Ultimately, it doesn't matter how lowly rated a company is as you need a spark for the share price to rerate. The one most likely to act as a catalyst is the most obvious: an improvement in the trading performance on a relative basis year on year.
So to gauge how well a company is doing relative to how it performed six or 12 months ago, I meticulously go through the last 18 months’ interim reports, preliminary results statements and trading statements to work out the underlying trends and pinpoint key growth drivers. This includes anticipating what company-specific newsflow is set to be released over the coming months and estimating the likely implications for the share price based on a series of likely outcomes.
This can be a very useful exercise, not to mention one that can also be financially rewarding, especially for companies that have gone through restructuring and have slimmed down their cost base. That's because modest increases in sales can have a disproportionately large impact on profitability as the operational gearing of the business kicks in. As a result it can pay big dividends to buy into these special situations before other investors cotton on to the accentuated positive impact on profitability from an improved trading performance and prior cost-cutting.
A great example of this was home shopping retailer Ideal Shopping Direct (IDS), which had cut its cost base significantly and was generating cash profits despite reporting reported pre-tax losses. Add to this director share buying (see 'Follow the leader: director share deals' below) and this was good enough for me to recommended buying the shares ('Investing in an Ideal world', 12 October 2009) as it was a dead cert that any improvement in the company's sales performance would lead to a sharp return to profitability. Not only did this scenario pan out perfectly, but IDS succumbed to a private equity bid 18 months later ('Ideal offer arrives', 4 May 2011) to generate us a bumper 130 per cent gain on our investment.
