives identifying suit
able target companies and waiting patiently for something to happen. Perhaps a
company doctor will be inserted by shareholders to find some deals to help create a new company.
Alternatively, a private company may wish to use the shell as a vehicle to achie
ving a Stock Market
quotation. This would be engineered by a reverse take
-
over, the shell buying the private business in a
reverse take
-
over. Either way, it could prove a long wait before the randomly chosen shell starts to
deliver some value and excitemen
t for you, the speculative investor.
Red Hot Value Investor
would rather use our extensive market and industry contacts to warn you of
situations where a new management team with a proven track record is already in place. Although that
might have caused s
ome uplift in the share price, it is more than probable that the real gains will be
made when the new directors start to do their first few deals. Thus, there will still be big profits to be
made and, hopefully, you will not have to wait too long to see th
em.
* The Red Hot Value Investor’s Guide to Ultimate Stock Market Success *

*
22
*
Chapter Four: Stop
-
loss, profit taking and top slicing
In the current volatile market in which South African find themselves, it is not unusual for investors to
wake up to find that the value of a whole swathe of their shares has fallen dramaticall
y in just one trading
session.
One solution to that problem is to apply a “stop loss” to all or some of your portfolio. That is to say, you
set a pre
-
ordained selling point that is triggered if the share price falls through it and thus acts as a
mechanica
l aid to selling decisions. It is a strategy advocated very convincingly by Michael Walters,
currently the deputy City Editor of the
Daily Mail,
and one of the few financial journalists writing today to
command any respect in the City.
Stop losses are var
iable and are set as a percentage of the current share price. With a share trading at
100 cents, for example, a typical 10% stop loss would be set at 90 cents (100 cents minus 10% of 100
cents, i.e. 10 cents). As the price rises so too does the stop loss.
So, should the shares hit 120 cents
then the stop loss would increase to 108 cents (120 cents minus 10% of 120 cents, i.e. 12 cents).
However, remember, although stop losses can rise they never fall in any circumstances. So, in this case
if the shares fa
ll to 110 cents, the stop loss remains at 108 cents, and if they then subsequently fall by
another 2 cents you sell at once.

The point of setting stop losses

Firstly, that you never bail out while shares still have upward momentum (remember, let the tre
nd be
your friend) since selling decisions are triggered only by a downturn in the long
-
term growth pattern
not by your personal, and thus irrational, concerns.

More importantly, a stop loss system stops you from holding onto investments in situations whe
re it is
rapidly becoming apparent that you have, for whatever reason, made a mistake or where unforeseen
circumstances have moved against you. We all find it hard, whether as investors ourselves or as
share tipsters, to admit that we have goofed. But if w
e do err, it is usually prudent to cut our position
and minimise the loss before the situation deteriorates further. Applying a stop loss forces us to do
that.

The problem is to decide where stop losses should be set. At 10% the trigger is relatively sens
itive
and could mean that
-
especially in today’s volatile markets
-
you cut positions erroneously. Your
trading volumes will be relatively high (which will make your commission hungry broker very happy)
and you will let some real long
-
term winners escape
your clutches. On the other hand, you will

always avoid the real horror stories.

Alternatively, some stop loss practitioners would advocate setting a tripwire at a relatively insensitive
level such as 50%
.
This will
-
we hope
-
rarely be triggered and, if
so, only to ensure you avoid real
catastrophes. However, unless you also take a relatively pro
-
active attitude to weeding out other
perennial laggards (but not outright disasters) within your portfolio you could find yourself lumbered
with some perennial u
nder
-
performers. The 50% tripwire will in affect, not absolve you, from that
tough decision of when to sell the investment that, while not crashing, does not perform.
* The Red Hot Value Investor’s Guide to Ultimate Stock Market Success *
*
23
*

The level at which you set a stop loss position is thus very much down to your own attit
ude to risk. If
you are innately cautious you might tend towards 10%, the more speculative among you might head
towards 50%
. Red Hot Value Investor

constantly reviews all our recommendations and will update
our investment stance in the light of any share p
rice weakness. But while every investor should not
only set their own stop loss rules, and stick rigidly to them, it is not for us to dictate to you what
should be your attitude to risk. Therefore,
Red Hot Value Investor
will not publish standard stop
-
loss
figures on our recommendations.

Whether to take profits, or not, is the subject of almost as much debate among investors as the right
level for setting stop
-
losses, although it is a rather more enjoyable dilemma to face.

One theory is that one should al
ways sell the losers within your portfolio and hold onto the winners
for the long term. There is some statistical backing for this strategy. The US investment guru James
O’Shaughnessy has shown that over a 40 year period those stocks that lagged their peer
s at the
beginning continued
-
on average
-
to perform poorly relative to the stars in any other given
timeframe of several years.

But, on the other hand, in the long term we are all dead. At a certain stage you may wish to realise
some gains. Perhaps, mo

re importantly, the sensible investor realises that overall market sentiment
can be fickle and volatile and that underlying economic and political conditions may change.

When reviewing the state of your portfolio it is always worth asking: would you inves
t in this particular
stock now, even after it has soared in value, at its new higher price? If the answer is an unequivocal
“no” then perhaps your cash would be better deployed elsewhere.

While a sensible stop loss strategy means you avoid excessive expos
ure to the Stock Market’s
losers, it would be wrong to sell your entire holding of proven winners merely because the short
-
term
share price looked a touch overheated. The exception, of course, would be if you were convinced
that a cataclysmic change in sec
toral or market conditions was imminent. Even so, could you be
confident that you had called the timing of such a downturn completely accurately and were not
missing out on a little bit more out
-
performance?
Top Slicing

The
Red Hot Value Investor
advocate
s a sensible strategy of top
-
slicing. The golden rule is to sell
half your holding on a double. If a particular share doubles in value then, if you sell half your holding,
you will cover all of your initial cash outlay and so will be guaranteed not to lose

any money. If the
share price doubles again then consider selling another half.

That way you will have made a guaranteed gain of 100%. Thereafter, you can just leave your shares
to soar and not worry what happens next, because you have already banked a
massive gain.

The more cautious investor might not wish to wait for a double and may wish to top
-
slice when sitting
on a gain of say only 66% and should such a strategy suit your individual risk
-
profile no
-
one can
argue with you. That is because you canno
t lose money on realised gains.

In South Africa, the dilemma is compounded by exchange controls. While at present investors are
restricted in their investments to South Africa, it is only a matter of time before you will be allowed to
invest offshore
–
in
to unknown territory. The hopes of gaining capital growth in dollars or pounds is
bound to attract many investors and, here, I recommend a rigid policy of both top slicing and stop
* The Red Hot Value Investor’s Guide to Ultimate Stock Market Success *
*
24
*
loss. It is difficult enough to invest in a familiar market, but into the g

lobalised world the risks mount
up quicker than the potential profits.

Intermittently
Red Hot Value Investor
will recommend selling out altogether, because we hear
rumours of an impending sea change. Sometimes that may appear premature, but it would be
prudent to warn you.
Summary

Your attitude to both stop loss strategies and to profits taking and top
-
slicing will depend very much
on your own attitude to risk and, occasionally on your need for cash and your own personal gearing.

Red Hot Value Invest
or
will advise, whenever appropriate, on cutting losses or, more usually, on
banking some of your gains. You may, however, wish to pursue a more aggressive or cautious
strategy than the one we outline. That is your choice, but it would be foolish to ignore
the potential
offered by stop loss and top slicing theories when managing your portfolio.
* The Red Hot Value Investor’s Guide to Ultimate Stock Market Success *
*
25
*
Conclusion
Contrary to what some pundits may have you believe, investing sensibly does not mean backing just dull
multinationals like Old Mutual or Liberty Life.
After all, some have issued quite ghastly profits warnings in

the last few years that saw their share prices virtually collapse. If you really want security and are happy
with minimal returns, leave your cash in a building society deposit account and hope
for a conversion
windfall.
We at
Red Hot Value Investor
believe that our readership is looking for a little more excitement and
much greater returns than those offered by these conglomerates. That does not mean that investing in
smaller company shares is
like gambling. A sensible spread of investments that have passed the
Red
Hot Value Investor’
rigorous stock selection procedure should deliver significant returns.
We admit that there will be occasional flops, because no matter how perfect any system or
share may
seem, it is always vulnerable to unexpected developments. We cannot pretend that all the shares we
recommend will be big winners and that there will not be the occasional upset.
However, we can spot companies for you with strong management, sou
nd products, healthy finances
and that appear to be well positioned for growth. If you buy a decent selection of shares you may not
strike gold at once, but you can realistically expect to increase the value of your portfolio over time. That
is something t
hat the
Red Hot Value Investor
is here to help you achieve.
One last piece of advice

Never change long
-
term strategy based solely on short

-
term market performances. Many traders
have such an ego attached to their trading skills that they cannot handle lo
sses. Several losses in a
row are devastating, which causes them to evaluate trading methods and systems based on very
-
short
-
term performances.

Statisticians tell us that there is no statistical reliability to a test unless you have 30 events to
measure.
Thus, the investor who chucks his system after four losses in a row is doomed to spend his
trading career changing from one system to another.

An investor should never start trading a system, that he has devised, based on only a few trades. In
addition,
investors must be wary of loosing confidence after a few disappointing trades. Performance
should be evaluated on many trades and only after three years of results.