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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Once upon a time JB Hi-Fi was a category killer: its returns on equity were unassisted by debt and stratospheric and it was all reflected in a strong share price. But something has changed. I wrote previously, and commented elsewhere, that JB Hi-Fi was maturing, that returns on equity were flattening and that the sun was setting on the ability of the business to reinvest profits at the very high returns of the past. The impact of this of course is flatlining intrinsic values. Indeed take a look at the Skaffold valuation line chart below. You can see that even by 2014, JBH’s intrinsic values are expected to show no appreciation from 2009/2010. Maturity.
That of course hasn’t prevented me from buying a few shares around$15.00. Fortunately however we were quick to change our mind and even secured a small profit.
I wonder whether the first signs of business performance beginning to mature, is often the point when it becomes worth watching what directors do with their shares for some further insights?
JB Hi-Fi’s CEO, Richard Uechtritz, had been at the company for a decade prior to his retirement in 2010 and those watching his share dealings may have drawn a different conclusion to those being lulled by a bullish share price.
At the outset let me say there is no impropriety in a director selling their shares and none is suggested here. Directors are free to sell shares within the bounds of their staff trading policy and are required to report their dealings to the market.
And it’s through these announcements that the investor can see what directors are doing with their shares.
On August 20, 2009, JB Hi-Fi’s CEO held 2 million shares and 627,000 options
and he exercised options to buy another 180,048 shares at $7.27. A week later, JB Hi-Fi’s CEO had sold all of shares he had just purchased the week before for an average price of $17.65.
Then, between September 2 and 3, 2009, another 500,000 shares were sold at an average price of $18.22. By now JB Hi-Fi’s CEO held 1.5 million shares (down from 2 million on AUgust 20) and 447,267 options (down from 627,000).
Skaffold’s Valuation Line Evaluate screen for JBH reveals a maturing intrinsic value – little growth and lower IV in 2014 than 2010.
To alleviate the need to read thousands of annual reports, for every listed company, going back a decade try www.skaffold.com
Now back to our regular programming…
Between August 20 and September 3, there are just 13 days – call it two weeks.
Another 174,656 options were granted on 14 October 2009, and then, in early February 2010, JB Hi-Fi announced the retirement of its CEO.. Having sold 680,048 shares in the seven months before the announcement, JB Hi-Fi’s CEO sold another 500,000 shares during the first five days of March 2010 at an average price of $19.74 leaving him with 1 million shares and 621,923 options.
In his final director’s interest notice in May 2010, the retiring CEO of JB Hi-Fi listed his direct equity interest in the company at 1 million shares and the 621,923 options. For investors who are interested in gaining a possible inside track on the prospects and potential of a business, it may be useful to watch directors’ dealings in their shares.
Of course sometimes the selling can mean nothing at all but my observation is that watching the selling offers some insights. If motivated by urgency, a desire to lock in lofty share prices or grim expectations, information about director’s selling can be more useful than watching their buying.
In April 2011 (about a year later), Richard Uechtritz returned to JB Hi-Fi as a Non-executive director. Until his return, he didn’t have director’s obligations so he was not obliged to make public any of his private share dealings. Upon his return, however, he revealed that he owned only 421,000 options. In other words, he appears to have subsequently sold the one million shares he held at the time of his retirement.
JB Hi-Fi shares do not enjoy the lofty levels they once commanded and investors who tracked the sale of shares by its CEO may have been given a prompt to look deeper into the company, its prospects or at least the impact of those prospects on its shares. Of course it could all be happenstance, company CEO’s have no particular insights and their selling is purely a reflection of the need to diversify. ANy subsequent share price declines may just be coincidental.
JB Hi-Fi’s latest results were less than spectacular and, while the company will continue to win in the race against its listed peers, the reality is its margins remain under increasing pressure, it’s losing share to the internet and its remaining store rollout plan is contributing to a maturing set of metrics. Oh, and the share price now? Just above $9.30.
So do you think you should keep an eye on director’s dealings? What have been your observations? Can you nominate some companies in which directors dealings having given you cause to pause…
Posted by Roger Montgomery, Value.able author, SkaffoldChairman and Fund Manager, 9 May 2012.
A 7% slump in sales for the first 3 quarters of 2012 has taken a predictable toll on the Harvey Norman share price – but will things turn around when the economy improves? Roger Montgomery discusses his views in this Sydney Morning Herald article published on 4 May 2012. Read here.
PORTFOLIO POINT: Office provider Servcorp is basking in strong earnings forecasts from analysts, but a capital raising in 2010 raises some important questions about the company.
Recently (Click here), I discussed Leighton and the quality of management’s relationship with its employees. Here I look at another company with a shareholder who holds a controlling stake, and examine its relationship with minority shareholders.
You can look at anything from a number of angles and, more often than not, reach an entirely different conclusion. Two investors, for example, presented with the same set of facts can reach polar opposite conclusions. It’s the old glass half-full versus half-empty line.
I find that having a set view and unwittingly being tied to that perspective limits one’s ability to switch fast enough when the evidence is mounting that the view might be wrong. Few are completely immune, but self-awareness is the first step to conquering any weaknesses.
The investing consequence of opening one’s mind to change is that portfolio turnover goes up. I may buy something back that I recently sold, because new evidence suggests I should, and that ‘re-purchase’ may be at a higher price. This may be seen as somewhat flaky and I agree it would be, if it were not evidence-based.
Looking at things differently, however, is necessary because it does produce fresh insights. On page 20 of Warren Buffett’s 2003 annual letter to shareholders, he wrote: “…I made a big mistake in not selling several of our larger holdings during The Great Bubble.” Shining a light – or perhaps a light with a different filter – undeniably helps our investment analysis.
With that in mind, I want to present some numbers from Servcorp’s annual reports and ask you to think about what your conclusion might be.
This service and virtual office provider has not produced growing profits since 2007.
Source: www.Skaffold.com PATENTS PENDING.
Back then, profits were $34 million, and while they grew to $39 million in 2009, they subsequently fell to $5 million in 2010 and $4 million in 2011. For the record, analysts are in aggregate forecasting profits to grow to $13 million in 2012, and $28 million and $37 million in 2013 and 2014, respectively.
So that’s one way of looking at this business and on that basis, you may be tempted to investigate the opportunity as a turnaround story. I certainly am, as any global recovery from the Euro crisis would position Servcorp well with the rollout of its floor leasing operations.
Is there another perspective?
But before I go jumping in, here’s another way to consider the information. In 2010, the full year profits plunged to $5 million, the company raised $78 million – on top of the $76 million already invested – by issuing 18 million shares. This move took shares on issue to 98 million and capital raised to $154 million. And looking at the retained earnings account for that year reveals that the balance declined by $10 million. This is something I want to pick up on.
When a company earns a profit of $5 million, as Servcorp did in 2010, retained earnings rise by this amount. Then, if dividends are paid, retained earnings goes down by the amount of the dividend. A net decline of $10 million in retained earnings after a $5 million profit suggests $15 million was paid in dividends.
One way to look at this situation is to assume that the capital raising is for growth; I will give the company the benefit of the doubt and agree. An alternative and admittedly more cynical way to look at it is to assume the capital raising might have been designed to pay for the dividend.
One response to the latter proposition and the one I am leaning towards is that the capital raising was much larger than the amount the dividend exceeded earnings by and therefore the real intention of the capital raising was, indeed, growth. In turn, one retort from a much more jaded or cynical investor could be that the capital raising was made larger to disguise the fact that a larger dividend was desired. It’s all rather circular, as you will discover in a moment.
Perhaps we might never know the thought process of the board at the time and such postulations are only speculative at best, but there are two important questions, answers to which would provide some illumination. The first would be whether the money invested does indeed lead to the growth in earnings that the analysts seem to be expecting – albeit growth that will only produce profits in 2014 that are in line with those of 2007/08. The second might be to ask whether a majority and controlling shareholder is present. Once again, we can’t prove motives, but as investors we are certainly within our rights to enquire.
In the first instance, only time will tell us whether the money is invested profitably. The cash is certainly now available to help grow the business, revenue and profits. To the credit of management, first-half 2012 profits were over $8 million. So the numbers are indeed moving in the right direction.
Regarding the latter issue of ownership, we find the managing director and CEO also owns 51% of the company. Of course, to retain control they must have participated in the capital raising during the 2010 financial year, but keep in mind it could be argued that half the dividend helped fund it.
And I always ask the following question: If a company is in need of capital, why pay a dividend? It’s a basic question and often – but not always – the answer seems to point to maintaining support for the share price, a noble (if perhaps unsustainable and diluting) goal. Directors are arguably acting in shareholder’s best interests by doing things that support the share price but it is imperative the techniques are sustainable. Ultimately the best method is a sound business.
In 2011, the company did almost the same thing as it did in 2010. While no additional equity was raised, and thus the controlling shareholder was therefore spared the requirement of writing another cheque, profits of $4 million were reported, but dividends of $16 million (51% of which went to entities associated with the CEO/MD) ensured that retained earnings fell to $59 million. The $8 million dollars (50% of the dividend) arguably further reduced the personal contribution of the majority shareholder to the capital raising.
For our fund, a return on equity now of just 7% suggests Servcorp is currently not investment grade, and its share price also appears to be expensive compared to our estimate of its intrinsic value. That would change if upgrades to guidance are provided.
While we haven’t answered the questions we posed, we have certainly raised the one we should ask management before we decide to invest. In theory the board works for the shareholders so you are within your rights to ask questions such as these of the board. For your own investing, I can only leave it to you to decide whether the cup is half-full or half-empty.
Posted by Roger Montgomery, Value.able author, SkaffoldChairman and Fund Manager, 3 May 2012.
Harvey Norman today gave its third quarter results reporting LFL (Like-for-like) sales down 6.6% and profit before tax down 24.8%. We think a picture tells a thousand words and offer the following two images (above, of the Apple Store in Sydney’s George Street and below, of the Harvey Norman Store in Bell Street Preston…yes, yes I know different foot traffic etc.) as an invitation for you to comment about what it takes a for a retailer to succeed. If branding and customer experience are two to keys to success….
One wonder’s whether reinvestment is a priority at HVN because we believe thats what retailing constantly needs.
Posted by Roger Montgomery, Value.able author, SkaffoldChairman and Fund Manager, 3 May 2012.
In this BRW article Tony Featherstone discusses the nature of sustainable competitive advantage and how Roger Montgomery swears by it in his Value.able investing strategy. Read here.
This article was published on 3 May 2012.
In this 2 May 2012 ASX Investor Hour presentation, Roger explains that while many investors focus solely on price, he (like Warren Buffett) selects his stocks, to buy or to sell, by comparing their current price to the value he ascribes to them. Roger discusses about his value principles and the technology he uses to filter stocks (www.skaffold.com). Watch video here and view slides here.
Join Roger as he discusses his Value.able approach to picking the best stocks for this ASX Investor Hour presentation delivered 2 May 2012. Watch here.
Learn Roger Montgomery’s Value.able insights into the latest 50 basis point cut in the the base rate and how it may impact housing prices in this interview with ABC The Business’ Ticky Fullerton broadcast 2 May 2012. Watch here.
Roger Montgomery uses Value.able investing techniques to assess the management choices made by BHP executives over the last 20 years with Ross Greenwood and stockbroker Michael Whiting. Listen.
Roger Montgomery discusses why the Spotless (SPT) board has finally accepted a Pacific Equity Partners takeover offer in this Sydney Morning Herald article published 1 May 2012. Watch here.
