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.
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Important viewing for the start of the week. Here’s the link if you’d like to view it at its source: http://www.cbc.ca/video/swf/UberPlayer.swf?state=sharevideo&clipId=2239470660&width=480&height=322
Posted by Roger Montgomery, Value.able author, Skaffold Chairman and Fund Manager, 27 May 2012.
Investors don’t have to have astronomic IQ’s and be able to dissect the entrails of a million microcap startups to do well. You only need to be able to avoid the disasters.
In an oft-quoted statistic, after you lose 50% of your funds, you have to make 100% return on the remaining capital just to get back to break even. This is the simple reasoning behind Buffett’s two rules of investing. Rule number 1 don’t lose money (a reference to permanent capital impairment) and Rule Number 2) Don’t forget rule number 1! Its also the premise behind the reason why built Skaffold.
Avoiding those companies that will permanently impair your wealth either by a) sticking to high quality, b) avoiding low quality or c) getting out when the facts change, can help ensure your portfolio is protected. Forget the mantra of “high yielding businesses that pay fully franked yields” – there’s no such thing. That’s a marketing gimmic used by some managers and advisers to attract that bulging cohort of the population – the baby boomers – who are retiring en masse and seeking income.
Think about it; How many businesses owners would speak about their business in those terms? “Hi my name is Dave. I own an online condiments aggregator – ‘its a high yielding business that pays a fully franked yield’. You will NEVER hear that from a business owner. That only comes from the stock market and from those who have never owned or run a business.
They key is not to think about stocks or talk stock jargon. Just focus on the business. Thats what we did when Myer floated in 2009. And with the market value of Myer now 50% lower than the heady days of its float, it might be instructive to revisit the column I wrote back on 30 September 2009, when I reviewed the Myer Float.
And sure, you can say that the slump in retail is the reason for the slump in the share price of Myer (I am certainy one who believes that the dearth of really high quality companies means multi billion dollar fund managers are bereft of choice meaning that a recovery in the market will make all stocks rise – not because they are worth more but because fund managers have nothing else to buy). But the whole point of value investing is to make the purchase price so cheap that even if the worst case scenario transpires, you are left with an attractive return.
It would be equally instructive to review the reason why we didn’t buy the things that subsequently went well (QRN comes to mind) so we’ll leave that for a later date.
Here’s the column from September 2009:
“PORTFOLIO POINT: The enthusiasm surrounding the Myer float is good reason for a value investor to stay clear. So is the expected price.
With more than 140,000 investors registering for the IPO prospectus, everyone wants to know whether the float of the Myer department store group will be attractive. This week I want to focus exclusively on this historic offer.
At present it is suggested the stock will begin trading somewhere between $3.90 and $4.90.
The prospect of a stag profit draws a self-fulfilling crowd. But if chasing stag profits is your game, I would rather be your broker than your business partner, for history is littered with the remains of the enthusiasm surrounding popular large floats.
Popularity, you see, is not the investment bedfellow of a bargain and being interested in stocks when everyone else is does not lead to great returns. You cannot expect to buy what is popular, travel in the same direction as lemmings and generate extraordinary results. Conversely thumb-sucking produces equally unattractive returns.
Faced with these truisms, I lever my Myer One card, obtain a prospectus and open it for you.
The Myer float is one of the hottest of the year and I am not referring to the cover adorned by Jennifer Hawkins! If those 146,000 people who have apparently registered for a Myer prospectus were to invest just $20,000 at the requested price, the vendors will have their $2.8 billion plus the $100 million in float fees in the bag.
A word about the analysis: It is the same analysis I have used to buy The Reject Shop at $2.40 (today’s close $13.35), JB Hi-Fi at $8 ($19.86), Fleetwood at $3.50 ($8.75), to sell my Platinum Asset Management shares at more than $8 on the morning they listed (at $5), and to warn investors to get out of ABC Learning at $8 (they were 54¢ when ABC delisted in August 2008) and Eureka Report subscribers to get out of Wesfarmers as it acquired Coles.
I don’t list these to boast but merely to demonstrate the efficacy of the analysis; analysis that is equally applicable to existing issues and new ones.
By way of background, TPG/Newbridge and the Myer Family acquired Myer for $1.4 billion three years ago. They copped flack for paying too much, but “only” used $400 million of their own capital; the remainder was debt. Before the first anniversary, the Bourke Street, Melbourne, store was sold for $600 million and a clearance sale reduced inventory and netted $160 million. The excess cash allowed the new owners to reduce debt, pay a dividend of almost $200 million and a capital return of $360 million. Within a year the owners had recouped their capital and obtained a free ride on a business with $3 billion of revenue. Good work and smart.
But I am not being invited to pay $1.4 billion, which was 8.5 times EBIT. I am being asked to pay up to $2.9 billion, or more than 11 times forecast EBIT. And given the free “carry”, the bulk of the money raised will go to the vendors while I replace them as owners. Ownership is a very good incentive to drive the performance of individuals.
And driven they have been. In three years, $400 million has been spent on supply chain and IT improvements, eight distribution centres have been reduced to four and supply-chain costs have fallen 45%. Amid relatively stable gross profit margins, EBIT margins improvement to 7.2% and a forecast 7.8% reflect disciplined cost identification and management. Fifteen more stores are planned for the next five years and the prospectus notes that trading performance improved significantly in the second half of 2009 and into the first half of 2010. The key individuals have indeed performed impressively, but with less skin in the game they may not be incentivised as owners in future years as they have been in the past.
And what value have all these improvements created? The vendors would like to believe about $1.4 billion, and if the market is willing to pay them that price, they will have been vindicated, but price is not value and I am interested simply in buying things for less than what they are worth.
In estimating an intrinsic value for Myer, I will leave aside the fact that the balance sheet contains $350 million of purchased goodwill and $128 million of capitalised software costs. This latter item is allowed by accounting standards but results in accounts that don’t reflect economic reality. Historical pre-tax profits have thus been inflated.
I will also leave aside the fact that the 2009 numbers and 2010 forecasts have also been impacted by a number of adjustments, including the addition of sales made by concession operators “to provide a more appropriate reference when assessing profitability measures relative to sales”; the removal of the incentive payments to retain key staff – not regarded as ongoing costs to the business; costs associated with the gifting of shares to employees; and, most interestingly, the reversal of a write-off of $21 million in capitalised interest costs – all regarded as non-recurring.
Taking a net profit after tax figure for 2010 of $160 million and assuming a 75% fully franked payout, we arrive at an owners’ return on equity of about 28% on the stated equity of $738 million, equity that could have been higher after the float if $94 million in cash wasn’t also being taken out of retained profits. Using a 13% required return, I get a valuation of $2.90.
Looking at it another, albeit simplistic way, I am buying $738 million of equity that is generating 28%. If I pay the requested $2.9 billion for that equity or 3.9 times, I have to divide the return on equity by 3.9 times, which produces a simple return on “my” equity of 7.2%. For my money, it’s just not high enough for the risk of being in business.
Importantly, the return on equity – based on the simple assumptions that three stores, each generating $40 million in sales will be opened annually over the next five years and that borrowings will decline by $60 million in each of those years – should be maintained. But the end result is that the valuation only rises by 6% per year over the next five years and delivers a value in 2015 of $3.90: the price being asked today.
My piece of Myer seems a bit hot for My money.”
That was 2009. Has anything really changed? Has the following chart reveals. Myer is now trading at close to Skaffold’s current estimate of its intrinsic value. Before you get too excited (although the shortage of large listed high quality retailers means even this company’s shares may go up in a market or economy recovery) take a look at the pattern of intrinsic values in the past and the currently anticipated path of forecast intrinsic values; Past intrinsic values have been declining (generally undesirable unless forecasts for a recovery are correct) and forecast intrinsic values are flat.
Fig.1. Skaffold Myer Intrinsic Value Line
And as the Capital History chart reveals, 2014 profits are not expected to be better than 2010. That 4 years without profit growth. Question: Would you buy an unlisted business (as a going concern) that was not forecasting profit growth for four years?
Fig. 2. Skaffold Myer Capital History Chart
Finally the cash flow chart reveals the company has produced what Skaffold refers to as a Funding Gap. Its cash from operations have not been enough to cover the investments it has made in others or itself plus the dividends it has paid. In other words for 2010 and 2011, the two financial years it has registered as a listed company, it appears from Skaffold’s data that the company has had to dip into either 1) its own bank account, or 2) borrow more money or 3) raise capital (the three sources of funds available if a funding gap is produced) to cover this “gap”.
Fig. 3. Skaffold Myer Cash Flow Chart
I’d be interested to know if you are a loyal Myer shopper or not and why? If you don’t shop at Myer, why not? If you do shop at Myer, what do you like about the company, its stores and the experience? And I am particularly interested to hear from anyone who DOES NOT shop there but DOES own the stock!
Posted by Roger Montgomery, Value.able author, Skaffold Chairman and Fund Manager, 27 May 2012.
In The Australian Roger Montgomery discusses why the laws of supply and demand suggest demanding times ahead for mining companies. Read here.
Learn Roger’s Value.able insights into the recent Qantas corporate restructure in this discussion with Radio 2GB’s Ross Greenwoood broadcast on 23rd May 2012. Listen here.
Forget Europe. That’s old news. The next surprise might just be a bursting of Japan’s bond bubble. Nay, a bursting of Japan itself?
According to Fitch, gross general government debt of Japan is likely to reach 239 percent of GDP by end-2012, the highest for any Fitch-rated sovereign. Moreover, Japan’s Fiscal Management Strategy envisages declines in the government debt/GDP ratio only from fiscal year 2021.
Would you lend Japan money (or any country with these financials) at rates approaching zero?
Strong private savings contribute to the country’s persistent current account surpluses. But that’s all going to change as ageing baby boomers (who the government has been borrowing money from at near zero rates – its called financial repression) start to ‘dissave’. As they get older they will stop saving and start needing the cash to finance retirement and healthcare. The result is that the government will need to turn to foreign investors for cash and they are not going to accept zero rates when the country has debt of 240% of GDP.
According to Bloomberg: “How low can bond yields go without triggering a meltdown?
“This question gains urgency as 10-year government yields disappear before the world’s eyes. At 0.83 percent, the lowest level since 2003, they hardly compensate investors for the risks inherent in buying IOUs from the most indebted nation. Public debt is more than twice the size of the $5.5 trillion economy. Worse, it’s still growing. Fitch Ratings today lowered the sovereign-credit rating by one step to A+ with a negative outlook because of Japan’s “leisurely” efforts to cut debt.
“Ignore news that gross domestic product rose an annualized 4.1 percent from the final three months of 2011. The only reason Japan is growing at all is excessive borrowing and zero interest rates. The moment Japan trims its debt, growth plunges, deflation deepens and politicians will demand that the Bank of Japan do more. That’s been Japan’s lot for 20 years now.
Yet what if the BOJ isn’t just setting Japan up for the mother of all crises, but holding the economy back?
“A bizarre dynamic is dominating Japan’s financial system, one evidenced by two-year debt yields falling to about 0.095 percent. That is below the upper range of the BOJ’s zero-to-0.1 percent target for official borrowing costs. It’s below the 0.1 percent interest rate the BOJ pays banks for excess reserves held at the central bank. Such rates raise serious questions.
“The BOJ does reverse auctions where it buys government debt from the market. Last week, it failed to get enough offers from bond dealers. Now think about that: The BOJ prints yen and uses it to buy government debt from banks, which typically hoard the stuff. Last week, banks essentially said: “No, thank you. We’d rather have these dismal interest-bearing securities than your cash, because there’s really nowhere to put that cash anyway.” Banks certainly aren’t lending.
“Politicians are pounding the table demanding that the BOJ expand its asset-purchase program. That, of course, isn’t possible. The BOJ can hardly force banks to swap their bonds for cash. So Japan is left with a problem unique to modern finance. Banks like to keep more cash on deposit at the BOJ than they need to in order to earn a 0.1 percent rate of return, which is pretty good by Japan standards. To pay that rate, the BOJ creates new money, which does nothing to help the economy.
“This dynamic keeps Japan’s monetary engine in neutral at best, and at times running in reverse. Japan’s central bank is essentially now there to support bond prices. It’s a huge intervention that gets little attention. Headlines roll every time the Ministry of Finance sells yen in currency markets. The BOJ’s debt manipulation barely registers.”
Why today?
Last year it was Iron Ore and recently it was minings services for which we suggested conventional wisdom should be questioned. I am posting this topic today because Fitch Ratings lowered Japan’s credit ratings citing rising risks to the sovereign credit profile due to higher public debt ratios.
The long-term foreign and local currency Issuer Default Ratings were lowered to ‘A+’ from ‘AA’ and ‘AA-‘ respectively. The Negative outlook on ratings was maintained.
“The country’s fiscal consolidation plan looks leisurely relative even to other fiscally-challenged high-income countries, and implementation is subject to political risk,” Andrew Colquhoun, Head of Asia-Pacific Sovereigns at Fitch.
The agency warned that a lack of new fiscal policy measures aimed at stabilizing public finances amid continued rises in government debt ratios could lead to a further downgrade.
Posted by Roger Montgomery, Value.able author, Skaffold Chairman and Fund Manager, 22 May 2012.
Do Jumbo Interactive (JIN), Seven West Media (SWM), Matrix Composites (MCE), Toll Holdings (TOL), Blackmores (BKL), Seek (SEK), Silverlake resources (SLR), Paladin Energy (PDN) and Qantas (QAN) make Roger’s coveted A1 grade? Watch this edition of Sky Business’ Your Money Your Call broadcast 22 May 2012 to find out. Watch here.
In Radio National’s PM program Roger Montgomery provides his Value.able insights into the short-term economics of the Australian airline industry to the ABC’s David Taylor. Read/Listen here.
This program was broadcast on 22nd May, 2012.
Facebook floated last week and amazingly it has been holding above its IPO price of $38 per share. I say amazingly because I reckon its value to be substantially lower. I will publish my completed calculations in the near future
Here’s a taster: “For a purchaser of Facebook shares today and wanting 15 percent per year over the next five years (doubling your money), Facebook’s market capitalization has to double to $200 billion without any additional shares being issued (options to be exercised will put paid to any fairy tale notions about that). Google is valued by the market today at $200 billion. Both businesses are similar in terms of margins etc so arguably Facebook needs to increase its sales tenfold in the next five years to achieve the same valuation as Google today. But keep in mind, Google has about $40 billion of cash in its accounts. Facebook has nothing like that.”
For now I thought the trading in Facebook on its first day was a useful entrée to the world of High Frequency and Algorithmic trading and I also thought that comic Andy Borowitz’s tongue-in-cheek look at Facebook provided a welcome break from the doom and gloom pervading investment markets.
From: http://www.borowitzreport.com/
MENLO PARK, CA (The Borowitz Report) – On the eve of Facebook’s IPO, Founder and CEO Mark Zuckerberg published the following letter to potential investors:
Dear Potential Investor:
For years, you’ve wasted your time on Facebook. Now here’s your chance to waste your money on it, too.
Tomorrow is Facebook’s IPO, and I know what some of you are thinking. How will Facebook be any different from the dot-com bubble of the early 2000’s?
For one thing, those bad dot-com stocks were all speculation and hype, and weren’t based on real businesses. Facebook, on the other hand, is based on a solid foundation of angry birds and imaginary sheep.
Second, Facebook is the most successful social network in the world, enabling millions to share information of no interest with people they barely know.
Third, every time someone clicks on a Facebook ad, Facebook makes money. And while no one has ever done this on purpose, millions have done it by mistake while drunk. We totally stole this idea from iTunes.
Finally, if you invest in Facebook, you’ll be far from alone. As a result of using Facebook for the past few years, over 900 million people in the world have suffered mild to moderate brain damage, impairing their ability to make reasoned judgments. These will be your fellow Facebook investors.
With your help, if all goes as planned tomorrow, Facebook’s IPO will net $100 billion. To put that number in context, it would take JP Morgan four or five trades to lose that much money.
One last thing: what will, I, Mark Zuckerberg, do with the $18 billion I’m expected to earn from Facebook’s IPO? Well, I’m considering buying Greece, but that would still leave me with $18 billion. LOL.
Friend me,
Mark
Following that lighthearted distraction, if you are interested in how High Frequency Trading and [some examples] of Algorithmic (Algo) Trading looks in the real world, watch this:
As the following chart reveals (you will have to suspend reality and imagine that the future always looks exactly the same as the past) some analysts think Facebook’s growth will mimic that of other high profile social networks. No doubt the underwriters of Facebook will hope they’re wrong.
Either way it will be more than a little interesting to watch. Did you buy shares in Facebook? If not, why not? And if you did, what were the reasons?
Posted by Roger Montgomery, Value.ableauthor, SkaffoldChairman and Fund Manager, 21 May 2012.
Matthew was so disappointed about the April takeover offer for a company he owned, that he wrote a letter to his rep – the CEO
More of us should be doing likewise, remembering the words of Richard Puntillo; “in theory, publicly traded corporations have shareholders as their kings, boards of directors as thesword–wielding knights who protect the shareholders and managers as the vassals who carry out orders. In practice, in the past decade, managers have become kings who lavish gold upon themselves, boards of directors have become fawning courtiers who take coin in return for an uncritical yes-man function and shareholders have become peasants whose property may be seized at management’s whim.”
Has a company you owned shares in been taken over and left you disappointed rather than elated? Its simplistic and a sign of immaturity as an investor to celebrate a takeover when the price paid does not justify the prize. Its far too easy for investors to do the ‘Wall Street walk’ when a bid is received. Matthew’s actions serve as a reminder that their are issues beyond the immediate return that must also be considered.
Hi Roger and team,
I sent the following letter to the CEO of a company today that I am a shareholder in called IDEAS International. They are a small company but very successful and operate in an area that is experiencing huge growth. They are little known, very thinly traded and not appropriate for most investors. Perfect for me!
IDEAS International was formed in 1981 and listed on the ASX in 2001. The IDEAS business is essentially one of analysing computer resource usage. This is important for companies who operate servers because this information allows these companies to increase efficiency and get value for money from their IT purchases. In a commodity like business (i.e. cloud servers) companies that can assist you to squeeze out another 1% in efficiency or when buying $20m of hardware to buy the correct servers for the job, paying a small fee to a company like IDEAS is a no-brainer. They provide independent advice based on real-world scenarios. They collect this information from the other part of their business which is in providing independent monitoring and analysis services to the same companies. Cloud computing is a huge growth area at the moment and it will get bigger. IDEAS is only just making a dent in this business and the demand for their services will grow as the cloud computing business is increasingly commoditised.
On wednesday they went in to a trading halt pending the release of information regarding a control transaction. Today they released a takeover bid by a large international IT outfit called Gartner with the full support of the board. No premium to current prices has been offered, the takeover is at $1.40, the same as the trading price for the last month. The quality of this company is high, it is cheap and Gartner are getting away with robbery.
The below letter doesn’t fit the theme of the recent “Guest Posts” but I thought you might consider it anyway. I won’t be at all concerned if you don’t think it is appropriate.
Kind Regards,
Matthew Rackham
**********
IDEAS InternationalASX Code: IDE“Takeover Disappointment”
Dear Mr Bowhill,
I read with interest the takeover proposal by Gartner for IDEAS released to the ASX this morning.
I am a private investor and I will be up front and say that I am very disappointed to hear that you are recommending the proposal.
IDEAS is a fantastic business. There are very few businesses as good as IDEAS in Australia, let alone on the ASX. Not only is this a fantastic business but by what I have read it seems to be run very well by management. Overlay this on the growth in the server space which IDEAS is in and my impression is this company has many exciting years of growth ahead of it.
In comparison Gartner looks to me to be a lousy business. Significant debt, slim profit margins and poor return on assets are the lot of Gartner’s management and shareholders.
But maybe these could be forgiven if the sale price rewarded current shareholders equally to future shareholders. Sadly however, it does not. If something close to recent performance continues I expect IDEAS to be worth in excess of $3 per share and maybe up to $4.20 in four years time. If the AUD drops this figure will be higher. Looking at your financial statements IDEAS will have the capacity to pay much larger dividends in the very near future as well. Net of cash Gartner are buying our company for $13.1 million and with earnings of $1.9 million and cash flow of $2.8 million – Gartner are making a steal. I expect Gartner will get their purchase outlay back within 4 years, and much earlier when they leverage their much larger distribution network.
I have to ask the question: Why if Gartner are so keen to use the resources of IDEAS do the management of IDEAS not license Gartner as a reseller/agent/partner ? This would ensure the value of IDEAS stays with the shareholders of IDEAS, allow IDEAS management to achieve their aspirations of making IDEAS a globally significant business and Gartner can continue on as, albeit slightly less so than before, a lousy performing business. In this scenario everyone gets the value they are entitled to.
Longstanding shareholders of IDEAS may feel that the performance of IDEAS share price has not been all that great for many years and this is a chance to “cash out” at a good price. What I would say to them is that (1) this is not the time to “cash out” given IDEAS is on the cusp of a large ramp up in use of it’s services – if they have waited this long surely they can hold on a few more years to realise the benefits of their patience and (2) higher share prices in normal circumstances result in greater liquidity in the shares so if they want to cash out they will be able to in a few years anyway. New shareholders from the GFC period have nothing to lose either way (good luck to them!).
I am very frustrated by this opportunistic offer for our company,
Kind Regards,
Matthew Rackham
In TheBull.com.au Roger Montgomery discusses his insights into the outlook for Australian commodities share prices over the near future. Read here.
