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Am I selling?

Am I selling?

The following article first appeared in  Alan Kohler’s Eureka Report on December 9, 2009.

Stocks in aggregate are no longer cheap. They were much earlier in the year, but based on the present levels of profitability they are not cheap any more. Those buying today are doing so in a patently perfunctory manner or are simply motivated by the fear of continuing to miss out. In the short term, losses rather than profits are more likely to ensue for those buying today.
Before you go selling your holdings in a fit of panic, remember there are always at least two views about the market’s short-term direction.

In one corner are the bulls, who say that the equity market’s recent strength is the beginning of a multi-year rally that owes its ongoing support to the fact that looming inflation will deliver negative returns from cash, which, combined with the massive expansion of the monetary base, represents a free, low-doc loan from the government.

In this environment many suggest that asset class inflation is assured. Indeed, just under $20 billion a week has been creeping out of the bomb shelters and into assets such as shares and gold.

In the other corner sit the economic bears, such as Nouriel Roubini, David Rosenberg and Marc Faber, who say the same inflationary and expansionary balance sheet policies of the West have given the US dollar an intrinsic value of zero, which will bankrupt America and produce a complete horror show that makes the last downturn look like a picnic.

Yield Curves.

So who was it that said two people looking at the same set of facts could not arrive at vastly different conclusions? Listening to and reading the apologetics and protestations of these extraordinarily successful investors must make the morning chat with your broker about whether AMP is paying too much for AXA seem inane. (Postscript:  AMP was paying too much for AXA – Nab’s purchase is even more ridiculous).

Perhaps more importantly, to whom do you listen? You cannot base that decision on who is smarter because both groups have geniuses in their ranks; nor can you base your decisions on previous successes because both groups have extremely wealthy proponents.

The answer does not lie with replicating the financial and reputational bets taken by the economists, strategists and traders. Indeed, it lies in not taking a view at all but allowing an entirely different group of facts to dictate your actions.

Those facts are the book values or the equity of companies on a per-share basis, the anticipated profitability of those book values, the manner in which profits are currently retained and distributed (in others words, capital allocation by management) and a reasonable required rate of return.

On these measures most companies are no longer cheap and many are downright expensive. This has occurred for two reasons, that combined, reflect the typical short-term focus of both professional and amateur investors.

The first reason is that share prices have obviously risen. They have risen because Australia has sidestepped a recession, interest rates remain accommodative, our output is in demand and overseas markets have recovered.

The second reason is that shareholders who may have stayed on the sidelines, have pumped money into attractively priced dividend reinvestment plans, placements and rights issues as many of Australia’s largest companies collectively raised $90 billion in the 2009 financial year.

And who can blame the investor who bought shares in Wesfarmers at $29 for wanting to bring down their average price and participate in an entitlement offer to buy three more shares at $13.50 when the rest of the shares they own are trading at $16?

But while the reduction of debt, associated strengthening of balance sheets and stag profits are attractive, there is a nasty downside to all of this.

If I have a company with $100 of equity on the balance sheet and 100 shares on issue, each share is entitled to $1 of the net book value of the assets. If, however, my company’s shares are trading at 10¢ because of the global financial crisis and my bankers ask me to reduce my $100 of debt to $50, I may choose to issue 500 shares at 10¢ to raise the required $50.

The first thing that happens of course is that company equity rises by $50 but more disturbing is that there are now 600 shares on issue. Where once each shareholder owned $1 of equity for every share they held, they now own just 25¢ worth of equity.

And if you are a small shareholder from whom the company couldn’t conveniently raise money, your holding has just been diluted because the institutions got the lion’s share of the placement.

Further, the money raised went to pay down debt rather than investment, so the earnings will only increase by the post-tax interest saved. As a result, the return on equity declines as well and because the true value of a company is inextricably related to the profitability of its book value, company valuations decline.

Valuations have thus declined and yet share prices have risen. As Benjamin Graham said, in the short term the market is indeed a voting machine. And I am not talking about one tiny or obscure corner of the market. Rights issues and placements, according to Paterson’s research, now account for more than 6.5% of total market capitalization: the highest level in more than 20 years.  (Postscript:  figures compiled by trade-futures.com show that 80% of small traders are bullish – the same level as when the market peaked in November 2007).

In the current environment, many value investors will succumb to temptation and their lack of discipline and reduce their discount rates. In doing so they try and keep their valuations from looking out of touch with ever-increasing share prices but really they’re playing catch-up. And when share prices fall slightly, value apparently and suddenly appears.

But the margin of safety is illusory and with returns from stocks unlikely to sustain returns so far out of whack from everything else, real value is some distance below. Only a demonstrated track record can prove otherwise.

Posted by Roger Montgomery, 9 December 2009

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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  1. Roger are you keeping up with retail sales in Australia? I’ve heard from many businesses xmas sales are nowhere near as good as last year. No stimulus payment to prop up sales.
    Incidentally, from American retailers employees/owners i’m hearing things are picking up. Must be why Warren pumped a truckload into Walmart.

    • rogermontgomeryinsights

      I am hearing the same thing. Mixed signals. I have been told by some very well connected people to expect a sharp upturn in the US but to be wary of discretionary retailers as inflation could be a problem. Locally, my retailing contacts have been giving me mixed feedback. A couple are well up on last year and several are well down. The same for my property development mate. One is the star of his bank’s loan book and the other has been relatively quite while yet another cannot find a site at a reasonable price because things have hotted up.

      Mixed signals occur at turning points!


  2. Roger, surely we’ve only got 500+100 = 600 shares on issue ? This would mean a shareholder equity of 0.17c per share. If we issued 5000 shares, surely we’d have $500 raised and 5,100 shares on issue ?

    I understand the principle all the same because I raised exactly the same point not too long ago within a particular letters column (and got published !) with some of the publication’s ‘Top 10 REIT picks’ and asked just how people expected EPS to grow after all this massive dilution across the sector ?

    Hence, when buying, one of my ‘screens’ was to look for companies that had not raised excessive amounts of capital and especially more than once during the GFC. For that reason, I did not choose companies like GPT and SGP.

    P.S. I know that this is an example only, but we’d be hard pressed to find shareholders to take up our offer at 10c (when they can get them for that on market) – but, saying that – I do know of shareholders, both large and small who will take up their entitlement regardless because of a) free brokerage and b) to escape dilution.

    My point to such smaller shareholders is to try and explain the scientific principle of “infinite dilution” to them (because their shareholding is probably so small in comparison to insto’s anyway).

    • rogermontgomeryinsights

      If a company issues shares at 10 cents to raise $50 it must issue 500 shares. Equity goes to $150 if $50 is raised. (assets stay the same and debt drops by $50). $150 of equity divided by 600 shares equals 25 cents of equity per share.

      The numbers were changed to see who was watching. A few of Alan Kohler’s readers who picked it up are receiving a prize.


  3. Roger,

    I’ve heard a few analysts say that book value is “old school”. It’s good when you are looking at capital-intensive businesses with plenty of assets on the books. But it doesn’t carry much meaning for service-based firms with few tangible assets, like Microsoft, whose bulk asset value is determined by intellectual property rather than physical property.

    • rogermontgomeryinsights

      The best businesses are those that are no capital intensive and have assets that cannot be replicated. These assets tend not to lend themselves to accounting precision and so are often not on the balance sheet. The result is high rates of return on equity for the best ones. I have written a chapter in my book about the difference between goodwill, book value and intrinsic value. You will love it. It shows the relationship between book value and intrinsic value for different companies.


  4. Hi Roger,

    There should be 600 shares on issue not 5100 (100 500). Thus, the ecquity per share $0.25 not 3 cents. This of cours does not chande the point you made. Great post anyway.

    Best Regards

    Irek Baran

    • rogermontgomeryinsights

      Hi Irek,

      100% correct. Well spotted. 25 cents is the right answer. Thanks for your ongoing support and your eagle eye.


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