In recent times, I had purchased a stock called Penguin International. Then it was 20+ cents and had price earnings and free cash flow ratio in the low single digits. It was a value investor's dream reporting strong growth and was priced attractively at its reported numbers. However, the share price has moved south and is now at 12 cents.
I had overlooked the fact Penguin's earning could be affected by a downturn. Penguin’s customers were companies in the oil & gas industry. Unfortunately, a downturn did happen and now deliveries and orders for its vessels has slowed. As a result, lesser revenue was recognized with increasing inventories. Penguin’s profitability only decreased one year after the slump of oil price.
This episode showed how reported numbers are merely the rear view mirror of a car; no matter how good they are, what matters is where the road is heading to. And to learn about the future earnings of a company, it is down to our ability to comprehend the industry's outlook. This is particularly true for cyclical industries such as: Oil gas, Property/REITS, Commodities and Shipping.
For example, while local properties companies have reported slightly increased profits, their share prices have stagnated or declined. This is likely due to their revenue recognition method. Majority of revenue currently recognised are for residential projects which had been sold in 2011/2012. Their Singapore segment will experience a decline later as residential sales had slowed since 2013. This too is applicable for Sembmarine and Keppel, where order books are only starting to decrease only a year after the oil slump.
Hence when investing in cyclical companies, it is always important to understand where the industry is heading before investing. While the financial ratios may look good at the current share price, there may be a reason why Mr. Market is still pricing the company at a low figure.