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 shows investors how he uses Skaffold to find great value stocks at the ASX Investor Hour Sydney. Watch the video.
Roger Montgomery shows investors how he uses Skaffold to find great value stocks at the ASX Investor Hour Sydney. Watch the video.
Investor Point: Andrew observes that companies in fast changing industries are prone to misguided adventures with shareholders funds after they mature (which they do very quickly in a country with a population of a mere 23 million).
(if you’d like to contribute a post send it to roger@rogermontgomery.com with the word CONTRIBUTION in the subject line)
The internet list companies have long been considered favourites of some of the community here (including myself). Their ability to generate lots of free cash and earnings against very little equity makes them prime considerations as a company some would like to own, especially as some have great competitive moats around them. However, is there an inherent risk that needs to be considered and compensated for when choosing to value and/or invest in these companies? This is a question I have been considering as of late and would like some help to answer.
Valuing companies is a forward looking exercise and so we must make certain decisions and adjustments based on how we think this company will grow over the years.
A company must be able to earn attractive rates of return on the incremental capital it puts to work. As a company moves further along on its life cycle this gets harder to do. When a company reaches maturity, earning these attractive returns becomes even more difficult and organic growth opportunities dry up. A company must then look for other avenues of growth and/or use its capital wisely to increase shareholder value whether it’s through increased dividends or share buy backs.
Usually a company can grow organically by opening up new stores for example, however you cannot do this on the internet. This lack of organic growth opportunities causes the growth stage of the business to be shorter and therefore the maturity stage to come around in a quicker timeframe than a tangible business. The lack of costs needed to operate this kind of business also means that when these companies reach maturity, there is very little scope to increase profits by becoming leaner.
This only leaves the option of new product offerings, purchased growth (M&A) and/or offshore expansion as the remaining avenues for growth. All of these options have risk to both the company and investor and could see real damage done to the return on equity of the business if not done well (for example paying too much for another company).
The growth versus profitability conundrum is one that has seen many companies go down a route, which leaves the investor worse off.
It is my opinion that acquisitions cannot be seen as abnormal or opportunistic exercises for these internet businesses. They are, instead, an inevitable result of the companies journey through the life cycle and therefore needs to be considered when making investment and valuation decisions. As an investor cannot know exactly when and where this acquisition will be made nor how much it will cost until it happens it therefore clouds the waters of valuation.
As has been said many times, it is better to be conservative and wrong than optimistic than wrong and one could easily use more conservative inputs to compensate for this unknown. Another option to consider is that there is a higher implied risk for this investment and there for an investor should ask for a higher required return (higher risk premium) or seek much larger margins of safety.
The investor cannot with the same certainty be able to invest in these companies over a long-term time horizon as some other businesses as the expected life cycle of such a business is shorter and involve constant corporate activity, which will require a meaningful amount of analysis. So far the main companies (REA, SEK, WEB, CRZ, WTF) have been negotiating the path reasonably well and hopefully that continues. However, some have been especially active in purchasing growth and/or going offshore. If this continues it is my opinion that the risk becomes higher as the risk of management error (paying too much etc) becomes greater.
Posted by Andrew
Postscript: Paying too much for the companies themselves is also possible (see valuation/price chart below for WEB)!
Posted by Andrew L with permission of Roger Montgomery, Value.able and Skaffoldauthor and Fund Manager, 21 February 2012.
Bloomberg:
“Walter Schloss, the money manager who earned accolades from Warren Buffett for the steady returns he achieved by applying lessons learned directly from the father of value investing, Benjamin Graham, has died. He was 95.
He died yesterday at his home in Manhattan, according to his son, Edwin. The cause was leukemia.
From 1955 to 2002, by Schloss’s estimate, his investments returned 16 percent annually on average after fees, compared with 10 percent for the Standard & Poor’s 500 Index. (SPX) His firm, Walter J. Schloss Associates, became a partnership, Walter & Edwin Schloss Associates, when his son joined him in 1973.
“He was a true fundamentalist,” Edwin Schloss, now retired, said today in an interview. “He did his fundamental analysis and was very concerned that he was buying something at a discount. Margin of safety was always essential.”
Buffett, another Graham disciple, called Schloss a “superinvestor” in a 1984 speech at Columbia Business School. He again saluted Schloss as “one of the good guys of Wall Street” in his 2006 letter to shareholders of his Berkshire Hathaway Inc.
“Following a strategy that involved no real risk — defined as permanent loss of capital — Walter produced results over his 47 partnership years that dramatically surpassed those of the S&P 500,” wrote Buffett (BRK/A), whose stewardship of Berkshire Hathaway (BRK) has made him one of the world’s richest men and most emulated investors. “It’s particularly noteworthy that he built this record by investing in about 1,000 securities, mostly of a lackluster type. A few big winners did not account for his success.”
Biography: While Walter Schloss’s name is not nearly as ubiquitous as Warren Buffett, Schloss was arguably one of the best investors ever. Like Buffett, Schloss was a student of Ben Graham, worked at Graham’s firm with Buffett , and is one of ” Super Investors” mentioned by Buffett in his famous essay The Super Investors of Graham-And-Doddsville.
Here’s a table of Schloss’s returns to 1984.
Walter Schloss was born in 1916. At 18 years old he worked as a Wall Street runner for on Wall Street. While he didn’t attend college he enrolled in several classes given by legendary investor Benjamin Graham. Schloss eventually went to work for the Graham-Newton Partnership. In 1955 Schloss launched his own value fund. He ran the fund until 2000.
Schloss was reportedly very frugal. In one year, legend has it that his total office expense was $11,000 while his partnership generated a net profit of $19,000,000.
Schloss stopped actively managing other people’s money in 2003 and was a treasurer for the Freedom House a non-profit group devoted to furthering democracy, and human rights.
Over the 45 years Schloss managed his fund he trounced the S&P 500 by producing returns of 15.3% versus 10% for the S&P 500. A $10,000 initial investment in Schloss’s fund would have grown to $12,344,268, compared to an initial investment of $10,000 in the S&P 500 which would have produced $1,173,909.
Farewell and Thank You.
Posted by Roger Montgomery, Value.able and Skaffoldauthor and Fund Manager, 21 February 2012.
Click on the image at left to see a close up of the stocks we like.
I reckon 2012 will be the year to get set and fill your portfolio with high quality businesses, demonstrating bright prospects for intrinsic value growth and a margin of safety. That will be the topic of my talk today as I kick off the ASX’s 2012 Investor Hour series. Here are the details:
Topic: Buying opportunity
When: Tuesday 21 February
Where: Wesley Conference Centre, 220 Pitt Street, Sydney (venue location)
Time: 12 noon – 1pm. Please arrive by 12.00 noon for start
Details:
The time to get interested in share investing and make good returns is precisely when everyone else isn’t. But know that the key to slowly and successfully building wealth in the sharemarket is to avoid losing money permanently.
At this event Roger will set out his principles for stock selection.
Roger Montgomery is a highly-regarded value investor, analyst and author and a regular contributor and commentator across the media. Roger is an analyst at Montgomery Investment Management Pty Ltd.
Presenter(s): Roger Montgomery, www.Skaffold.com, www.Montinvest.com
Posted by Roger Montgomery, Value.able and Skaffoldauthor and Fund Manager, 21 February 2012.
I was surprised to read mainstream financial commentary today, suggesting today’s sell off reflected a “shrugging off” of a “solid” domestic labour report, and that instead, the market focused on disappointing earnings reports from large cap domestic companies and growing fears Greece is moving closer to default. Putting aside the fact you’d go nuts trying to make sense of every zig and zag of the market, lets examine the influences todays market gyrations are being attributed to and come up with a better approach to investing.
First regarding Greece: They ARE BANKRUPT. If a country needs $171 big ‘B’ billions in rescue funds, they are bankrupt. The reports that suggest they will default in mid March “if” they don’t get the money means THEY DONT HAVE THE MONEY! And generally, if you don’t have the money to make interest payments or pay out maturing loans, you call in the administrators, receivers of liquidators.
Deputy RBA governor Guy Debelle told me this week that if you owe the bank $100 its your problem but if you owe them $100 billion, its the banks problem. Not quite sure why this should give us any comfort – its a problem. Suffice to say officialdom is sanguine about the risks in Europe and believe the worst is over thanks to the ECB’s unlimited cheap 5-year facility offer last year.
Turning locally and I thought it worth thinking about that “robust” labour situation in Australia and mentioned above: Jobs are being shed in manufacturing, financial services, banking, retailing and in Qantas’ing. I am getting calls from analysts all over who are being made redundant and looking for work (and I can think of nothing better than taking them all on to create the an Equities Newsletter the likes of which this country has never seen. Lets park that. It beggars belief that anyone would suggest that employees on the east coast of Australia are content and secure. And don’t forget that when one person loses their job, they commiserate with friends and they all stop spending “just in case” it happens to them too.
Permabear Steve ‘Kosciusko’ Keen looked even deeper at this and particularly at the following quote from the RBA’s decision last week not to raise rates; “Information on the Australian economy continues to suggest growth close to trend… the unemployment rate increased slightly in mid year, though it has been steady over recent months…With growth expected to be close to trend and inflation close to target, the Board judged that the setting of monetary policy was appropriate for the moment.”
But Steve noted: the “steady over recent months” phenomenon that the RBA referred to above was entirely due to a fall in the participation rate. Had this remained at the November level, the ABS unemployment rate would have jumped to 5.6 per cent last month.
On one side of the investing coin is the idea that you lay out money today to get more back later. The flipside is that buy purchasing today you forego consumption today for the ability to consume more later.
They aren’t quite the same thing of course, because the latter idea introduces inflation and suggests the purpose of investing is to at least maintain purchasing power (generate returns in line with inflation) or increase purchasing power (generate real returns in excess of inflation). In a useful reminder Buffett observes:
“Even in the U.S., where the wish for a stable currency is strong, the dollar has fallen a staggering 86% in value since 1965, when I took over management of Berkshire. It takes no less than $7 today to buy what $1 did at that time. Consequently, a tax-free institution would have needed 4.3% interest annually from bond investments over that period to simply maintain its purchasing power. Its managers would have been kidding themselves if they thought of any portion of that interest as “income.””
Therefore an investment that is price stable but loses purchasing power is very risky (think US T-Bonds) while an asset that is volatile in price but almost certain to increase purchasing power over time is less risky than the conventional measures of risk would dictate.
This is how Buffett begins an excerpt of his forthcoming letter to Berkshire Hathaway shareholders HERE. One scenario his introduction does not contemplate of course is deflation. Japanese real estate and equity prices are fractions of their previous levels and a bond offering even a miniscule return would produce an increase in purchasing power. Like many readers, you might reach the conclusion that the absence of this scenario in his letter along with the knowledge of aggressive equity purchases in recent months, indicates he does not believe deflation is a possibility.
The other subject of his letter is Gold. Melted down all the gold in the world would amount to one 68 cubed foot of uselessness. Somewhat ironically he reflects on its purchasing power today – all the agricultural land in the United States, sixteen companies as valuable as Exxon and a trillion dollars in walking-around money.
But he points out that the companies will have thrown off dividends and the land would have produced food. And so the article leads to the defence of buying businesses as a superior strategy (to owning gold ‘that just sits there’) – as we believe at Montgomery Investment Management, and you might as Value.able graduates (after seeking and taking personal professional advice).
I believe Buffett’s take on the investing landscape is ultimately correct (bubbles are always followed by a bust and nothing goes up forever);
“What motivates most gold purchasers is their belief that the ranks of the fearful will grow. During the past decade that belief has proved correct. Beyond that, the rising price has on its own generated additional buying enthusiasm, attracting purchasers who see the rise as validating an investment thesis. As “bandwagon” investors join any party, they create their own truth — for a while.”
But I trust you can see the irony in claiming gold is useless and yet it can buy 16 Exxons and so on. As the chart shows, it has underperformed stocks over the long term and without boasting about it Buffett uses the S&P500 index to demonstrate the superiority of stocks. In a thinly veiled warning to gold bugs he likens the current enthusiasm for gold to the internet bubble and US housing speculation pre-2007.
In his enthusiasm for stocks being best able to retain purchasing power or increase it, I can’t but help remembering that Buffett was a more circumspect proponent of stocks in the seventies – a period of very high inflation. While in 1974, when Forbes asked Buffett how he felt about the stock market at the time, Buffett replied, “Like an oversexed guy in a whorehouse”, his 1979 letter to investors serves as a useful reminder of the limits of any asset to retain purchasing power during bouts of high inflation.
“Just as the original 3% savings bond, a 5% passbook savings account or an 8% U.S. Treasury Note have, in turn, been transformed by inflation into financial instruments that chew up, rather than enhance, purchasing power over their investment lives, a business earning 20% on capital can produce a negative
real return for its owners under inflationary conditions not much more severe than presently prevail.
If we should continue to achieve a 20% compounded gain – not an easy or certain result by any means – and this gain is translated into a corresponding increase in the market value of Berkshire Hathaway stock as it has been over the last fifteen years, your after-tax purchasing power gain is likely to be very close to zero at a 14% inflation rate. Most of the remaining six percentage points will go for income tax any time you wish to convert your twenty percentage points of nominal annual gain into cash.
That combination – the inflation rate plus the percentage of capital that must be paid by the owner to transfer into his own pocket the annual earnings achieved by the business (i.e., ordinary income tax on dividends and capital gains tax on retained earnings) – can be thought of as an “investor’s misery index”. When this index exceeds the rate of return earned on equity by the business, the investor’s purchasing power (real capital) shrinks even though he consumes nothing at all. We have no corporate solution to this problem; high inflation rates will not help us earn higher rates of return on equity.”
Another warning to stick to high ROE businesses…
Finally remember that if you are buying stocks, unlike commodities, there exists management risk, execution risk, result risk, competitor risk, economic risk, currency risk etc. Anything can go wrong in a business and frequently does. And while Chalrie Munger has pointed out that “Almost all good businesses engage in ‘pain today, gain tomorrow’ activities”, you must know what you are doing.
I think stocks are indeed the best opportunity to retain and increase purchasing power but only the good quality ones. Knowing what you are doing and sticking to high rates of return on equity, little or no debt and A1 or A2 businesses increases your chances of doing even better than the both the stock market index of which they are constituents and inflation.
Posted by Roger Montgomery, Value.able and Skaffoldauthor and Fund Manager, 14 February 2012.
After repotting a reduced annual net profit, what does the current economy hold for JB Hi-Fi’s future performance? Roger Montgomery discusses his insights with the ABC’s David Taylor on The World Today program broadcast 13 February 2012. Read/Listen here.
Following on from our comment yesterday about BHP and comments in the media explaining why we weren’t buyers of BHP or RIO (falling Iron Ore prices and a contracted customer (28% of RIO’s revenue last year) who won’t honor contracts), we are interested in the flow of information through the week.
First the RBA held off cutting rates. Did they know that China would soon be exporting inflation (cost pressures there)? Then the next day China reported…guess what….the biggest jump in inflation…so forget about rate cuts there to help out US and Euro exports?
And now we are hearing that over at RIO a freeze has been placed on contractors and recruitment. Read; “massive overspend / cost inflation”.
Today Bloomberg quoted an analyst on China: “Domestic demand was genuinely weak in January, while exports remained on a gradual downward trend,” said Yao Wei, a Hong Kong-based economist for Societe Generale SA. And “Tom Albanese, chief executive officer of Rio Tinto Group, said yesterday he remains confident of a so-called soft landing in China… Inflation (CNCPIYOY) accelerated last month for the first time since July as food prices climbed before the holiday that started Jan. 22, a statistics bureau report showed yesterday. An index of export orders in the agency’s survey of manufacturing purchasing managers released last week showed a contraction for the fourth straight month. The IMF said in a Feb. 6 report that China’s economic expansion may be cut almost in half from its 8.2 percent estimate this year if Europe’s debt crisis worsens, a scenario that would warrant “significant” fiscal stimulus from the government.(See my postscript).
17/2/2012 PostScript: An analyst we regard highly wrote this to us today:
“On this recent visit, our wise counselor forecast China’s growth rate will be in therange of 8 to 9% in 2012—assuming no major external shocks. Inflationary pressurewill be lower this year than last, especially in the first half of the year. The inflation ratein China for the entire year will be lower than 4%. Low inflation will allow thegovernment to deregulate prices—water, natural gas, and power.Our trusted counselor believes that export markets cannot be counted on to deliver thegrowth that China needs in 2012. Likewise, domestic consumption, while on the rise as apercentage of GDP, is hard to stimulate quickly. Therefore, the only remaining option to preventChinese economic growth from slowing is for the government to use investment as a stimulus.”
Here’s a quick view from Skaffold of RIO. To become a Skaffold member and enjoy having every stock in the Australian market quality rated and valued and all valuations and data automatically updated for every company every day CLICK HERE
Posted by Roger Montgomery, Value.able and Skaffoldauthor and Fund Manager, 10 February 2012.
It’s been a lackluster start to this year’s company confession session. Only a few companies have so far bucked the stable / downward trend in revenues and profits.
At the top of this list, reporting what I would consider to be quality results are CCP (SQR A2) – so far the clear standout and a business we own in the Montgomery Private Fund. This is followed by WEB (SQR A2) a business whose Total Transaction Value (TTV) is growing at rates 4x the industry average but is a little expensive in terms of its future prospects for now.
And that’s about it at the quality end of the investment spectrum (with the exception of Breville, Forge and Decmil’s updates). Remember that we rate every single listed company from A1 (the best) to C5 (the worst) so we follow them all. If you want to find opportunities such as CCP before everyone else, take a look at Skaffold.com
There have been a number of other businesses which have reported so far and on face value, while LGD (SQR B2) experienced strong revenue and profit growth; a large proportion of its growth was driven by several recent acquisitions. Organic growth is less than 50% of that being reported currently; something to watch in future reporting seasons.
Now to our friends long Telstra:
(SQR B3) the half year was a little sobering for those who have bought the stock for its dividend yield. Whilst reported Free Cash Flow was $1,795b and dividends paid amounted to $1,738b, one would assume the yield was fully covered. Not so. The free Cash number reported did not include $559m in interest repayments on almost $15b debt. $500m additional debt was borrowed to fund dividends and CAPEX – debt to equity thus increased and is currently 104%. While dividends are being paid, and will probably continue being paid, its just worth noting how they are being funded…
Over at the Big Australian – BHP:
Staying at the big end of town and global diversified mineral and petroleum producer BHP (SQR B1) reported a HY NPAT $9.9b NPAT down on last year’s. The lower results was despite very attractive Iron Ore, Bulks and Petroleum margins – prices which declined in the latter part of 2012 and which may impact profits further in the 2nd half. The acquisition of Petrohawk for $13b (which pushed gearing to 34%) contributed to earnings but couldnt arrest the decline. Industry-wide cost pressures with consumable, labour and contractor costs added $400m to cost inflation! On a more positive note, the project pipeline of $27b and $5b in actual committed projects. In the half total CAPEX (investment) projects + exploration spend was $9b – this continues to support EPC / EPCM engineers, drillers, mud suppliers (Decmil, Forge, Maca, Fleetwood et. al.) which are all operating at full capacity and expanding like there is no tomorrow. However for BHP investors, because the company continuously has to invest in greenfield projects to offset natural production decline, this results in a capital intensive investment program – something investors in BHP 20 years ago might be acutely aware of. Although they have long-life, world class assets and significant cash flows that are able to meet the demands currently, over the past three months profits have been downgraded from circa $25b to circa $19b. Indicative of an economic slowdown and slowing demand for resources. So something to be watchful of is the fact that declining profits = declining cashflows = declining future investment. Albeit the investment future and plans looks like its all boom time right now.
Posted by Russell Muldoon per Montgomery Investment Management, Value.able and Skaffoldauthor and Fund Manager, 9 February 2012.
