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A C5? But it’s a blue chip!

Companies, Investing Education | Comments (34)

A C5? But it’s a blue chip!

Last week on the Sky Business Channel Peter Switzer asked me for one ‘blue chip’ stock that I rate as ‘A1’.

So I asked… what is a blue chip? Peter described such businesses as having a very good reputation and great brand name, pay a good dividend and have stood the test of time. Such businesses, Peter said, also tend to go up with the market.

Whilst I couldn’t name an A1 blue chip, I can name plenty that fall in my C4 and C5 categories.

Last night I revealed 18 ASX-listed businesses that some investors consider ‘blue chips’, yet don’t make my A1 grade. Westfield, Transurban, Asciano, Lend Lease, Ten Network and Virgin Blue are just a few.

Switzer TV with Peter Switzer was broadcast on 22 July 2010 on the Sky Business Channel. Visit www.rogermontgomery.com to secure your First Edition hard back of Value.able, my step-by-step guide to valuing the best companies and buying them for less than they are worth.

This video is provided by Switzer.com.au, an online portal for retail investors and small business owners. Switzer also provides Financial Planning and Business Coaching services.

Posted by Roger Montgomery, 23 July 2010.

INVEST WITH MONTGOMERY

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.

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34 Comments

  1. Mick
    :

    Thanks Roger

    Your answers and comments always help while trying to tie it all together. I’m particularly interested in the required return (RR) part of the Buffet formula for intrinsic value. Here’s what I was thinking/guessing – tear it apart, all feedback welcomed.

    Add a ‘risk-free’ rate of return, inflation and tax to get a ‘base’ rate for RR; then add in a ‘risk’ metric (as I don’t know where else in the formula to put it!)

    RR = risk-free + inflation + tax + risk metric

    And how to get that risk metric? Using your ranking system. A1-C5 is 15 categories, but why the 3 groups ABC? Why not simply 1-15?

    I took it that ABC were ‘quality’ ratings (A grade footy etc), but what does quality mean? Lots of things, but re investing it means not losing money, and that means a safety margin to counter/mitigate the risk of losing money.

    Therefore (to me) quality can relate to risk/safety, so A’s could be higher quality (low risk/high safety), B’s ‘average’, and C’s lower quality/higher risk.

    The ‘safer’ higher quality A’s would attract a lower risk metric to be added to the base RR eg A 2%; B 4%; C6%.
    Eg
    RR(A) = 5% + 2% + 3% + 2% = 12%

    RR(B) = 5% + 2% + 3% + 4% = 14%

    RR(C) = 5% + 2% + 3% + 6% = 16%

    The RR is the ‘adaptable risk proxy’ – RR will change dependent on quality/riskiness (A/B/C), hence the IV will change and that’s what we’re trying to take into account. RR could then be further modified re your 1-5 ranking – and personal opinion of course.

    Sorry for the essay, look forward to the book!

    Cheers

    • Roger Montgomery
      :

      Hi Mick,

      The approach you outline is a sensible one and I see no issues, mainly because the selection of the discount rate really has no ‘right’ answer. You could for example go with CAPM which uses the volatility of the share price as a proxy for risk. Of course that doesn’t take into account the quality of the business, or its debt levels or the level of competition it faces or anything else. And so are left with an approach a little like yours. In 1994 Buffett said,” In a world of 7% long-term bond rates, we’d certainly want to think we were discounting the after-tax stream of cash at a rate of at least 10%”. So there are a variety of methods. Yours is ok too. Just remember that I see no reason to value a C5 business for example. You have to be careful that you don’t risk buying one even if it is at a discount to intrinsic value after using a very high discount rate.

      • Mick
        :

        Thanks Roger

        I’m a bit funny with CAPM; it seems weird to use volatility of share price when I’m trying to avoid using price in calcs.

        Same goes with Cost of Equity re WACC: for mine, CoE is really just a risk-free rate with a risk premium related to the business value.

        (I haven’t come up with anything better though!).

        Could you use volatility of IV instead of volatility of share price to develop a risk proxy like CAPM? Is that kind of what the ABC ratings are?

      • Mick
        :

        Thanks Roger

        If I see such a calc in ‘Roger Montgomery’s Australian ValueLine’, or it appears in ‘Value.able 2: Roger’s Return’, I will expect a discount!

        PS I cannot believe I posted re CAPM/CoE/WACC before I read the book – you said the same thing in the book! I know you are primarily a fund manager, but even so, for a FM you are a bloody good teacher – thanks yet again.

        Mick

  2. fred
    :

    Hi Roger,

    I think that I am better understanding your method but I did have 12500 DOW downer edi share’s and sold it at $3.75 and now its $4.75 or so. Your method still seems correct long term but today it hurts………..lol

    • Roger Montgomery
      :

      Hi Fred,

      Downer is not a company I have discussed in detail on a blog post here but for what its worth, its a B2 which means its on the better side of the quality scale. It is also trading at a discount to intrinsic value currently of $5.89 but that intrinsic value is not going up in any great hurry with a forecast of $6.44 in two years. Most importantly, part of understanding this method is that valuing a company has nothing to do with predicting its price. You note the rally in the price from $3.75 to $4.75 but we mustn’t forget the very losses incurred by investor as the shares recently fell from over $9.20.

  3. Adam
    :

    Gday Roger,

    Just wondering what your intrinsic valuations for QBE, WOW and LEI are at the moment, and are they still all A1s?

  4. Peter Carroll
    :

    Roger,

    I very much enjoy your sparing with Switzer. He had a go at you tonight after WES put on $1 after announcing their sales results.

    In relation to the stocks you listed i.e. WDC,TCL,AIO ….
    could you please list the stocks and their ratings i.e. WDC C4,TCL C5. By my count there were 17 stocks from WDC to
    Sigma.

    Looking foward to receiving your book.

    Many Thanks
    Kind Regards

    Peter Carroll

    • Roger Montgomery
      :

      Thanks Peter.

      He’s just trying to be contraversial. You get no credit when the shares fall from $32.75 to $27.95 but a ribbing when they go up a dollar. In any event, I am the first person to tell you that I have no ability to predict short term share prices. I cannot tell you what the share price is going to do tomorrow, next week or next year even. Valuing a company is not the same as predicting its price.

      I will put up a post on the scores for each.

  5. Ben
    :

    I know that buffet as well as yourself don’t speak highly of businesses employing debt financing..which brings me to the point; does your method take into account the net interest cover ratio of a company? What are the pitfalls of using such a ratio?

    It’d be interesting to examine what B&B’s position was in regards to interest cover.

    • Roger Montgomery
      :

      Hi Ben,

      Yes there are references to debt and interest cover in the metrics. The reasons for having several ratios related to borrowing is to understand the true nature of the risk to the business and its owners.

  6. Yavuz Atasoy
    :

    Hi Roger,
    Listening your interview, you mention two small resource service companies, namely Decmil and Forge. While I was reading on the weekend I came across a buy recommendation on NRW holdings. Looking at it from key criteria you set; ROE, % debt, balance sheet strength it comes good. Its share price also appears to be below its intrinsic value (as determined by the web site I was visiting). I would be interested in hearing your opinions on NRW holdings
    Thanks,
    Yavuz Atasoy

  7. BCC
    :

    Hi Roger

    I’m eagerly awaiting my copy of Valueable.

    I have a question though: You often (as several value investors do) talk about declining RoE as an indicator that a business doesn’t represent good value, but would there be instances where you wouldn’t be concerned with a declining RoE? I guess what I’m asking is are there situations where the reduction in RoE might actually result in more cash in shareholders pockets, say through an acquisition, that whilst dilutive still maintains a high — albeit slightly lower — RoE and in the long run maybe positive.

    Thanks

    Ben

    • Roger Montgomery
      :

      Hi Ben,

      The ROE doesn’t change when the earnings are paid out or retained. You will find a chapter (or two) about this in my book or you can read the work of Walter/Simmons which also described the relationship.

  9. Damian
    :

    Roger,

    I have been looking at a company called Thorn Group (TGA). Has it come across your radar? Any initial thoughts?

    • Roger Montgomery
      :

      Hi Damian,

      Yes, Thorn has come up in the past. Try typing the name into the search box and see if it comes up in a previous post. If it doesn’t, I will discuss it in a near future post.

  10. Lloyd
    :

    Roger,

    A very enjoyable and informative clip. I really loved the comment/query from the host on a default event: “…the CEO may leave under strange circumstances?”

    What an insight on the depth of financial understanding in populist investment circles.

    On Westfield’s Montgomery Quality Ration or MQR: in addition to the points you make I would add the fact that the annual dividend/distribution is accompanied by several pages of explanation of how to account for it for tax purposes says it all. The complexity of the structure means less transparency, lower levels of understanding and independent scrutiny and thus a higher chance of nasty surprises.

    In my experience, business complexity and complex business structures march lockstep with higher investment risk. The less transparency, the less people understand such a business the greater the propensity for management to bury bad stuff in the complexity, only to be revealed in tough times – witness Babcock and Brown, Allco Finance and ABC Learning as recent prime examples of the consequences of this lack of transparency.

    To paraphrase Churchill, “I cannot forecast to you the action and performance of a less than transparent business. It is a riddle, wrapped in a mystery, inside an enigma; but perhaps there is a key. That key is management’s self interest.”

    Keep up the good work in trying to lift the game of of the popular investment media. Do you ever feel like King Canute in this task?

    Regards
    Lloyd

    • Roger Montgomery
      :

      Thanks Lloyd,

      I am not quite sure what he was referring to, so I let it go to the keeper. Like a King I have never felt. Regarding Westfield, keep in mind that while it receives a lower quality rating, I don’t believe its an ABC, Allco or Babcock.

      Thank you for raising transparency as a topic. I agree that if you can’t understand an annual report, you should move on.

    • GregM
      :

      I dont think we can blame WDC for their “pages of explanation of how to account for it for tax purposes “. Blame the the complex aussie tax system, CGT, 12mth discount, tax deferred, tax exempt, foreign income, foreign credits etc etc etc. Each and every item is require to complete your tax return. Thats why I no longer buy OS companies or trusts, simply to save on complex paperwork.
      Greg

  11. Lloyd
    :

    Roger,

    Does the Montgomery Quality Rating or MQR (trade mark protected?) take into account in any way the concept of durable competitive advantage, or the competitive moat to which Buffet refers?

    It seems to me that based on what you have disclosed to date, that the MQR takes little direct account this factor. Good business health and performance ratios such as low debt/equity and high ROE suggest a well managed business currently in a strong competitive position, but say little of the durability of this position. For example, high ROE’s will attract competition and in the absence of of a durable competitive advantage this competition will see margins erode with a reasonable likelihood that the the business slip down the MQR scale.

    My perception is that there are few, if any businesses in the Australian equity market that enjoy a durable competitive advantage. Also can I suggest that a useful addition to the MQR would be a qualitative qualifier, perhaps a third letter, or digit, addition to the MQR, that reflects the depth and breadth of the competitive moat that a company possesses (e.g. 0 for none, 1 for modest, 2 for strong, 3 for almost unassailable).

    Your thoughts on durable competitive advantage in the context of listed Australian business would be welcome.

    Regards
    Lloyd

    P.S. In my experience a Blue Chip is what you find in the bottom of a bucket of gravel and usually worth about as much in the long term.

    • Roger Montgomery
      :

      Hi Lloyd,

      There are many things that can be reduced to a score like an A1. There are also many ratios that reflect the persistence of a competitive advantage. There are however a range of observations that can not be quantified. So, separately to the calculation of a score, one needs to be satisfied of the existence of a competitive advantage and its durability/sustainability. Of course, this involves the asessment of competitors. Notice this would be almost impossible to reduce to a quantitative score.

  12. Luke
    :

    Hi Roger,

    Out of interest then, can you give an example of an A9 business or a C1? That is, high possibility of default (I guess high debt/equity, bad quick ratio etc) and cheap for C1. The other end of the opposite spectrum is low debt, lots of cash/assets and expensive. Would BHP be an A9?

    Cheers, looking forward to your book!

  13. Rici Rici
    :

    Very interesting interview.

    I just want to clarrify,
    A-C is the qualitative aspect of the business.
    1-5 is the financial risk of the business.

    is this correct

      • Mick
        :

        Hi Roger

        A few questions if I may…

        1. Would it be safe to say your A-C is a ‘risk rating’, while 1-5 is a ‘performance rating’? (I am guessing the 1-9 above was a typo)

        2. Do you use the required return in your calcs as a kind of ‘adaptable risk proxy’?

        3. If so, does that A-C risk rating then directly affect your required return figure used in your calc?

        3. Does the A-C have any bearing on the intrinsic value calc other than the required return figure you adopt?

        I hope they make sense? If not, I’ll have the book soon enough!

        Cheers

      • Roger Montgomery
        :

        1. Would it be safe to say your A-C is a ‘risk rating’, while 1-5 is a ‘performance rating’? (I am guessing the 1-9 above was a typo)
        Not quite. The scoring must be considered as a whole in order to be displayed in my mind as continuous variables and there are many of the same inputs in both parts of the score. Generally though the complete score is about probabilities.

        2. Do you use the required return in your calcs as a kind of ‘adaptable risk proxy’?
        Hmm? “ARP” I think you have come up with something new. I am not sure what an adaptable risk proxy is but if I am guessing correctly, what you say would only be true if the risks were only reflected or taken into consideration here. They are also included elsewhere in the calculations.

        3. If so, does that A-C risk rating then directly affect your required return figure used in your calc?
        Multiple inputs that don’t feed into the scoring system are used for the required return. The risk and performance are not how I view the score.

        3. Does the A-C have any bearing on the intrinsic value calc other than the required return figure you adopt?
        Yes. In several places, and even in determining the nature of the calculation adopted.

        I hope they make sense? If not, I’ll have the book soon enough!
        I hope my answers help you. If you tell me what you are trying to achieve, we can bypass these steps and get right to the point.

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