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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Roger Montgomery runs through the numbers behind Billabong’s spectacular 40% sell-off this week. Read Roger’s article at www.eurekareport.com.au.
Thank you for your support in 2011 and for all of your wonderful contributions to the knowledge bank.
I am delighted to finish the year on a positive note with Cochlear (see post below) announcing it has identified the source of the malfunction of its Nucleas CI500 cochlear implant. This will also be positive news for many Cochlear implant recipients who put their quality of life in the company’s hands.
I have also published a recent column on the possibility of a convergence of Eurozone default, economic slowdown, a decline in consensus earnings estimates and a throwing in of the towel by investors who are fed up with low returns and heightened volatility (see below).
Hopefully that will stimulate some serious contemplation over the Christmas break.
Next year I am hoping to reconfigure the Insights Blog. My idea is to create and share the publishing role with any number of you who wish to write 300-600 word columns of an investment topic of your choice. I will remain editor and I am looking for twenty six (26) Graduates who can contribute two columns each in 2012. Of course if you wish to contribute more, be my guest.
We also intend to restructure the blog to allow easier searching and viewing of multiple threads. Stay tuned and if you would like to contribute send an email to me at roger@rogermontgomery.com with “CONTRIBUTOR” in the subject heading.
I am delighted that, in 2011, so many investors have found Value.able and Skaffold so useful. Many Graduates have said the Skaffold approach to investing is at once easy to understand and rational. And according to Daman’s feedback, Value.able!
“On Friday the 16th Dec, Bendigo announced a takeover of the Australian arm of a Greek bank at purchase price reflecting a return on equity around the same as a 12 month term deposit with Ubank. Alongside this was a $96M or so write down to its Margin Lending Business (due to the poor economic conditions). Today, its appears upon recommencing trading and Mr Market being nervous in general the share price of BEN has fallen over 6%.
Good news is that I sold my holdings in BEN on the 7th of December. Thanks to your teachings on the importance of ROE I was able to recognise that this business does not have superior performance characteristics, among several other factors. As a result I secured a somewhat reasonable profit of 14% on my holdings and a 2,740% ROB (return on [your] book).”
If you have not already secured your copy of Value.able or become a member of Skaffold and want to kick 2012 off the Skaffold way, go to www.Skaffold.com.
To the Value.able Graduates and Skaffold members (Skaffolders?), thank you for taking the time to share with me just how much you have been impacted by each. I am delighted to hear your amazing stories of investing success and I am pleased we can look forward to 2012 with enthusiasm.
I will return in late January. Our team will continue to publish your comments here at the blog, post new videos to my YouTube channel, reply to your emails and take your calls.
We leave 2011 with one of the world’s most successful billionaire hedge fund managers telling his clients; “Trust has been lost, confidence in the system is being lost, and the ultimate consequence of this break down – sovereign defaults – are imminent.”
In the meantime may your Christmas be filled with the love of family and friends. I look forward to corresponding with you again beginning February 2012. I will always be enthralled by Caravaggio’s work. The Adoration was painted in 1609.
Posted by Roger Montgomery, Value.able author and Fund Manager, 20 December 2011.
We have talked here at the blog about hypothecation, re-hypotecation and hyper-hypothecation, about credit default swaps about a Chinese property bubble bursting, about lower iron ore prices, slower economic growth, increased savings and declining rates of credit expansion and a European sovereign default. Always the value investor, we are on the look out for anything that can impact the values of companies and those things that might offer the prospect of picking up a few bargains.
If your portfolio still has some rubbish in it, then being able to identify it is a key part of preparing for cheaper prices if they eventuate.
I recently wrote a column for the ASX and pondered the possibility of a climactic event coinciding with a complete throwing in of the towel by equity investors who are simply fed up with poor medium term returns and increased volatility recently.
The ASX200 hasn’t generated a positive capital return since 2005 but quality companies have. The ASX200 contains stocks that are rubbish so it is no wonder that an index based on that rubbish has gone nowhere. Step 1 then is to clean up the portfolio and step 2 is to be ready for quality bargains when they arise.
This is just one of many scenarios and frameworks I am operating with and I wonder what would transpire if the poor returns or the recent heightened volatility continues for a little longer? Will investors simply throw in the towel, leave equities and believe all those advisors offering their own brand of ‘safe’, ‘secure’ and stable investments? On the one hand, I hope so. It would mean certain bargains.
Here’s the Column:
As global sharemarkets decline, remain volatile and produce poor historical returns compared to other asset classes, it will be easy to be swayed by the latest investment trend – to move out of shares. I believe the trend away from shares will gather pace soon as more and more “experts” use the rear-view mirror to demonstrate why sharemarket investors would have been better off somewhere else.
In 1974 US investors had just endured the worst two-year market decline since the early 1930s, the economy entered its second recessionary year and inflation hit 11 per cent as a result of an oil embargo, which drove crude oil prices to record levels. Interest rates on mortgages were in double digits, unemployment was rising, consumer confidence did not exist and many forecasters were talking of a depression.
By August 1979, US magazine BusinessWeek ran a cover story entitled ‘The Death of Equities’ and its experts concluded shares were no longer a good long-term investment.
The article stated: “At least 7 million shareholders have defected from the stockmarket since 1970, leaving equities more than ever the province of giant institutional investors. And now the institutions have been given the go-ahead to shift more of their money from stocks – and bonds – into other investments.”
But be warned. The time to get interested in share investing and make good returns is precisely when everyone else isn’t.
Your own once or twice-in-a-lifetime opportunity may not be that far away and Labor’s promised tax cut on interest earnings may sway even more to give up shares and put their money in a bank, providing the opportunity to obtain even cheaper share prices.
If prices do fall further – and they could – you will need to be ready and will need some cash. The very best returns are made shortly after a capitulation. Cleaning up your portfolio becomes crucial and this article looks at how to do that.
Rule one: Don’t lose money
The key to slowly and successfully building wealth in the sharemarket is to avoid losing money permanently. Sure, good companies will see their shares swing but the poor companies see the downswings more frequently.
Therefore, the easiest way to avoid losing money is to avoid buying weak companies or expensive shares. One of the simplest ways I have avoided losing money this year in The Montgomery [Private] Fund has been to steer clear of low-quality businesses that have announced big writedowns.
These are easy to spot using Skaffold.
Not-so-goodwill
I have often seen companies make large and expensive acquisitions that are followed by writedowns a couple of years later. Writedowns are an admission by the company that they paid too much for an asset.
When Foster’s purchased the Southcorp wine business in 2005 for $3.1 billion, or $4.17 per share, my own valuation of Southcorp was less than a quarter of that amount. Then in 2008 Foster’s wrote down its investment by about $480 million, and then again by another $700 million in January 2009 and a final $1.3 billion in 2010.
When too much is paid for an acquisition, equity goes up but profits do not and you can see that too much was paid because that ratio I have worked so hard to make popular, return on equity (ROE), is low.
These low rates of return are often less than you can get in a bank account, and bank accounts have much lower risk. Over time, if the resultant low rates of return do not improve, it suggests the price the company paid for the acquisition was well and truly on the enthusiastic side and the business’s equity valuation should now be questioned. If return on equity does not improve meaningfully, a large writedown could be in the offing. This will result in losses if you are a shareholder, and you have also paid too much.
Just remember one of the equations I like to share:
Capital raised + acquisition + low rate of return on equity = writedown.
When return on equity is very low it suggests the business’s assets are overvalued on the balance sheet. That, in turn, suggests the company has not amortised, written down or depreciated its assets fast enough, which in turn means the historical profits reported by the company could have been overstated.
Scoring bad companies: B4, B5, C4 and below…
These sorts of companies tend to have very low-quality scores and often appear down at the poor end of the market – the left side of the screen shot in Figure 1 below.
Figure 1. The sharemarket in aerial view (Source; Skaffold.com)
Each sphere in Figure 1. represents a listed Australian company and there are more than 2000 of them. The diagram is taken from Skaffold. Their position on the screen can change daily as the price, intrinsic value and quality changes. The best quality companies and those with positive estimated margins of safety (the difference between the company’s intrinsic value and its share price) appear as spheres at the top right.
Companies that are poor quality (I call them B4, C4 and C5 companies, for example) are found on the left of the screen and if they have an estimated negative margin of safety, they are estimated to be expensive and will be located towards the bottom of the screen.
Highlighted with blue rings in Figure 1 are eight of the companies that announced this year’s biggest writedowns. Notice they tend to be at the lower left of the Australian sharemarket, according to my analysis.
If your portfolio contains shares that are red spheres and on the lower left, you could also be at risk because these companies tend to have low-quality ratings and are also possibly very expensive compared to their intrinsic value.
As is clear from Figure 1, this year’s biggest writedown culprits were all already located in the area to avoid.
The impact of owning such a business outright would be horrendous. Table 1 below reveals the size and details of these writedowns and as you can see, collectively the losses to shareholders amount to $4.6 billion.
Table 1. Predictable losses?
Warren Buffett once said that if you were not prepared to own the whole business for 10 years, you should not own a piece of it for 10 minutes.
Clearly you would not want to own businesses that pay too much for acquisitions and subsequently write down those assets. If you are not willing to own the whole business, don’t own the shares. Although in the short run the market is a voting machine and share prices can rise and fall based on popularity, in the long run the market is a weighing machine and share prices will reflect the performance of the business. Time is not the friend of a poor company, and companies Skaffold rates C4 or C5 are best avoided if you want the best chance of avoiding permanent losses.
Look at Figure 2 below. Those big writedown companies not only performed poorly but so did their shares. These companies (shown collectively as an index in the blue line below) produced bigger losses for investors than the poorly performing indices of which they are part. And that’s just over one year.
Figure 2. The biggest writedowns compared to the market
Take a look at the companies in your portfolio. Do they have large amounts of accounting goodwill on their balance sheet as a portion of their equity? Have they issued lots of shares to make acquisitions and are they producing low and single-digit returns on equity? If the answer to all these questions is yes, you may have a C5 company.
Cleaning up your portfolio not only lowers its risk but will produce cash that may just prove handy in coming months.
If you have made it this far then here’s evidence of the giving up I referred to in the column: http://www.smh.com.au/business/investors-turn-to-term-deposits-in-shift-away-from-equities-20111219-1p2ir.html
Posted by Roger Montgomery, Value.able author and Fund Manager, 20 December 2011.
Aside from fears of reputational damage, one of the big concerns surrounding Cochlear’s recall earlier this year, was how long it would take to return to market. As you know we purchased shares after the announcement that it had recalled its Nucleus CI500 cochlear implant much to the chagrin of some investors who follow our musings here at the Insights blog.
In NSW every child receives a hearing test within two days of birth. Those identified as having profound hearing loss are often assisted by Cochlear. And thats just NSW. Cochlear sells its devices in 100 countries. Once implanted changing devices is not easy. Changing brands may be even harder. Audiologists and speech pathologists are involved and the devices are finetuned to ensure the device suits the individual.
As Matthew pointed out here on the blog a few days ago: “A family member [of Matthews’s] is a key member of a large Australian charity that does a lot of work with children that are deaf and many get the implants. All the equipment they use to “map” or finetune the device after implanting is specific to that company. For example the only brand they have is Cochlear. Recently they had a child from the US that they began to support that had a different brand implanted – they had to change many things to be able to help them. When thinking about market share with these devices I think it is important to know that the decision isn’t solely with the surgeon or specialist, because all of the support people have to change too. I don’t think market share will change quickly or by very much because of these barriers.”
Analysts at Macquarie recently surveyed 389 US-based Audiologists. Despite the product recall, Cochlear is still the world leader in CI devices and retains 60% market share selling into 100 countries. The broker also believes the market is growing at 12 per cent per year.
Many of you know we purchased shares in Cochlear after the September recall (see below), confident this was a temporary issue being treated as permanent by a perennially short-term-focused market.
That now appears to be the case as today’s announcement, posted on the ASX platform by the company reveals; 20122011_COH CI500 impant update
The company previously covered the subject in its AGM presentation here: http://www.cochlear.com/files/assets/corporate/pdf/agm_presentation_18102011.pdf
Analysts were subsequently concerned that 1500 units are going to have to be removed through surgery and another 2800 units have been pulled from shelves. They also worry that an inventory shortfall across the entire market will lead to market share losses from insufficient inventory as well as damage to reputation.
Today’s announcement reveals any small market share loss (we estimate five percent and some analysts suggest between five and ten per cent overall) will be now stemmed by the timely identification of the manufacturing issue that resulted in the failure of 1.9% of devices and their subsequent recall.
Cochlear has ramped up production and its early intervention has enhanced its reputation rather than damaged it as evidenced by several surveys with clinicians. In fact, 93% of doctors surveyed by Macquarie felt that Cochlear handled the recall well, while only 8% believe the company’s reputation has been tarnished.
Ultimately the company’s intrinsic value is determined by its profit and we expect there will be an impact on profit of some import. Cochlear has already created a provision of $130-$150 million and an after tax cash cost of $20 to $30 million. Given the news flow that will now transpire, one expects these costs may be treated by analysts as a ‘one-off’ and investors may have to wait for another temporary setback before being able to buy shares cheaply again…
For those of you interested in following our thoughts back in September 14 (COH $51.30), I wrote the following :
“Imagine spending years waiting patiently for the opportunity to buy that rare coin, vintage bottle of wine or celebrated painting, only to be outbid when it finally comes up for auction.
Sometime later the opportunity presents itself again and you are outbid once more, this time by much more. Successive auctions only take the price further out of your reach – if only you acted sooner!
Then one day you stumble across that very thing you desire being offered for sale by someone who appears to have no interest in its long-term value, for a price you regard as a fraction of its real worth.
Would you buy it?
That is the situation I find myself in today as the Cochlear share price plunges another 14% to $51.30, or about 40% since its April 2011 high of $85.
As Cochlear’s technicians work to isolate the problem with the Nucleus 5 range, the company will dust off the Nucleus Freedom range, which it has marketed successfully for many years against products such rivals as Advanced Bionics and Med-El.
Overnight one of those rivals received FDA approval to sell its product (which was itself recalled in November last year) into the US market. This turn of events is not unusual for the industry … but it is unusual for Cochlear and that’s why the news this week came as such a blow. Cochlear is one of the highest-quality companies trading on the ASX today. The company that almost never puts a foot wrong appears to have tripped itself up and investors are spooked.
The financial impacts of these events (and there will be an impact) have yet to be quantified so until they are why don’t we look at how the company has performed in the past and see if we can’t learn something about it in the interim.
Over the past decade, Cochlear has increased profits every year with the exception of 2004. Net profit was just $40 million in 2002 and last week the company reported profits of $180 million for 2011.
Operating cash flow over the same period has risen from less than a $1 million (an exception for 2002) to more than $201 million, allowing debt to decline to just $63 million from nearly $200 million in 2009. Net gearing is now minus 1.86%.
Those impressive economics have resulted in an intrinsic value that has risen by nearly 18% each year since 2004. If your job as a long-term investor is to find companies with bright prospects for intrinsic value appreciation – believing that in the long run prices follow values – then it quite possible that Cochlear is being served up on a plate.
The recently reported net profit figure of $180.1 million for 2011 was up 16% and in line with consensus analyst estimates, although this occurred despite sales of $809.6 million exceeding analysts’ estimates. It seems the analysts did not expect the EBIT and NPAT margins that were reported. These were flat, which given a very strong Australian dollar, suggests impressive efficiency gains in the operations.
If only that blasted “Australian peso” would go down and stay down!
Back on August 19, 2009, I wrote: “Fully franked dividends have risen every year for the past decade, growing by almost 500% (or 22% pa) since 2000. These are not numbers to be sneezed at; the company has produced an impressive and stable return on equity since 2004 of about 47% with very modest debt. Clearly this is a company worth some significant premium to its equity.”
Nothing changed really for 2011. A final dividend of $1.20 per share was 70% franked and up 14%.
Importantly, it seems Cochlear’s market is growing. Unit sales volumes were up 17% for the year and, given in the first half they were up 20%, it suggests the second half were up 14%. Double digit growth was reported in sales volumes for all major regions and Asia was the most impressive, rising more than 30% to the point where it makes up 16% of total revenues.
This really is impressive stuff. Just two years ago the company reported unit sales growth of only 2%, to 18,553 units, and many analysts were blaming slow China sales. Nobody expected the company to ever repeat its 2007 and 2008 volume growth of 24% and 14% respectively, and certainly not off a higher base.
Growth has always been viewed as is limited by the high cost of the devices and the reliance on insurance and healthcare schemes to subsidise the costs and those of surgery to implant to them.
According to the World Health Organization however, almost 280 million people suffer from moderate to profound hearing loss and an ageing population means this figure will rise. Cochlear is one of a handful of companies that actively contributes to improving the quality of life of its clients.
When great companies stumble, the impact can be exaggerated by the reaction of shareholders who never believed it could happen. Then comes a wave of selling amid doubts that the company will ever regain its mantle.
But strong market share and strong cash flow, high returns on equity and low debt, are rarely offered at bargain prices so I picked up some Cochlear stock yesterday for the Montgomery [Private] Fund. It is likely that I will to add to this position over the coming days and weeks when the full financial impact of the recall is known.
I must confess I didn’t bet the farm on this particular investment because the financial impact of the recall – and there will be one – remains unclear; when that changes it will impact my intrinsic value estimate (UBS has revised its forecast net profit for 2012 by 10.5% to $179.5 million).
Whatever the impact, it will be temporary, even though it won’t necessarily preclude lower prices from this point. During the GFC, Cochlear shares fell from $78 to $44. No company is immune to lower share prices and I don’t know when or in what order they will transpire.
What I do know is that in 2021 we aren’t likely to be thinking about this recall, just as nobody now talks about the Wembley Stadium delays that dogged Multiplex back in 2006. Mercifully, investors’ memories tend to be short.
Recalls, competition, marketing gaffes and wayward salary packages are all part of the cut and thrust of business and if lower prices ensue for Cochlear shares, it will be important to determine whether the recall will inflict permanent scars. My guess is that it will not.”
Posted by Roger Montgomery, Value.able author and Fund Manager, 20 December 2011.
You will have noticed that since November 16 every post here at the Blog has been a cautionary one. You have not seen me post a ‘here’s possible good value’ story. There is a little method in that, even though we might be unduly conservative. But here goes again…
Many of you have heard me discuss JB Hi-Fi and its preferred status among retailers – I believe if JBH is doing it tough everyone else is doing it even tougher. But we sold JBH from our holdings at $15.50 recently and I thought the story of why (ahead of a downgrade as it turns out) would be a good insight into the way we think. Hopefully other investors can gain some insight into the process and fill in the 1) ‘bright prospects’ part of the equation that also requires 2) extraordinary businesses and 3) discounts to intrinsic value.
Starting way back in February 2010 we commented on the impending retirement of JBH’s Richard Uechtritz (now looking as well-timed as other prominent CEO departures, such as the Moss departure from Macquarie and I am sure you can list a few more – go right ahead) and the maturing outlook for the business itself.
“If JB Hi-Fi could re-employ all of its profits at the returns of about 45% it is generating now, its value would be over $38. That’s a pipe dream. The company is generating cash faster than it can ask its employees and contractors and landlords to employ the funds to open new stores. And because the profits also produce taxes and associated franking credits that have no value for the company, shareholders are being handed back the funds, which is a disappointment. However, as chairman Patrick Elliott implied when I spoke with him on radio this week, this is a function of growth and the limited size of the Australian population.
It happens eventually to all retailers and it will happen to JB Hi-Fi in the next five to seven years. The best you can hope for is that once the stores have saturated the market, directors stick to their knitting, and the company continues to generate high returns but pays out all of those earnings out as a dividend (becoming like a bond) rather than make some grand attempt to buy something offshore or diversify too far away from their core expertise (often at the behest of some institutional shareholder) and blow up the returns.
The result of not employing as much retained earnings at 45% is that the intrinsic value declines. It is still going up but not as much.”
In August here at the blog we wrote:
“The big story however is that Terry Smart will need to start looking beyond this organic growth to other strategies if JB Hi-Fi is to avoid developing the profile of another mature Australian retail business like Harvey Norman.”
and
“JB Hi-Fi needs to establish new and emerging business models to try and counter the shift away from physical music unit sales.”
and
“Having said that, the current sales environment is probably not representative of the future. Share market investors generally use the rear view mirror when assessing the future. I have previously discussed the “economics of enough”, which David Bussau from Opportunity International introduced me to many years ago. As it applies to consumers generally, they will get sick of trying to keep up with the latest technology, be happy with their TVs and replace everything less often – opting instead to ‘experience’ travel, food, adventure and other cultures. That of course doesn’t mean JB can’t grow its share-of-wallet. In the face of declining retail sales volume growth over the last five to ten years and deflation, JB is proving it is already the market leader.”
and
“JB Hi-Fi’s quality score dropped from A1 to A3 and interestingly, this was only partly due to the increase in debt. (We really need to know whether it was just timing issues and new stores that contributed to the jump in inventory).”
In addition to these comments I wrote more recently:
“The release of the iPhone 4S seemed to underwhelm technology reviewers when launched and a portion of the population do take their purchasing cues from such quarters.
The 4S is apparently an evolution in the iPhone series, rather than a revolution, and as such, fewer users of the most recent release – the iPhone 4 – will upgrade. Instead, it is likely that they will wait until the iPhone 5 is released next year (owners of the previous model the iPhone 3GS, however, should be coming off their two-year contracts about now and are expected to upgrade). We’ll come back to that shortly.
The iPhone doesn’t contribute anything like a majority profit to JB Hi-Fi’s bottom line. This is because margins on Apple products are slim. But the iPhone does generate foot traffic and phone upgraders also buy protective covers and other accessories on which JB Hi-Fi makes much more significant margins.
So why do we care so much about the iPhone?
It’s because when JB Hi-Fi announced its full-year results the company forecast more than $3 billion in sales and management cited growth from computing, telco, and accessories. They said:
“While we anticipate the market to remain challenging, our diversified product portfolio, particularly the categories of computers, telco and accessories, from which we expect strong growth, will assist JB Hi-Fi in delivering another year of solid sales and earnings in FY12. Assuming trading conditions are comparable with FY11, we expect sales in FY12 to be circa $3.2b, an 8% increase on prior year.”
It’s the lower “telco and accessories” sales that are expected to stem from the iPhone 4S underwhelming so-called early adopters and its most ardent fans that may put pressure on that sales forecast.”
Indeed the only thing that was going for JB Hi-Fi was its discount to intrinsic value. Many investors believe that a stock I mention is below intrinsic value is a “darling’ of mine. It isn’t. A company must meet all of our criteria and it will only be held for as long as it does. Those of you using Skaffold will however have seen JBH was trading only at a discount to one of the intrinsic value estimates – the intrinsic value based on analyst forecasts – but not the more conservative Skaffold Line valuation estimate of $13.16. See Figure 1.
Figure 1.
Both valuations are now likely to decline further in coming days -even the more conservative $13.16 valuation SKaffold has been displaying – and the downgrade may also be reflected in pressure on the company’s cash flow which Skaffold members would have already seen in the 2011 results and which prompted some of the above comments. (See Figure 2. and note the negative funding gap line (international patents pending))
Figure 2. Showing declining operation cash flow and a growing Funding Gap (patents pending).
JB Hi-Fi was 5 per cent of our portfolio however we sold all of our position at $15.50 recently. Our reasoning was simple; Given present circumstances and expectations for retailing (having spoken to many retailers recently) many retailers JB Hi-Fi would have to revise their earlier outlook statements and this would produce lower future valuations. At the same time analyst forecasts are typically optimistic in the first half of the financial year (this year being no exception to that rule) and we should therefore be demanding much larger discounts and JBH was not offering that margin of safety. We also commented to our peers in conversations over the phone and in person that the delfation story – as explained by Gerry Harvey who noted selling plasma TVs for $399 this year means he has to sell three times the volume as last year to make the same money – would put pressure on profits because people already had enough plasma TVs. Finally we also believed that ANZ’s profit growth being dominated by bad debt provisioning writedowns meant that credit growth was non-existant. When you take away growth in credit card purchases – thats got to hurt discretionary retailers.
On November 7 we wrote to our Montgomery [Private] Fund investors thus:
A prominent media commentator and broker however wrote on December 6
“Our No.1 discretionary retail recommendation remains JB Hi-Fi (JBH). We all know 21% of JBH’s register is currently shorted, a massive short position usually reserved for financial impaired or structurally stuffed stocks. JBH is neither, and that is why we continue to be aggressively recommending buying the stock which generates 25% of its annual profit in December. JBH is trading on 11.2x bottom of the cycle earnings. Nowadays, the P/E’s of cyclical stocks compress with their earnings, meaning that both P/E and E bottom concurrently.”
So, JBH still has long term prospects that surpass many of its peers and I believe it still has a competitive advantage. And if all those short sellers cover their position, the stock could rally. That however would be speculating. On the flip side, changes to accounting reporting standards will give it a lot more liabilities – contingent liabilities such as operating leases will need to come onto the balance sheet. Also, the medium outlook, which includes deflation continuing, will put pressure on JB to sell more volume at precisely the time everyone may just have enough stuff. Finally, the market may now finally catch up to the maturity story we described way back in 2010. Of course consumers will return at some point and spending and credit growth will recover, but given the current weakness and fear among consumers the idea of requiring very, very large discounts to the more conservative estimates of intrinsic value dominates our thinking.
As always be sure to do your own research and seek and take personal professional advice.
Posted by Roger Montgomery, Value.able author and Fund Manager, 16 December 2011.
Continuing on our hypothecation theme, David Stockman, former Director of the White House Office of Management and Budget during the Reagan Administration penned the following to Mrs Lee Adler of the Wall Street Examiner. Stockman is currently writing a book on the financial crisis and some of the thoughts he expresses in his exchanges with Adler relate to the ideas he is developing in the book.
Those you hoping for a quick end to the ructions in Europe and a return to normal levels of volatility may wish to ponder Mr Stockman’s thoughts on why European Banks are on the verge of collapse:
“The real story of the present is the shadow banking system, the unstable and massive repo market, and the apparent daisy chain of hyper-rehypothecated collateral. It looks like the sound bite version amounts to the fact that the European banking system is on the leading edge of collapse for the whole system. These institutions are by all evidence now badly deficient of the three hallmarks of real banks—deposits, capital and collateral.
BNP-Paribas is the classic example: $2.5 trillion of asset footings vs. $80 billion of tangible common equity (TCE) or 31x leverage; it has only $730 billion of deposits or just 29% of its asset footings compared to about 50% at big U.S. banks like JPMorgan; is teetering on $500 billion of mostly unsecured long-term debt that will have to be rolled at higher and higher rates; and all the rest of its funding is from the wholesale money market , which is fast drying up, and from repo where it is obviously running out of collateral.
Looked at another way, the three big French banks have combined footings of about $6 trillion compared to France’s GDP of $2.2 trillion. So the Big Three [F]rench banks are 3x their dirigisme-ridden GDP. Good luck with that! No wonder Sarkozy is retreating on France’s AAA and was trying so hard to get Euro bonds. He already knows he is going to be the French Nixon, and be forced to nationalize the French banks in order to save his re-election.
By contrast, the top three U.S. banks which are no paragon of financial virtue—JPM, Bank of America, and Citigroup—have combined footings of $6 trillion or 40% of GDP. The French equivalent of that number would be $45 trillion. Can you say train wreck!
It is only a matter of time before these French and other European banks, which are stuffed with sovereign debt backed by no capital due to the zero risk weighting of the Basel lunacy, topple into the abyss of the shadow banking system where they have funded their elephantine balance sheets. And that includes Germany, too. The German banks are as bad or worse than the French. Did you know that Deutsche Bank is levered 60:1 on a TCE/assets basis, and that its Basel “risk-weighted” assets are only $450 billion, but actual balance sheet assets are $3 trillion? In other words, due to the Basel standards, which count sovereign and other AAA assets as risk free, DB has $2.5 trillion of assets with zero capital backing!
This is all a product of the deformation of central banking and monetary policy over the last four decades and the destruction of honest capital markets by the monetary central planners who run the printing presses. Furthermore, this has fostered monumental fiscal profligacy among politicians who have been told for years now that the carry cost of public debt is negligible and that there would always be a central bank bid for government paper. Perhaps we are now hearing the sound of some chickens coming home to roost.”
Posted by Roger Montgomery, Value.able author and Fund Manager, 16 December 2011.
Investors should keep a close watch on Monadelphous and Fleetwood. If their premiums to intrinsic value decline, they may present attractive opportunities. Read Roger’s article at www.eurekareport.com.au.
How many of you have heard the financial term ‘Hypothecation’? Microsoft word hasn’t – the bug-prone program constantly tells me to check the spelling. If it’s also new to you, take note because you may be hearing a lot more about it and it could impact your portfolio.
Prior to the collapse of MF Global, it’s unlikely that many in the investment world would have ever heard of the terms; ‘hypothecation’ or ‘re-hypothecation. If you hold any dollars in an international brokerage / trading account, especially one where your funds are dispatched to somewhere in the UK, hypothecation may be the canary in the mine.
MF Global was allegedly using client-segregated monies for its own trading activities – a practice that is for obvious reasons, not practiced in most countries. The trading brought a 230-year old firm to its knees in a matter of weeks and resulted in the freezing of client funds. Funds thought to be ‘segregated’ and separate from the working capital of the firm, weren’t. But is MF Global an isolated case or is a practice that levers clients funds widely practiced and one that could undermine the financial system?
What the MF Global collapse has uncovered is that laws designed to prevent to access to ‘segregated’ accounts are being circumvented. Some firms may have also shifted accounts to countries where it is legal to access client’s funds for the firms trading activities. When you thought the only risk was that of your trade or investment selection going wrong, think again.
Hypothecation is, in simple terms, the practice of a borrower putting up collateral to secure a debt. An example of this is the typical purchase of a house. The buyer puts down a 20% deposit and borrows the remaining 80%. In this case the borrower has put up some cash and the house (at an agreed value) as collateral to cover the debt until the mortgage is paid off. Until such the borrower retains ownership of the collateral. Thus the collateral (both the deposit and the house) remains “hypothetically” controlled by the creditor, usually a bank. If the borrower can’t afford to meet agreed repayments (default), the creditor can take possession of the collateral and sell it to recover its assets. That’s Hypothecation – hypothetically the borrower owns the house, but in fact, they don’t until all loans are paid off. The same goes for securities purchased on margin.
With the basics out of the way we return to MF Global. Surprisingly hypothecation occurs when an investor puts their capital into a trading account to buy and sell securities such as CFD’s, Futures, Options, Commodities, etc.
And that should be that. Your money sits in your segregated trading account as collateral covering your positions – margined or not – until such as a time that you suffer an inability to pay back your debt to your broker (creditor) – if you ever do. And that is as we know it in Australia. MF Global here in Australia appears to have followed that procedure. But has it done so in the UK and the US? And how do others behave?
The practice and rules regulating hypothecation vary depending on the jurisdiction in which the trading account exists. In the US for example, the legal right for the creditor to ONLY take FULL ownership of the collateral if the debtor defaults is classified as a lien – a form of security interest granted over an item of property to secure the payment of a debt or performance of some other obligation.
In the UK however, these rules are more than a little different. In the US there are some breaks, re-hypothecation is capped at 140% of a client’s debit balance. In the UK however, there is no limit on the amount of a clients funds that can be re-hypothecated, except if the client has negotiated an agreement with their broker that includes a limit or prohibition. UK brokers can ‘REUSE’ collateral put up by clients to secure their own trading activities and borrowings through a little unknown process called Re-hypothecation! While you may think that your ‘segregated’ capital is being used only as collateral for your own trading activities and borrowings / margin, a firm such as MF Global who operates out of the UK, can re-use their clients collateral to back their own trades and borrowings! Are you thinking credit card on credit card, gearing on gearing, leverage on leverage? And how do excessively leveraged position usually work out? Not well generally.
In the industry it’s referred to as “fractional reserve” synthetic liquidity creation by Prime Brokers. The IMF in their 2010 paper The (sizable) Role of Rehypothecation in the Shadow Banking System” Manmohan Singh and James Aitken state: “Mathematically, the cumulative ‘collateral creation’ can be infinite in the United Kingdom”. They add that courtesy of no re-hypothecation haircuts one can achieve infinite “shadow” leverage and the creation of a large shadow banking system.
Gary Gorton in his 2009 paper “Haircuts” about systemic risk in the repo market (something I used to teach for the Securities Institiute of Australia) suggests that banks’ reliance on the repo market constitutes a systemic fragility which renders the entire banking system prone to runs: “Gorton predicts the crisis was not a one-off event and it could happen again”.
He also addresses the relationship between confidence and liquidity suggesting when “confidence” is lost, “liquidity dries up” and concludes the financial crisis was a manifestation of an age-old problem with private money creation, banking panics. ‘Haircuts’ are the functional equivalent of information arbitrage: “When all investors act in the run and the haircuts become high enough, the securitized banking system cannot finance itself and is forced to sell assets, driving down asset prices. The assets become information-sensitive; liquidity dries up. As with the panics of the nineteenth and early twentieth centuries, the system is insolvent.” “Liquidity requires symmetric information, which is easiest to achieve when everyone is ignorant. This determines the design of many securities, including the design of debt and securitization.”
What Gorton says is that the increasing complexity of banks and the securities they issue is motivated by the need to obfuscate the masses and distract them from what is really occurring.
Let’s say a hedge fund (who is managing your money) puts up $100,000 collateral to support a leveraged position of $1,000,000. If the broker then re-hypothecates that $100,000 and uses this to support the same level of leverage, the firm is in a position where just $100,000 in collateral (not theirs) is supporting $2,000,000 in leveraged market positions.
A move of just 5% on $2,000,000 equates to $100,000 in profit and both you and your broker make $50,000 each. A move however of 5% against a $2,000,000 position can however wipe most of the collateral – and such moves are not uncommon today. While a single trade will unlikely bring down a broker’s diversified trading book, if all trades move in unison (remember US house prices were never expected to all decline at once), as was the case when MF Global traded European bonds, you can see how quickly everything can unravel.
And remember, while the broking firm enjoys all of the trading profits and fees, the clients bear the risk. If the broker loses, they file for bankruptcy, leaving clients holding an empty can. This appears to be what transpired at MF Global. It’s the ultimate privatization of profits and socialization of losses. And according to an increasingly vocal group of experts it could all happen again if a sovereign defaults.
And now you also have the reason why Central Banks around the world are applying a policy of ‘price stability’ or ‘price support’ in asset markets like the stock market – everyone is leveraged to the hilt.
It has been estimated that in 2007, re-hypothecation accounted 50% of the worlds Shadow banking system and the IMF estimated that US banks received $4 trillion of funding from the UK from re-hypothecation using just $1 trillion in clients funds, funds being levered several times over. In this light, don’t think for a moment that MF Global is alone in using client’s funds to trade and borrow for their own trading activities.
It appears in the current market environment that the first question you should ask is not whether or not your investment idea will work out correctly, it’s more a question of whether the money you put into your broker sponsored account will ever come back.
And now that re-hypothecation is exposed, I wonder how many assets have been double, tripled and quadruple-counted. An expose on this subject by Reuters about this subject following the collapse of MF Global, revealed that “Engaging in hyper-hypothecation have been Goldman Sachs ($28.17 billion re-hypothecated in 2011), Canadian Imperial Bank of Commerce (re-pledged $72 billion in client assets), Royal Bank of Canada (re-pledged $53.8 billion of $126.7 billion available for re-pledging), Oppenheimer Holdings ($15.3 million), Credit Suisse (CHF 332 billion), Knight Capital Group ($1.17 billion), Interactive Brokers ($14.5 billion), Wells Fargo ($19.6 billion), JP Morgan($546.2 billion) and Morgan Stanley ($410 billion).”
And if you are wondering what the implications are, it may not be what you think. Initially there will be the denials and then, if Prime Brokers have to recall all the stock they lent out, imagine the global short covering rally?
And meanwhile the Euro crisis related elimination of deficit spending could force banks into administration or liquidation, which in turn causes assets to be marked down to market and pressure on equities. We invest in interesting times…but don’t forget highest quality stocks at substantial discounts to intrinsic value.
Posted by Roger Montgomery, Value.able author and Fund Manager, 12 December 2011.
In 2010 here at the Insights Blog I wrote:
“a bubble guaranteed to burst is debt fuelled asset inflation; buyers debt fund most or all of the purchase price of an asset whose cash flows are unable to support the interest and debt obligations. Equity speculation alone is different to a bubble that an investor can short sell with high confidence of making money.
The bubbles to short are those where monthly repayments have to be made. While this is NOT the case in the acquisitions and sales being made in the coal space right now, it IS the case in the macroeconomic environment that is the justification for the purchases in the coal space.
China.
If you are not already aware, China runs its economy a little differently to us. They set themselves a GDP target – say 8% or 9%, and then they determine to reach it and as proved last week, exceed it. They do it with a range of incentives and central or command planning of infrastructure spending.
Fixed asset investment (infrastructure) amounts to more than 55% of GDP in China and is projected to hit 60%. Compare this to the spending in developed economies, which typically amounts to circa 15%. The money is going into roads, shopping malls and even entire towns. Check out the city of Ordos in Mongolia – an entire town or suburb has been constructed, fully complete down to the last detail. But it’s empty. Not a single person lives there. And this is not an isolated example. Skyscrapers and shopping malls lie idle and roads have been built for journeys that nobody takes.
The ‘world’s economic growth engine’ has been putting our resources into projects for which a rational economic argument cannot be made.
Historically, one is able to observe two phases of growth in a country’s development. The first phase is the early growth and command economies such as China have been very good at this – arguably better than western economies, simply because they are able to marshal resources perhaps using techniques that democracies are loath to employ. China’s employment of capital, its education and migration policies reflect this early phase growth. This early phase of growth is characterised by expansion of inputs. The next stage however only occurs when people start to work smarter and innovate, becoming more productive. Think Germany or Japan. This is growth fuelled by outputs and China has not yet reached this stage.
China’s economic growth is thus based on the expansion of inputs rather than the growth of outputs, and as Paul Krugman wrote in his 1994 essay ‘The Myth of Asia’s Miracle’, such growth is subject to diminishing returns.
So how sustainable is it? The short answer; it is not.
Overlay the input-driven economic growth of China with a debt-fuelled property mania, and you have sown the seeds of a correction in the resource stocks of the West that the earnings per share projections of resource analysts simply cannot factor in.
In the last year and a half, property speculation has reached epic proportions in China and much like Australia in the early part of this decade, the most popular shows on TV are related to property investing and speculation. I was told that a program about the hardships the property bubble has provoked was the single most popular, but has been pulled.
Middle and upper middle class people are buying two, three and four apartments at a time. And unlike Australia, these investments are not tenanted. The culture in China is to keep them new. I saw this first hand when I traveled to China a while back. Row upon row of apartment block. Empty. Zero return and purchased on nothing other than the hope that prices will continue to climb.
It was John Kenneth Galbraith who, in his book The Great Crash, wrote that it is when all aspects of asset ownership such as income, future value and enjoyment of its use are thrown out the window and replaced with the base expectation that prices will rise next week and next month, as they did last week and last month, that the final stage of a bubble is reached.
On top of that, there is, as I have written previously, 30 billion square feet of commercial real estate under debt-funded construction, on top of what already exists. To put that into perspective, that’s 23 square feet of office space for every man, woman and child in China. Commercial vacancy rates are already at 20% and there’s another 30 billion square feet to be supplied! Additionally, 2009 has already seen rents fall 26% in Shanghai and 22% in Beijing.
Everywhere you turn, China’s miracle is based on investing in assets that cannot be justified on economic grounds. As James Chanos referred to the situation; ‘zombie towns and zombie buildings’. Backing it all – the six largest banks increased their loan book by 50% in 2009. ‘Zombie banks’.
Conventional wisdom amongst my peers in funds management and the analyst fraternity is that China’s foreign currency reserves are an indication of how rich it is and will smooth over any short term hiccups. This confidence is also fuelled by economic hubris eminating from China as the western world stumbles. But pride does indeed always come before a fall. Conventional wisdom also says that China’s problems and bubbles are limited to real estate, not the wider economy. It seems the flat earth society is alive and well! As I observed in Malaysia in 1996, Japan almost a decade before that, Dubai and Florida more recently, never have the problems been contained to one sector. Drop a pebble in a pond and its ripples eventually impact the entire pond.
The problem is that China’s banking system is subject to growing bad and doubtful debts as returns diminish from investments made at increasing prices in assets that produce no income. These bad debts may overwhelm the foreign currency reserves China now has.”
I now wonder whether we are seeing the bubble slip over the precipice? Falling property prices (10 per cent of the Chinese economy) leads to lower construction activity, leads to declining demand for Australian commodities, leads to falling commodity prices, leads to bigs drops in margins for a sizeable portion of the market index…
Watch this video and decide for yourself.
Posted by Roger Montgomery, Value.able author and Fund Manager, 8 December 2011.
Buying shares in the right businesses will help investors avoid being caught in an index that is going nowhere. Read Roger’s article at www.eurekareport.com.au.
