De-coding 4C reporting season with pro investor Josh Baker
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4C reporting season is upon us, which means a deluge of quarterly filings as ASX small caps race to meet the January 29 deadline.
The 4C is a useful scoreboard-check for companies with tight cash-flows.
But apart from the usual metrics (e.g. the cash balance compared to the prior quarter), how can investors use them to get an edge?
We got the rundown this week from Josh Baker at Capital H Management, for insights on how a pro investor uses 4Cs as part of their investment strategy.
When it comes to 4C reporting season, which companies actually have to file one? It’s all about cash-flow.
Cash-flow statements have three components — operating cash-flows, cash-flows from investing and cash-flows from financing activities.
Operating cash-flows give an important read on a business because they summarise the key input (cost of goods, cost of staff) costs required to generate revenue.
If a company’s operating cash-flows are negative, the ASX rules dictate they must file a 4C.
To free themselves of the 4C reporting burden, companies need to book positive operating cash-flows for four consecutive quarters.
“You could be a concept stock where the price gets rammed to the moon. But if you’re not generating revenue, you’ll be doing 4Cs forever,” Baker said.
Baker added that 4Cs are a useful way of uncovering reporting inconsistencies, a “pet peeve” of his in the microcap space.
“They might sign a contract and talk about ARR (annual recurring revenue), but then the next three quarterlies they have no cash. Or there may be trial periods then the ARR drops off. So I’m looking for those inconsistencies.”
Baker says when you’re fresh to a stock, “it’s good to go back and see what metrics they’ve been reporting (in previous 4Cs)”.
“If they start leaving things out you’ve got to work out why. It’s important to keep tabs on how they evolve and what’s missing from one quarter to the next, because usually it’s telling what they don’t choose to talk about.”
Baker contrasted that chicanery against a positive example — US-focused SaaS business Pushpay (ASX:PPH).
The metrics in Pushpay’s 4Cs are “the same every quarter. Customer numbers, ARR, transaction volumes — it’s all consistent so you can track the business,” Baker said.
“That’s what a tell a lot of smaller companies I work with — work out what numbers are important to the business, and stick to them. No matter how good or bad they look.”
One of Capital H Management’s portfolio positions is in Schrole Group (ASX:SCL), the HR-tech platform for international schools.
“Working in the international school sector, most of their revenue is in US dollars, so that’s what they report in.”
“Just getting all those metrics consistent is a good ‘tell’ for a company, because you know they’re trying to be professional about it.”
In line with the importance of consistency, each filing in 4C reporting season “shouldn’t be looked at in isolation”, Baker said.
Tracking 4Cs over time gives you an opportunity to piece together the operations of a business, and build a more sound understanding.
In other words, it’s a useful way to DYOR (do your own research).
“The first thing is you’ve got to actually have expectations of what the numbers might look like,” he says.
And you can’t establish expectations with doing some background research. “Make sure you understand the business model — how their accruals work and the timing of when they receive cash from contracts”.
As an example, Baker pointed to the software-as-a-service (SaaS) sector — an investor favourite which counts a number of ASX small caps looking to scale recurring-revenue business models.
“They might announce the contract, but then it will be 3-6 months until the service is implemented. So they book the revenue, and then you can use the 4C three months later to see if they’ve collected the cash.”
Also, keep an eye out for companies looking to overstate the importance of once-off cash injections such as R&D grants or tax benefits.
“Say they have an uplift in work — depending on the timing of the tax payment on your BAS (business activity statement), you can punch out a really strong cash flow number. But in the next quarter you can get a reversal.”
“So again, with the timing around payments you have to look at it in conjunction with prior quarterlies.”
“When you’re assessing those numbers, you need to ask — what’s the previous outlook from the company, and are they living up to that narrative? That’s really important for microcaps,” Baker said.
“As part of that, you’re looking at entire peer set — is there an organic growth tailwind that they’re all benefitting from?”
“In that context it’s not just 4Cs — you’re also looking for trading updates from mid-cap or large cap stocks that are operating in the same sector.”
“For example in online retail everyone benefitted, we know the tailwind’s there. And that’s when it comes back to what the expectations are.”