Another Aussie Investing Classic.
I enjoyed the process of writing Value.able immensely and its best seller status suggests there’s a growing band of individuals in Australia who’d like to be successful value investors. If you want to become a successful investor or simply invest successfully, I believe it’s best to learn from those that have a demonstrated track record. As Buffett once observed, “Wall Street is the only place that people ride to in a Rolls Royce to get advice from those who take the subway.” One bloke who I count as a mate, a successful investor and who doesn’t need to take the subway, has written a book on investing that I think will prove to be a classic. Matthew Kidman and I were on CNBC together recently and knowing we were going to be on air together we happened to bring in our respective books, which of course we swapped. I have finished reading Matthew’s Bulls Bears & a Croupier, enjoyed it immensley and I commend it to you. If you were wondering what you were going to read over Easter, well now you have a very profitable suggestion. I am sure Matthew would love to hear what you think so be sure to return here and post your thoughts and questions.
Before I go, here’s an extract from Bulls Bears & a Croupier (pp173-176). It’s one of the many real life stories in the book and this one ties in nicely with our value investing and ROE methodology…
“ABC Learning Centres
I first met Eddy Groves in 2001. I was sitting at an outdoor cafe with Geoff Wilson when he came strolling down Macquarie Street with a stockbroker, planning to pitch the float of his childcare company, ABC Learning Centres. If memory serves me correctly, he was wearing a light grey suit with an open neck shirt. He didn’t quite fit the textbook profile of a CEO, with his shoulder-length blond hair and Cuban-heeled boots. When I said to Geoff, ‘Here they come’, he leaned over and said, ‘How are we going to invest with this guy? He looks like Johnny Farnham’.
Over the next hour Eddy, still only in his thirties, was subjected to a range of tough questions, but to his credit, he wowed us with his knowledge of the childcare business. At that stage the company only had 31 centres in its portfolio but Eddy knew every employee in every centre, every rental charge per square metre, the occupancy level of each centre, the waiting lists and so on. He was also disarmingly honest, telling Geoff and me straight up,‘The key to our business for the shareholders is the occupancy levels at our centres. If occupancy is above 90 per cent then we start to make a lot of money.’ He repeated that comment several times during that session and in many subsequent meetings. I have not met a CEO before or since that day who demystified a business so rapidly for incoming investors.
At first we weren’t convinced. Still sceptical of this young Queenslander, and never having come across a childcare operator that relied heavily on government spending, we decided to give the float a miss. Before the company listed on the sharemarket a couple of months later, I met Eddy at least twice more and said to Geoff that we needed to look at this company more carefully, because this guy really knew his stuff. Not many people were prepared to look at the company because it was so small, but I thought it fitted into our sweet spot — undiscovered and fast growing.
The stock listed and Eddy got busy buying more centres and spreading the gospel of his company to investors. He had enough energy to run a power station. It wasn’t long before the broader market discovered the company and its colourful chief executive. In those early days he worked exceedingly hard with only a handful of stockbrokers hovering around sniffing for fees as the company needed to raise capital to fund its endless list of childcare centre acquisitions.
Whatever Eddy Groves was doing, it was working, and the share price increased threefold in a short space of time. It was only then that we wilted and decided to help buy a parcel of shares in ABC held by Hunter Hall, who had profited nicely. Luckily for us, though, Eddy was only just getting started. His empire around Australia was expanding exponentially and over the course of the next year or so we watched our investment triple before our eyes. Things got so hot and steamy the company thought it necessary to split its stock to create more liquidity and give the impression it was not so expensive. The pièce de résistance was the merger with Australia’s other largest childcare centre manager — Peppercorn.
The brokers were now lining up to support the company, which was like a fee-generating machine on the back of so many capital raisings and mergers. ABC now stood at the top of the mountain.
Then the 20 per cent plus growth that investors had become accustomed to started to become harder to achieve. Eddy turned his attention offshore and before you knew it he had bought businesses in the United States, followed by operations in the United Kingdom. Following a series of capital raisings, the market capitalisation of the company had soared into the billions, while the PE kept travelling north to well above 20 times forecast earnings as investor interest started to emerge from all over the globe.
There had been some public detractors of the stock, including well-known analyst, market commentator and fund manager Roger Montgomery, who made the prescient observation that returns in the business had gradually declined over time as more and more acquisitions were made. He was, like Winston Churchill, a voice in the wilderness, with the share price rising each day as investors, including me, ignoring the financial fundamentals.
In 2006 I went to a presentation by ABC at a big brokerage firm where there was standing room only. I was lucky to grab a seat near the door but due to the size of the crowd I couldn’t see Eddy — but I could hear him. I had decided to come along just to get an update on the latest acquisition and find out how the business was travelling. There were a lot of new investors in the room asking questions that long-term investors had asked many times before, so I was guilty of not concentrating and reading something else. And then one person piped up and asked the question: ‘What are the occupancy levels of the centres in the US?’ Eddy replied that it wasn’t important to concentrate on occupancy levels. I nearly fell off my chair. Another person asked why that was the case and Eddie launched into a long-winded answer that didn’t really make much sense.
I didn’t stick around to hear the rest of the presentation, sneaking out the door that I was sitting near. I raced back to the office and as I walked in I said to Geoff,‘ We need to seriously think about selling our ABC Learning shares’. He said, ‘It’s fine with me’. We spent the next few days re-examining the accounts and we had a lot of questions, including what had happened to $400 million of cash that had seemingly disappeared. Fortunately for us the stock was still trading in tremendous volumes and we were able to sell our shareholding at slightly more than $7 a share.
As is well documented, ABC Learning hit the wall in 2008 when the GFC hit. The company, which had enjoyed investor support to the tune of more than $1 billion through a series of equity raisings, had somehow found a way to fall prey to a multi-billion dollar debt burden.
There were many lessons to learn from the ABC Learning experience, but the point here is that stocks can be in the limelight for days, months or even years, only to become a disastrous investment down the track. Invariably as a story spreads across the market and more and more people get interested, more exotic reasons are created to buy the stock. Stockbrokers will place price targets for the stock near the current share price level, and when the PE ratio goes from say 10 to a head spinning 20, the analysts will generally follow with their valuations of the business. Things like sagging returns and higher debt levels are conveniently pushed to the side by investors and brokers as they all get sucked into the vortex of a rising stock price. At some unknown time in the future the share price will reflect the financial fundamentals and start to fall. For the investor the hardest aspect is timing when this will happen rather than if it will happen.
Our croupier Peter Proksa learned this the hard way. In his bid to avoid paying too much for a stock he has limited his investments to shares or options that trade at 1 cent of less. This method also removes the possibility of his becoming enchanted by the story rather than concentrating on the facts presented in the accounts.
The reality was, however, that if you were onto the ABC Learning story early, like the Hunter Hall investment team, then you could have made many times your money. The key was seeing that things were changing and working out when to sell. Roger Montgomery picked it and was happy to tell the rest of the market, which should have listened more carefully. Things had changed at ABC Learning over the years and Eddy admitted it in that meeting, but most people holding the stock just weren’t listening to the message he gave everyone.
There are snakes and ladders everywhere
Many people will argue these two examples do not apply to the big end of town, where a special breed of stocks called blue chip resides. And there is a grain of truth in this. There is very little chance of a big company going broke in Australia due to an unwritten contract between investors and company management who know they are too big to fail. That does not make them immune from being shocking investments.”
With Permission.
Extracted From Bulls Bears & a croupier, John Wiley & Sons, 2012
Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.
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.
peter bryan
:
Roger,
Could you please point me to your paper titled Cash Flow through a Business?
Cheers
peterB
Tony Connellan
:
To Roger & fellow bloggers
I have just finished ch 26 (nearly finished ) of Bulls, Bears, and a Croupier by Matthew Kidman.I am finding it well written , easy to read and informative. The overall thought that comes through to me from the book is the concentration on share price and PE.Price is not only Matthews predominant focus, but it is also the dominant focus of most of the investing public including many of the contributers to this blog.(It is my impression, & I could well be wrong)
I am an Ex private business owner/manager ( heavy manufacturing for 30 years ) Throughout that time I could not have told you what the market price of the business was, but I could have told you almost any time what the approx cumulative earnings were.I was earnings driven.
When I started investing in shares, this earnings focus was foremost. Sure the share price comes into the buy/sell decisions but in between it is my confidence in the future earnings that keep me invested in a particular share, not the price gyrations and if you asked me today what the PE of any of my investments is I would have to look it up.
When the GFC came my portfolio value (market capitalization) crashed but my portfolio earnings still grew. For me the volatility of share price is much greater than the volatility of earnings.
The Government (tax office),values my SMSF by market capitalization (share price).
So it seems to me I am way out of step with the Investing community when it comes to making a living out of the share market.
Are their others out there like me?
My random thoughts on the theme of the book.
Regards
TC
calmac
:
Roger, I recently finished reading this book too, and would recommend it to any investor. I found it comforting to read from Matthew, that just because he was paid to invest other people’s money, and whilst he did have special access to interview and grill the managers of the companies he was looking to invest in, his investment strategy was still very much focused on the key fundamental points (i.e. cashflow, low gearing, and recurring revenues), which experts like you have spoken about for sometime. I also enjoyed his chapters on some of the mistakes he had made, along with his assessment of company management, and his dealings with some of the more difficult CEOs – many of whom I note are no longer around as CEOs. Fantastic read!
Matthew Smith
:
I would recommend people consider reading “Margin of Safety” written by Seth Klarman (Baupost Group)
There is a reason why this is one of the most highly priced investment books EVER!!
Hope you are all curious enough to find out why…
Roger Montgomery
:
I have a copy Matthew and I liked it but cannot see what the fuss is about.
David Sinclair
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Hi Matthew,
The reason why this is one of the most highly priced investment books EVER is the limited print run. You can get a copy of the Intelligent Investor in almost any bookshop, but if you want a copy of Margin of Safety you need to be able to hunt down a second-hand copy and convince the current owner to part with it. Simple supply and demand makes Margin of Safety much more expensive to purchase than The Intelligent Investor but I don’t think you will find too many people who think it is a much better book.
Dave S.
Roger Montgomery
:
Agreed.
Matthew Smith
:
The book is demanded because Klarman & Co have one of the best investment track records of returns ever.
Once you take into account the risks of the specific investments made and the average cash holding of ~30% – it truly is one of the most superior risk-adjusted return records I have come across.
Compounds capital at ~17.5%pa and has only lost money in two years since 1983 – that is true capital preservation and following rule number one!!
Some of his investments like the AIG subsidiaries bonds that he bought in late ’08 on a Tuesday for 20cents that matured on the Thursday for par – makes me think that there should be a fuss about his book is all – Baupost earned 52% that year and avg cash balance was around the 50% mark.
I firmly believe that your investment process is the only step you can control – consistent and long term great outcomes will be preceded by a robust process.
The focus on process was probably the biggest take away for me – everyone takes away different messages.
Quite a few other professionals have never heard of him let alone the general public – just throwing the title out there for those who have likely not heard of him
Roger Montgomery
:
Only losing money in two years is amazing. He does it by picking good value. Is the book good value though at current prices?
Craig B
:
Matthew Kidman was interviewed by Peter Switzer last night.
He came on immediately after Switzer gave Tom Petrovski a faint backhander for his support of the RBA. If you were a retailer I guess Switzer would have your full support, but I feel he forgets that the period immediately prior to the GFC wasn’t NORMAL. It was fuelled by a debt binge. People obviously started businesses – or made investments in existing businesses – on the back of numbers that were inflated by mountains of borrowed money. (And look where that got us!). That the sea of cash has dried up should have been a considered risk, but it seems to have been overlooked, both in the heady days prior to the GFC, and now by Peter Switzer and others of the view that retailers should be saved by dropping interest rates.
I have more faith in the RBA’s abilities to consider all factors, and to manage rates for the overall wellbeing of the economy, than I do in the narrow interests of those struggling to live up to results achieved in more favourable circumstances.
I will grant Switzer and his fellow travellers some slack though, in the shadow of the too-big-to-fail bailouts, even though they didn’t happen here. In PURE capitalism the big boys wouldn’t be saved either. We aren’t practising pure capitalism though, due to fears of greater evils, but that’s another argument.
As for Kidman, he brings a warm fuzzy glow to the not too distant investing future. He thinks there’s a good chance that this year presents the best buying opportunity for some time, with the benefits to flow through in subsequent years starting in 2013. A GOOD chance, not a certainty.
He said on his recent visit to America he was surprised at how much better conditions were than he’d previously thought, and that Bernanke wouldn’t be able to leave rates low through to 2014, as prevously stated. This will decrease the differential with our rates, and lower the Australian Dollar, bringing relief to businesses here suffering while its above parity.
The other factor Kidman raised was the obsession with a surplus – clearly, if you listen to virtually any economist of note, at odds with responsible fiscal policy given our current environment. This should provide the RBA with plenty of leway – which it currently lacks – in reducing rates (thus bringing cheer to Peter Switzer) as it will take some basis points off GDP growth.
Kidman thought it might be as much as 100 bps that comes off interest rates before the end of the year.
He brought a few substantial arguments to back up his bullish view for 2013 and beyond.
Made me want to read his book.
Roger Montgomery
:
Matthew and I agreed on this point when we appeared on CNBC together earlier in the year : “this year could present the best buying opportunity for a very, very long time”
Rainsford
:
Hi Roger
I have just finished it and agree it is a great read. Some highlights for me.
1. The frequent discussion about PE ratios. What a mysterious beast. I prefer your approach – generally ignore them!
2. The final chapters discussing historical bull and bear markets and secular bull and bear markets and what history might mean for the future. The explanation of secular markets was a great education for me.
If Matthew is right in suggesting the current secular bear market may be close to being over, bring it on!.
Rainsford
Matthew Smith
:
I would suggest that you not ignore P/E’s completely
They are a simple short hand DCF and because a lot of people use them they can be useful for quite a few things;
Screening for potential ideas
Putting a stock market value on a companies subsidiary
Gauging relative valuation to peers
Please do not mistake me for saying PE’s or its relative value is gospel – just one of a few main factors when judging a business.
I have seen a company sell for PE of 17x but the assets provided immense tangible downside protection!!!!
Value is one (very important) thing but sometimes you have to be a good trader – this is a really hard part of investing i.e. when to buy and how much
Historical P/E trading range could give you an idea and aid you with this
Mechanical models have provide us with empirical evidence that low P/E portfolio outperform long term – check out James Montier and his research
Try not to be too quick throw stuff out the widow….unless its CAPM!!
Roger Montgomery
:
I’m on your side Matthew. Agreed.
Rainsford
:
Roger I find your comment interesting. To quote a couple of excerpts from Value.able:
“..price earnigs ratio and all its derivatives cannot tell you anything about what a company is really worth”….
And then the comparison with C S Lewis….” it has every available quality except that of being useful”
Roger Montgomery
:
Just acknowledge the market does.
Rainsford
:
Understand. Thanks for your, and others, wise remarks.
Rainsford
Craig B
:
Tweedy Browne have a paper available on their website entitled “What has worked in Investing” which, if I remember rightly, also shows evidence of buying at low PE’s – and abstaining from buying at high PE’s – working well.
However, like all investing maxim’s, that there is evidence it works generally, doesn’t mean it works specifically, and in all cases.
Josh E
:
I finished this book between some business travelling that I had recently and would suggest people read it. It helps to put a lot of things in perspective and also provides some great examples along the way. I found it really simplified things down a lot to an easy to understand level and hammered home the importance cashflow.
I definitely need to go back over the book and note down the parts I think are relative to my personal situation and what I think I can use myself. It’s solidified in my mind that there doesn’t need to be any special tricks to finding great investments. Low Debt, Cashflows and high Returns on Equity make a great starting point for any value investor.
Roger Montgomery
:
Low Debt, high cash flows and high returns on equity….hmmmmm…..solid advice!
Hiten
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Add to that high profit margins and low to no payout ratio with attractive valuations due to Mr Market being depressed and then you are on to something :)
Ash Little
:
Nice Story Josh
Cheers
Ken
:
Roger,
So you were a “voice in the wilderness” when ABC was running. A bit like my own opinion stated on this blog some time ago, when I said FGE was a better investment than MCE. I was subjected to ridicule from all quarters, yet today FGE order book is $1.3B and MCE is about a tenth of that.
It’s nice to be right isn’t it ?
Ken
Roger Montgomery
:
Yes Ken, there was vehement opposition to your comments as well as ours after the HY11 results were out and the cash flow was clearly a problem. Well done and thanks for posting. (Disclosure: The Montgomery [Private] Fund owns FGE but not MCE, which was sold after the HY11 results revealed deteriorating cash flow on 18 Feb 2011 – that was the date of the announcement but not the date we sold. We did sell some time after that as we also participated in the capital raising at $8.50 in April (we all make mistakes). Our exit price was around the $7.20 mark if my memory serves correctly.)
Nick Mason
:
Please Roger, everyone on this blog rates your knowledge and stock picking abilities highly so there is no need to constantly remind the blog of your incredible dexterity when it comes to buying and selling companies at their highs/lows as also I’m sure everyone remembers you saying that the Montgomery Fund bought shares in the recent Matrix capital raising at $8.50 which was done in April of last year, well after the HY report was released. Everyone makes mistakes, no one is infallible.
Roger Montgomery
:
Absolutely correct Nick. Thanks for keeping me accountable.
Andrew
:
Sounds like a great read roger, i will have to add it to my list. I really enjoyed the ABC story and thought it had some very interesting bits of info in there. Good on Matthew for noticing that although nothing changed in the business, something changed in Eddy Groves mind where occupancy rates were no longer important.
I actually think that the ABC Learning story should form some part of year 11/12 business courses. I remember in my business classes, when it came to investing for instance it was basically “a share represents ownership of the company and you come at the very bottom when it comes to claims if the company goes bust. Now how about you pick some companies and we will see whether they go up or down in the next few weeks”.
I think ABC is an example of a really big trap that a lot of investors fall into and thats looking at profit growth rather than profitability. Profit and profitability are two very different things, i think that is the most important lesson one can learn in investing perhaps along with cash-flow is king.
Roger Montgomery
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Cash flow is very important. On that note I am working on a paper to help everyone here understand how the cash flows through a business with some neat and simple metrics to help measure whether its good and improving or not.
Andrew
:
I am looking forward to reading it Roger, as i am sure everyone else is as well. It is probably the area that i feel i have the most to learn in my analysis and consider myself to have still quite a basic levfel of understanding.
I taught myself by imagining an industrial process where a nozzle (operating cashflow) spits out cash into a bucket (investing cashflow), when that bucket is full they spill over into another bucket (free cash flow). If the nozzle cannot fill up the buckets to the required amount they need to use the emergency nozzle (debt).
Like i said, still pretty basic but i think the analogy is accurate.
Roger Montgomery
:
I like the funnel idea too.
Ash Little
:
Looking forward to it
Cheers
stuart
:
wow, what a fantastic title for the book!!! sums things up nicely.
from the extract it appears to be very well done.
perhaps another great book by another great mind, just like his “mate’s” book!!!!
thankyou roger for all your time and effort you give freely to try and educate the little investor like myself. i am sure i am not alone in when i say it is greatly appreciated…….
regards stuart
Roger Montgomery
:
Dear Stuart,
Matthew’s books deserves to be a best seller too. I am incredibly grateful for the support Value.able has received and where I find a complimentary title such as Matthew’s that I am sure will add to an investor’s framework, I am delighted to be able to support it. Thanks for the encouraging feedback.
Boon
:
Is this another example of Lehman’s brothers?