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Why today’s 15% plunge attracts me to this falling knife

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Shares in small-cap Renold (LSE: RNO) slumped by as much as 15% in early deals this morning after the company issued a poor trading update. 

Renold, which manufactures and supplies chains as well as power transmission products, revealed today that management now expects adjusted operating profit for the year to 31 March 2018 to be slightly below the lower end of the current range of analyst forecasts. 

While the company does not say what the current range of forecasts is within the release, according to my research, City analysts had been expecting it to report earnings per share of 5.3p, up 16% year-on-year. 

Short-term headwinds 

It looks as if rising costs are to blame for Renold’s deteriorating outlook. The Torque Transmission division delivered growth in underlying revenue of 6.3% during the period and including the major project win for UK Couplings, underlying order intake increased by 27.4%.

Meanwhile, the Chain division delivered strong year-on-year underlying revenue growth of 8.2% in the first fiscal quarter. However, a major machine breakdown at the group’s Germany facility reduced the availability of key product lines increasing shipping and maintenance costs to mitigate the impact on key customers. As a result, revenue for the second quarter declined 4.5%.

Higher materials costs have also compressed group margins. While management is increasing prices to try and offset the impact of these costs, margins have come under pressure from the lag between raw material increases being incurred and sales price rises working through the order book.

It now looks as if Renold has controlled these issues, and the actions should begin to pay off in H2. Commenting on today’s trading update, Robert Purcell, Chief Executive, said: “It has been a frustrating first half for the Chain Division. Organic growth opportunities, particularly in Europe, have been converted but have failed to deliver the expected improvements in profitability due to issues at Einbeck and the rise in raw material prices. Management actions to address these issues are expected to benefit the second half of the year.”

It could be time to buy

As the company pushes ahead, I believe that today’s declines present a great opportunity for long-term investors to get in on Renold’s growth story. As noted above, the first half headwinds only seem to be temporary, and higher sales prices, as well as the restoration of the German facility, should mean business as usual during the second financial half. 

And even though management is now expecting the company to miss full-year forecasts, the shares still look cheap on revised figures. Assuming the firm misses the City consensus target by 10%, according to my calculations, Renold is still on track to earn 4.8p per share for the year to March 2018. This gives a forward P/E of 9.6 at a share price of 46p.

If it returns to growth and hits City targets for the following financial year (analysts are currently projecting earnings of 5.8p per share) the shares are trading at a 2019 P/E of 7.9 — a valuation some investors might find too hard to pass up. 

Bottom fishing 

Catching falling knives is a risky sport. If you don't do your research, you can end up with blood on your hands. 

With this being the case, many investors don't like to buy stocks like Renold. If it is not for you, you should take a look at this opportunity from the Motley Fool, which we believe to be one of the market's top small-caps.

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Rupert Hargreaves owns no share mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.