Further thoughts on McMillan Shakespeare
We posted last week an article that set out some of our thoughts on McMillan Shakespeare (ASX: MMS), and the logic that led us to add to our position following the precipitous price drop last week.
We expect it may be a bumpy ride from here, but we are very comfortable with the decision to buy MMS on the open last Thursday (subject of course to new developments). However, judging from some of the comments and feedback we have had, it seems like there is some merit in an additional post, specifically focused on the risk management aspects of a decision like this.
Firstly, it needs to be acknowledged that there is a significant level of risk in this investment. If the proposed changes to FBT regulation are implemented, they will have a devastating effect on MMS’s business. It is possible to envisage a $5.00 share price in that scenario, which would indicate a 30 per cent loss on investment in a short space of time. This is an uncomfortable downside scenario.
At the same time, we need to consider the upside. Our analysis last week led us to think that, if the changes were not implemented, the business would survive largely intact. For the sake of argument, let’s ascribe a $16.00 per share valuation in that scenario.
Some commentators have argued that even if the changes are not implemented, the market will de-rate MMS shares as a result of the recent scare. That may be so, but we are value investors and we don’t try to guess what the market may do. What happens in the short run is anyone’s guess, but in the long run we believe that price follows value, so we try to stay focused on value.
To estimate the value of MMS shares in the face of these different scenarios, we need an estimate of the probability attaching to each scenario. If we ascribe, say, a 20 per cent probability to the changes being implemented, the value can be calculated as 20 per cent x $5.00 + 80 per cent x $16.00 = $13.80.
We can debate the scenario probabilities and the scenario valuations (perhaps in a third article), but for the sake of this discussion, let’s take it as given that the probability weighted valuation is significantly higher than the current share price, even though there is a real prospect that the “bad” scenario unfolds, resulting in a material loss on investment. What does a risk-averse investor do in these circumstances?
The critical point to understand is that risk is not inherently bad. Risk that is not adequately rewarded is bad, but risk that is well-rewarded is good. Risk that is well-rewarded is something that investors should seek out.
One way to see that this is a good risk is to consider what would happen if you had the opportunity to take a large number of independent trades of this kind. Some of the trades would lose, but many would win, and the overall result – on average – would be $13.80 of value for a $7.00 investment. In this light, it becomes clear that this sort of trade is not “gambling” – it is a very rational investment where the odds are stacked in your favour. If you could fill your portfolio with investments like this you would be silly not to.
In practice, we may not have a large number of investments like this available to us at any one time, but over a lifetime of investing we will certainly face a number of comparable decisions. If we can approach each one rationally, then in the long run we can expect the law of averages to work in our favour.
The final point to address is portfolio construction and position size. Even good risks need to be managed, and it would be unwise to bet everything on an investment with a significant chance of going bad. However, if we allocate a sensible fraction of our capital to each opportunity, then we can be in a position to absorb the losses as they occur, while gaining the benefit of those that succeed.
Taking on these sorts of investments exposes us to the risk of short-term underperformance, but being willing to accept this means that we have a good chance of doing well over the long term.
As professional investors, that is what we should be doing.
Montgomery Investment Management owns shares in McMillan Shakespeare.
This article is the first in a three part series on McMillan Shakespeare. Click to read part one and here for part three.
To find out more about investing with Montgomery Investment Management, click here. To request an information pack, click here.
This article was written on 30 July 2013. All share and other prices and movements in prices are to this date.
Tim joined Montgomery in July 2012 and is a senior member of the investment team. Prior to this, Tim was an Executive Director in the corporate advisory division of Gresham Partners, where he worked for 17 years. Tim focuses on quant investing and market-neutral strategies.
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.
Les Smith
:
MMS has become a volatile stock with an uncertain future. It started wIth the announcement of the Henry tax review (at which time I sold out) and re-kindled by K-Rudd. I understand 30% of its salary packaging + revenue comes form one client – the Queensland State Government. Hardly reliable. Plus, it seems, some $160 million has been paid out to directors / managers as ‘remuneration’ entitlements over the past four years. Thank goodness its business model has been diversified and strengthened by the purchase of the Holden floor plan business. Not enough to excite me.
Roger Montgomery
:
Thanks Les,
Its always useful to receive a well-articulated argument against.
cameron happ
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What’s the correct play from where we have got to now. With the shares rising anything between 70-80% depending on where you got in on the big drop day, is it now time to sell out and take an amazing short term profit, and take all the risk off the table?
Roger Montgomery
:
We’ll leave that decision for you and the rest of the blog community to debate. While our entry might have been around the 7.25 mark, we’re not clever enough to trade like that.
Colin Petersen
:
I’ve been mulling the same dilemma Cameron. The first conclusion I’ve reached is that I don’t think there’s cause to rush to sell as it’s likely we will continue to see (slower than recent) upward movement as the election draws closer and the ‘no change to FBT’ outcome becomes more certain (assuming election polling remains relatively unchanged).
If you accept that, then the next questions that you now have an unhurried few weeks to assess are:
i) What are the future prospects of the MMS business?
ii) What are the short-mid term prospects of the MMS share price?
iii) What personal factors exist for you (e.g. CGT implications, how MMS fits into your overall investment strategy)?
My current thoughts are:
Re: (i) I have concerns for MMS in the mid-long future as I think the Coalition government may revisit Rudd-like FBT changes in search of revenue. MMS has an established history of being an excellent business but recent events have shown the risk they are exposed to and that they have very little control over.
Re: (ii) I think it’s highly unlikely that in the short-term the share price will recover to previous ~$18 levels as this scare will cause the market to re-rate legislative/sovereign risk and MMS won’t trade at the same PE as it did previously, so the question is “if not $18, where *will* it get to?” My estimate is ~$13.50-14, with more risk on the upside than down. We may see a drop post-election if people who bought last month cash in after the election (assuming Abbott wins) but I expect that drop would only be short-term as the increased certainty of the election result should similarly bring back some of the risk-averse who sold recently. Another factor to provide support is that as the share price recovers some instos that sold will rebuy to rebalance as MMS’ index weighting grows again. MMS reaches $1bn market cap at a share price around $13.30 and milestones like that can also trigger some insto mandates.
Re: (iii) This will vary from person to person, but CGT implications seems like a big factor.
Hmm, well I didn’t set out to write an essay, but those are my current thoughts :)
Roger Montgomery
:
Thanks for taking the time to articulate your thoughts so comprehensively Colin.
Rj
:
This is exactly the type of forum I’ve been hunting for- great analysis and insightful comments. I note that one reader said an arbitrage opportunity may exist here by buying shares in the company and backing labour, which is now paying out at 6 rather than 4 dollars. My only concern is that it’s not a perfect arbitrage opportunity- according to the diagram there is still a 5% risk that the changes get passed even if the coalition wins, which would be a double loss on the shares and the bet. Cheers
michael stait
:
there is an arbitrage in the MMS scenario if you are convinced the libs will reverse this [no guarantee] you buy MMS with the hope the price rises to say $12-13 and simply ring your local bookie and back LABOR to win at about $4
Roger Montgomery
:
Nice Michael. The ‘hoping’ part is the only weak link in the trade…
michael nordin
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Thanks not only for your tremendous insights on a company, Roger, but also for the great probability tree. I hope you don’t mind that I shared it with my year ten maths class, along with an opening chat into shares and a plug for your company! Amazingly timely, as we studied probability trees just two days earlier.
tim kelley
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Your comment made my day, Michael. Delighted to hear our work was able to be put to such good use.
David White
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Doesn’t buying MMS at this point in time equate to speculating?
It seems to go counter to an article you distributed today on Facebook about Value Investing V Speculating.
Roger Montgomery
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probability weighted valuations aren’t speculations but the Bayesian probability idea is subjective…
Ian Giraud
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Thanks for the article and the example of a rational approach to analyising risk. Personally, I don’t see the problem with allocating a small proportion of your investment portfolio to such an investment. The key thing is that it is a small position….
gavin clarke
:
A company with such a long term excellent record may suffer in the short term from the current political uncertainty. However, these “reforms”have yet to be implemented,and even if they are,the world is not going to change overnight.There are always new interpertations being made on any “law”.I agree, they are a good long term buy as a result of overselling.I have added them to my portfolio, albeit not at your lower price.
Jarrod Cook
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Roger, I am a little perplexed.
Contained within your book, and talked about many times by you on this insights blog, is the requirement to invest in stocks with little to no debt.
My calculations of MMS show a debt/equity ratio somewhere in the 90% range. To my thinking, this is considerable debt, and especially so when there is a real risk of a large proportion of revenue being affected by regulation.
I would have thought that this level of debt alone would eliminate MMS from your fund?
Roger Montgomery
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Hi Jarrod,
This is a finance company! Think banks…
Jarrod Cook
:
Thanks Roger.
My next problem is the diversion from buy at a discount to intrinsic value. I cannot for the life of me get to a valuation around the levels Tim’s article indicates that the fund bought at. I would think that high debt and regulatory risk would suggest a reasonably large required return when calculating Intrinsic Value (IV). Even at $15 to $18, in a perfect world, it seemed overvalued to me.
Is it possible the first purchase was a bit of blunder?
Jarrod Cook
:
Thanks Roger.
My next problem is the diversion from buy at a discount to intrinsic value. I cannot for the life of me get to a valuation around the levels Tim’s article indicates that the fund bought at. I would think that high debt and regulatory risk would suggest a reasonably large required return when calculating Intrinsic Value (IV). Even at $15 to $18, in a perfect world, it seemed overvalued to me.
Is it possible that the first purchase was a bit of a blunder?
Roger Montgomery
:
The company is a finance company. Perhaps you could try to think of the debt as working capital.
James
:
If buying is the rational thing to do, then does this mean if you don’t buy, you must be considered irrational? I may have been very irrational, as I have not bought.
Yavuz Atasoy
:
To me the key sentences in this article are ” Risk that is not adequately rewarded is bad, but risk that is well-rewarded is good. Risk that is well-rewarded is something that investors should seek out”. If we want 100% certainty then should we go to cash, bonds, or whetever is perceived to be at 100% certainty at the time? As we have seen lately there are different risks attached to all of these alternative investiemt options, including do-nothing, or wait and see approach. I do not think any investment is 100% safe. It is all relative, depending on what we mean by safety? Understanding risk can be challenging, and may require us to overcome over own beliefs, biases, etc..
Andrew Legget
:
Very good points Yavuz. Nothing is 100% safe. Cash under the mattress can be lost, bonds can default, stocks can and will rise and fall, property prices can fall, you can lose tennants and the buidling itself can be damaged, gold is more a religion than investment and art is very subjective. It is easier to look at the investments which just don’t look good from any viewpoint (airlines, car makers and sports teams come to mind) but that leads me into my next point.
What the posts about MMS show is a way that Roger and his team use to try and eliminate what you say, “bias”. It is eaverywhere in investing and people need to understand that it exists and overcome it. Not enough is said about bias in investing but is something we need to deal with as it drives everything we do in a way. I don’t value companies due to some type of intellectual exercise, i do it because i believe it may be undervalued and an opportunity to make money (bias 1), i then plug a bunch of variables in to come up with a figure and without a rational framework for these numbers it is easy to plug in growth rates that match your biased expectations (bias^2) which will of course match the viewpoint i had at the beginning (pepertual bias).
There can never be any certainties but by making your decisions based on some form of non-subjective point of view you are more likely to come up with a outcome that is closer to reality than plucking things out of the air. Then we use the wonderful thing called “big margin of safety” as an insurance policy to cover us and make us look clever.
Lochlin
:
Roger,
The main issue I see with the assessment is the probability of parties winning the election.
Without talking politics I think an 80% chance of a party winning an election would be a stretch in most circumstances. Even the likes of Obama would have been a serious stretch at 80%.
Most of the other probabilities seem reasonable but this one seems excessively skewed.
Please correct me if there is some reasoning here I am missing.
Roger Montgomery
:
Indeed. They are subjective probabilities.
Colin Petersen
:
Lochlin I think what you might be experiencing is the common confusion between win probabilities and 2-party preferred vote. A 52-48 vote split does not translate to a 52% LNP win percentage, it equates to ~75% win probability (if the poll’s margin of error is 3%, which is a commonly quoted figure).
The reason for this is that the election is not one roll of the dice with 52-48 odds, it is a race to win a majority out of ~15million rolls of the dice with those odds, and the law of large numbers will tell you that when you run that many trials the final results tend to revert to the mean quite accurately; so the real variable is how accurate the polling results reflect the voting probability.
Famed US election stats blogger Nate Silver put Obama at 91% to win the 2012 election on the back of polling about 52% (http://tinyurl.com/bqamvub) …the US presidential race probabilities get more extreme much faster than our federal elections since there are only 2 voting options whereas we have more possible outcomes, but I think that highlights the big different between win% and vote%.
Enrico rumi
:
If Tony A wins, looks over the black hole in the budget he will inherit, do u think there will any effort/focus to restore the perks that will increase the hole and MMS business will go back to a “new” normal. (when my brother visited from the US a few years back, he queried why everyone drove new cars). If China craters and the market derisks, do you think MMS will be one of the stocks that stands up well with an uncertain future. Reckon you’ll see sub 7 again before 13. Good luck as they say when you walk into the casino.
doris.gonzalez.3114
:
Tim, I would be very happy to see you discuss further the scenario probabilities and scenario valuations.
From my understanding to date there appears to be three possible scenarios: 1) ALP win the election and take control of the Senate. 2) ALP victory but without Senate. 3) Liberal party victory. It would appear that only scenario 1 can see the proposed changes to the FBT enacted in full and in a relatively short period.
Though there are other risks even under a Liberal party victory such as a downgrade to 1H2014 forecasts and dividend due to the current uncertainty, but this outcome can also be counter argued that MMS could recoup most of these losses due to pent-up demand since the proposed changes.
I’ am sure there are many other risk worth mentioning such as what may happen under scenario 2, were the continued threat of change subdues the price for an extended period. But from the information at hand the greatest risk appears to be outcome 1 and given the current political environment this seems low.
Anthony Scelzi
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If I was a gambling man , I would be backing take on MMS. Having followed him for the past three years, his track record speaks volumes. I for one will be buying MMS.
Michael
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Before the government annoucement anyone investing in MMS must have thought that the probability of a change being proposed in legislation was sufficiently low to invest. With this judgement being wrong it would appear a little strange to then double down and roll the dice again.
The probability exercise may well account for all the ‘known unknowns’, but it may be that the ‘unknown unknowns’ will have an impact in the future. There must be easier ways to make money. I know there is a concern that there are not many opportunities at the moment, but I’m not sure that you need to convert the stock market into a casino. Good things come to those who wait.
The risks should not only be viewed as a small loss in the fund. The reputation of the fund will take a hit if this gamble does not come off.
Roger Montgomery
:
Unknown unknowns are the one constant we can be sure of always. If you genuinely believe the reputation of the fund hangs on one investment going right or wrong, we have wasted several years educating here at the insights blog and elsewhere. Let me say right now, just as a 100-to-1 nag can win a horse race, so Labour could win the election then pass the necessary legislation and MMS could fall precipitously…And it won’t make too much difference to the long term performance of the fund.