GT Advanced bankruptcy is a stark risk reminder

GT Advanced Technologies (GTAT) filed for bankruptcy on Monday and its stock proceeded to lose about 90% of its value.

There are several lessons that tech investors can take away from the news.

I’ll get to a discussion about GT and its failings in a moment. But right now, I’d like you to know three things:

1)    I don’t own GT Advanced Technology shares in the Crabtree Technology portfolio.

2)    I’ve never owned GT Advanced Technology shares in the portfolio.

3)    There are three reasons why it would be unlikely that a company like GT would find its way into the portfolio.

GT Advanced Technology is a New Hampshire-based company that develops and sells equipment that is, in turn, used to manufacture silicon, polysilicon (the underlying material in solar cells) and synthetic sapphire. Founded in 1994, GT recorded revenue over the past 12 months of more than $150 million.

Business unraveled

In late 2013, GT signed an agreement with Apple (AAPL) to outfit an Arizona factory with GT Advanced Technology’s equipment for the production of sapphire. After completion, the factory would be run by GT.

While unreported at the time, the plan was for the factory to produce sapphire for the clear touchscreens on Apple’s iPhone 6 and 6 Plus handsets.

Unfortunately for both parties, the prototype sapphire screens produced in the factory and provided to Apple didn’t have the desired attributes (better scratch resistance, in particular) the companies had been hoping for.

The new iPhones were released in September with screens from Apple’s existing supplier Corning (GLW) and Apple recently withheld a payment to GT. The now heavily indebted GT, lessee of a plant with no customers for its products, filed Chapter 11.

When I read the headlines about GT, I immediately looked at my quantitative model to see how well it scored. Or, in this case, didn’t score. First off, GT shares were trading at a price: sales ratio of about 10. Our hurdle is much, much lower – less than 25% of that. So it failed to pass our quant model for that reason alone.

Earnings misses

We don’t use a valuation hurdle for valuation; we’re not value investors. Rather, we use valuation as a proxy for fame. That’s because all things being equal, less famous companies outperform more famous companies. And with the luster from its association with Apple, GT was plenty famous.

Second, I noticed that GT had fallen short of earnings expectations in each of the last four quarters. We use this measurement as a report card on how well companies are executing on their operational and financial goals.

By itself, earnings ‘beats’ or ‘misses’ don’t say a lot. But when combined with other factors, like a company’s cash flow, it’s a strong indicator to us of how well a company can execute in the future.

And speaking of cash flow, I noticed that in my most recent model, GT had negative operating cash flow over the last year, and negative free cash flow over that time as well. Our investors and regular readers know that we’re really big on a company’s ability to generate cash.

Cash is the lifeblood of business. And we believe current cash flow is the strongest predictor of future cash flow. All companies selected for the Crabtree Technology model have positive operating cash flow over their most recent 12 months.

At Crabtree, we place a very high emphasis on keeping portfolio volatility low and that means foregoing exciting stocks with sexy stories and high profile partners (example: Apple) when they don’t meet our standards.

Risk capital

Make no mistake: no stock in the Crabtree Technology portfolio is perfect or is immune from under-performing.

Moreover, the news of a GT-type blow-up will affect the share prices of other, similar stocks, even the shares of companies that are performing well and in no apparent danger of a shocking development like GT’s bankruptcy. This is the stock market, after all. People are investing risk capital. We never forget that.

September was mixed for the Crabtree Technology portfolio. The portfolio fell 2.5% in the month, much better than the 6.2% decline in the Russell 2000 Index (RUT) but trailing slightly the -1.6% decline in the S&P 500 (SPX) benchmark.

Our internal benchmark, the Merrill Lynch Technology 100 (MLO) also fell 2.5% in September. The most widely held technology ETF, the State Street Global Advisors’ Technology Select SPDR (XLK) fell -0.5% during the month, including the effect of a dividend.

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DISCLAIMER: The investments discussed are held in client accounts as of September 31, 2014. These investments may or may not be currently held in client accounts. The reader should not assume that any investments identified were or will be profitable or that any investment recommendations or investment decisions we make in the future will be profitable. Past performance is no guarantee of future results.

The post GT Advanced bankruptcy is a stark risk reminder appeared first on Smarter InvestingCovestor Ltd. is a registered investment advisor. Covestor licenses investment strategies from its Model Managers to establish investment models. The commentary here is provided as general and impersonal information and should not be construed as recommendations or advice. Information from Model Managers and third-party sources deemed to be reliable but not guaranteed. Past performance is no guarantee of future results. Transaction histories for Covestor models available upon request. Additional important disclosures available at