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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“Yet you do not know about what may happen tomorrow. What is the nature of your life? You are but a wisp of vapor that is visible for a little while and then disappears“. James 4:14
“Suddenly a mist fell from my eyes and I knew the way I had to take.” Edvard Grieg
“Fog and smog should not be confused and are easily separated by color.” Chuck Jones
With apologies to 90’s rapper M.C Hammer, today I plan to lift the lid, ever so slightly, on a misconception about the value of tangible assets. I’ll throw in a few Value.able intrinsic valuations for you too.
Were you as fascinated recently, as I was, to read Harvey Norman suggesting that the price premium to book value of JB Hi-Fi compared to that of itself was unjustified? The company pointed out – and allow me to paraphrase – that the market capitalisation of JB Hi-Fi ($1.9 billion) against just $365 million of book value is high, when Harvey Norman’s market capitalisation is $2.7 billion and its book value is expected to be $2.2 billion at the end of this financial year.
The attachment to physical assets held by many is not unusual, nor is the belief that intangible assets are akin to a puff of smoke. Premiums to book value however are justified when that ‘book’ generates above average rates of return. And it is assets of the intangible variety – the economic goodwill (rather than the accounting variety) – that are more valuable anyway. Physical assets can be replaced, imitated and replicated. Any competitor (with deep enough pockets) can purchase almost all of them. Ultimately, any unusual returns these generate will be competed away as competitors secure the same machines, tools, equipment etc. Many in the printing game experience this phenomenon. A new machine gives them a marginal advantage only for as long as it takes their competitor to make the same investment.
Assets of an intangible nature are less easily copied and so high rates of return can be sustained longer, and are therefore worth more.
A company’s book value is the net worth of its assets. Book value is made up of both tangible assets and intangible assets. Tangible assets are physical and financial and include property, plant & equipment, inventory, cash, receivables and investments. Intangible assets aren’t physical or financial and may include trademarks, franchises and patents.
To demonstrate the difference in value between intangible and tangible, have a look at Google; That company’s market capitalisation is US$165.5 billion and yet its book value is just US$48.6 billion. Its price to book value is 3.42 times. JB Hi-Fi’s price to book value is 5.2 times and Harvey Norman’s is 1.22 times. But Google’s ‘book’ generates returns of 19.16%, JB Hi-Fi; 41.5% and Harvey Norman; 11.6%. There is indeed a relationship between the price premium to ‘book’ and the profitability of that ‘book’ (‘ROE’). A business is worth much more than its net tangible assets when it produces profits well in excess of market-wide rates of return.
I wrote about the capital intensity of airlines in Value.able (re-read Pages 60-63, 122, 164, 172-3), so you should know my thoughts about this already (You can also read any of these articles and transcripts for a refresher: Taking-off or crash-landing?, Qantas cuts costs to stay in profit, Qantas cuts staff, flights to counter fuel price hit and Flights reduced, jobs cut at Qantas).
When it comes to physical assets, less is more. For a business to double sales and profits, there is frequently the requirement to increase the level of physical assets. The higher the proportion of physical assets compared to sales that are required, the less cash flow available to the owner. This is the antithesis of the intangible-heavy business that continually produces profits without the need to spend money on maintenance, upgrades or replacements.
Let me demonstrate with an admittedly rudimentary example. Take two companies Rich Pty Limited and Poor Pty Limited. Both companies earn a profit of $100,000. Rich Pty Limited has net assets of $1 million. Intangible assets, such as patents and a brand, represent six hundred thousand dollars while physical assets, including machinery running at full capacity and inventory, represent $400,000. Poor Pty Limited also has a net worth of $1 million, but this time the intangible/intangible mix is reversed and eight hundred thousand dollars represents tangible assets and $200,000 is intangible.
Rich P/L is earning $100,000 from tangible assets of $400,000 and Poor P/L is earning $100,000 from tangible assets of $800,000.
If both companies sought to double earnings, they may also have to double their investment in tangible assets. Rich P/L would have to invest another $400,000 to increase earnings by $100,000. Poor P/L would have to spend another $800,000.
For many investors a large proportion of physical assets – also reflected in a high NTA – is seen as a solid backstop in the event something catastrophic should befall a company. I would suggest that the opposite may just be true. A high level of physical assets may be a drag on your returns.
Physical assets are only worth more if they can generate a higher rate of earnings. Any hope that they are worth more than their book value is based on the ability to sell them for more, and that, in turn, is dependent on either finding a ‘sucker’ to buy them or a buyer who can generate a much higher return and therefore justify the higher price.
With these ideas in mind, its worth looking at a list of companies that further investigation may show have very high levels of tangible assets compared to their profits. Let’s also throw in those companies that have highly valued intangible assets too. If they are generating low returns on these, the auditors should arguably take a knife to their stated ‘book’ values.
Starting with those companies whose market captitalisation is more than $1 billion (156), I then ranked them by return on equity (return on book value) in ascending order. 49 (31 per cent) companies generate returns less than your bank term deposit. The 16 largest (based on market capitalisation) companies with low ROE, possibly indicating either high levels of tangible assets or possibly overstated intangible assets carried on the balance sheet, are:
I have excluded resource companies. For while there are plenty that qualify, their returns are dependent on commodity prices.
Something to remember about the Quality & Performance Rating…
Rated A1 to A5, B1 to B5 and C1 to C5, every listed company is rated based on a series of over 30 discrete metrics, measured at both a point in time and over time. Most importantly, the Quality and Performance Rating is applied without any subjectivity. All companies are judged according to the metrics they generate. A1s have the lowest probability of a liquidation event. “Lowest probability” however doesn’t mean a liquidity event won’t occur. It just means far fewer A1s will have a liquidity event imposed on them compared to C5s. A liquidity event includes a capital raising, debt default or renegotiation, administration, receivership etc. An A1 company could of course raise capital if it needs to fast track construction of a new factory. MCE is an example of a high quality company whose cash flow has needed supplementation for this reason. Sticking to A1s and avoiding C5s should, over time, produce better returns. I demonstrate in the following chart:
The above chart shows the performance of a portfolio of the 20 biggest companies listed on the ASX rated ‘A1’. The red line is the poor old ASX 200.
There is merit with sticking to A1s (just as those who like the taste of Coca-Cola don’t settle for Pepsi). My team and I are fine-tuning something that will make the identification of A1s extraordinarily simple. So ignore those ‘Beat-the-tax-man’ pre-June 30 ‘special’ offers from various investing experts and other ‘helpers’. Avoid the temptation of an extra one, two or three month ‘subscription’, a show bag full of tips, a free magazine, DVD, or even a set of free steak knives.Wait for an A1 opportunity instead. Your patience will be rewarded.
Posted by Roger Montgomery and his A1 team, fund managers and creators of the next-generation A1 service for stock market investors, 13 June 2011.
There’s a lot in this post. So sit back and relax. Put up your feet, pull down the blinds and get comfortable.
Billionaire Oilman J. Paul Getty famously advised; “Buy when everyone is Selling and Hold until everyone is Buying”. Knowing what price to pay most certainly helps to enhance returns in the long run.
An investor without the knowledge to estimate Value.able intrinsic valuations is surely blind to the opportunities presented by a sea of red ink. Without it, one cannot see beyond today. And without intrinsic values one sees only falling prices and fears further declines – frozen in the spotlight of a market collapse.
Even though they told themselves they would buy if prices dropped, now they can’t. Tomorrow, they reassure themselves, will be a better day.
Focus instead on business quality. Seek out those whose prospects are bright and whose Value.able intrinsic values you expect to rise 10, 15, 20 per cent over the years. Identify those whose returns on equity puts your term deposit to shame and whose balance sheet can survive the next GFC, should it occur.
With the downturn in the US’s business cycle triggering fears of recession, I would like to share with you a list. It’s not a list of A1s, and it’s not a list of all companies trading at prices less than they’re ‘worth’.
It is instead a Value.able watchlist of companies that achieve some of our higher quality and performance ratings – A2 or B1 (I shared a list of A1s here a couple of weeks ago) and includes CSL, Data#3, David Jones, Decmil, Mortgage Choice, Oakton, Saunders International, Treasury Group, West Australian Newspapers, Wridgways Australia, Austin Engineering, Myer and Woolworths.
Each business reported return on equity greater than 20 per cent last year and may or may not be demonstrating a safety margin. Some have a track record of extraordinary performance; whilst others, well, won’t (p.s. that’s a clue)
Your Long Weekend Study Guide
The watchlist forms part of your Value.able education. Like the Insights blog itself, it is for educational purposes only. If you haven’t reviewed Value.able lately, I encourage you to spend some time over the long weekend (between periods of relaxation of course) reviewing Part Two – Identifying Extraordinary Businesses, then research your answers to the following questions for each company.
1. Extraordinary prospects: Does the future look bright? Or, if you don’t believe the future will be as extraordinary as the past, why not?
2. Competitive Advantage: What sets this business apart from its competitors?
3. Debt/Equity: How has management managed capital? What is the evidence?
4. Cashflow: Track record of cash flow? Use my quick back-of-the-envelope calculation to asses the true cash power of the business.
5. Which three are going straight to the top of your Value.able watchlist, and why?
Lets build a body of ideas under this post that adds value. If you complete the questions for one or all the companies listed, or if you have identified another company you would like included, go ahead and add it in. Please try and keep your comments under this post consistent with the above, five-part format.
And if all that seems like too much work, keep calm. My team and I are fine-tuning something that will knock your value investing socks off.
Those who have already had a private screening don’t want to be without it, and some Graduates are happy to pre-pay for it, sight unseen!
So ignore those ‘Beat-the-tax-man’ pre-June 30 ‘special’ offers from various investing experts and other ‘helpers’. Avoid the temptation of an extra one, two or three month ‘subscription’, a show bag full of tips, a free magazine, DVD, or even a set of free steak knives.
Wait for an A1 opportunity instead. Your patience will be rewarded.
If you like the taste of Coca Cola, you don’t settle for Pepsi. Even if Pepsi throws in more – an extra 300ml, an extra can or bottle, or even a free holiday – it’s just not the real thing.
Nothing matches what we are putting the finishing touches on for you.
We have been told it is the ‘next-generation’. Actually, its five generations ahead of anything else we have seen. It is A1, it is world leading with global plans and soon it could be yours.
So save your pennies because it won’t be discounted and we won’t need to fill a show bag full of other stuff to convince you.
If Value.able is the menu, then our next-generation A1 is the entire fine-dining kitchen.
Value.able Graduates will be offered first priority, followed by the loyal Facebook community.
So if you haven’t yet ordered your copy of Value.able, now is not the time to procrastinate. Remember, Value.able Graduates will be offered first priority.
Posted by Roger Montgomery and his A1 team, fund managers and creators of the next-generation A1 service for stock market investors, 9 June 2011.
Jesse, Michael, Young Les, Justin, Matt, Rad, John, Ron, Young Max, Gary, Dan’s mum, Gary, George, Steven, JohnM, Paul, Steven and Sophie, Michael, Alya, Martin, Bernie, Amit, RBS Morgans Gosford, Jim Rogers, Daniel, Keith, Gavin, Graeme, Nick, Gelato Messina, Chris, Rodger, Phil, Vikki, Mark, Hien, Kenneth, Greg, Peter, Bernie, Paul, John, Bill, Bryan, Di and Lesley, Craig, Scotty, Chris, Main Amigo Stan, Charles, Fred, David, Mark, Collin, Nevada Cody and Winston, Peter, John, Nathan, Mal, John, Tony, Les, William Grant, Greg, Mike, Paul, Roger, Mike, David, Paul, Sinaway, Anders, Frank, Jake, Johan, Mark, Rob, Ian, Joan, Claude, Toni, Richard, Matt Jnr, Indrash, Sara, Garry, Jonathan, Ganesh, James, Kevin, Jim, Peter, Greg, Stuart, Craig, Eric, Robert, Ermin, Mike, Syed, Wilma, John, Alf, Tony, Phillip, Robyn, James, Carolyn, Roy, Peter, Jack, Kevin, Howard, Leo, Jonathan, Carole, Eileen, James, John, Martin, Ordan, Warren, Andrew, Liz, Jim, Anthony, Bob, Douglas, Christine, Frank, Martyn, Michael, John, Dave, Peter, Darrell, Jeffrey, David, Joof, Tom, Leigh, Mervin, Paul M, Paul K, Noel, Bob, George, Leigh, Bob, Steve, Monica, Richard, Frank, Brett, Steven, Colin, Wayne, Joanne, Dan, Garry, Lin, Judi, Allan, Stephen, Garth, John, Joab, Phillip, Kevin, John, Robert, Tweety and Bert, Peter, Mike, Patrick, Eugene, Brian, Harold, Russell, Brad, Rajest, Tim, Gemma, William, Bill, Robert, Geoff, Gary, Emily, Kent, Lucas, Neil, Peter, Rowley, Jason, Simon, Charles, Russell, Grahame, Lester, David, John, Richard, Mitra, John, Dave, Peter, Geoff, Paul, Derek and Rod have already submitted their photographs for inclusion in the Graduate album. My team – Russell, Vanessa, Rachel and Chris, will add theirs shortly.
Have you emailed yours?
We plan to frame the album and hang it at the entrance of our office, next to another invaluable piece – Stay Calm and Carry On.
Posted by Roger Montgomery and his A1 team, fund managers and Value.able Graduates, 9 June 2011.
The broad market selloff is an opportune time to begin constructing a portfolio blueprint for 2011-12. Roger lists 10 stocks for Value.able Graduates to consider. Read Roger’s article at www.eurekareport.com.au.
Last night on Sky Business, I discussed a quick back-of-the-envelope way to get to the heart of a company’s true cash flow performance. This will be useful for you during the upcoming reporting season to help you determine whether to investigate further, or to move on.
It’s very simple. The exception being financial services and insurance companies, which can be problematic and require many more ‘edge-case’ explanations that are best kept close to my chest (with apologies).
So here’s what you do.
1. Find the Balance Sheet and Cash Flow Statement of a business you wish to examine (use the current year’s annual report) and lay it out on a table.
2. Pull out the headings you need and arrange them as illustrated below (Cash at Bank, Current Borrowings, Non Current Borrowings, Contributed Equity).
3. Put a negative sign in front of Cash at Bank.
4. Now sum the two columns.
5. Subtract the current year Total from the previous year. You can do this with half-year results too, for example, compare the 1HY11 with the final 2010 results.
6. Finally add back any Dividends actually paid in the 2011 Financial Year (get this from the Cash Flow Statement).
7. Done.
Now you have a number that better reflects the true change in the company’s cash position. The changes in every other item on the balance sheet will explain this number. But this number – Company Cash Profit – is the number.
The company at left earned a positive cash profit. What about the one on the right? It lost cash during the year (or spent it on an acquisition(s)). Click the image to enlarge.
Why don’t you run the steps yourself on a few companies in your portfolio and see what you come up with. Where there is a big difference between your calculation of the company’s cash position and the reported profit, pop it up here at our Insights Blog.
This simple calculation is just one of over a dozen other simple strategies detailed in Value.able to help you improve your investing. They’re all there in one comprehensive guide.
If you haven’t yet ordered your copy, now isn’t the time to procrastinate. The last print run for a long while is walking out the door right now. Order your copy at my website, www.rogermontgomery.com.
Posted by Roger Montgomery, author and fund manager, 3 June 2011.
In the lead up to reporting season, Roger Montgomery says it’s a good time to work out which companies in your portfolio are actually making money. In this appearance on Switzer TV, Roger reveals, step by step his quick-back-of-the-envelope Value.able method you can follow to get to the heart of a company’s true cash flow performance. Watch the interview.
Roger Montgomery, one of Australia’s most respected analysts says there appears to be value in certain retail and financial services businesses and in the biotech-healthcare sector. Read article
Roger Montgomery talks to CNBC’s Oriel Morrison about the future of the Australian economy, and why a market decline is a good opportunity to find quality businesses trading below their Value.able intrinsic value. Roger believes that retail is precisely the sector to be looking for the best stocks and buying them for less than they’re worth right now. Watch the interview.
If you take your cues from price rather than values, fear may have recently set in. For Value.able investors, a market correction is a reason for celebration rather than consternation. Roger Montgomery explains why holding on may be the wiser decision. Read Roger’s article
As a young child growing up, the United States was the world’s policeman and Australia was a friend. Part of that picture will change in the lifetime of my children. The US no longer seems to command the authority it once did.
Its waning imperialism is at least partly reflected by last weeks visit to China by Pakistani Prime Minister Yousef Gilani. He described Beijing as Islamabad’s “best and most trusted friend”. Meanwhile, a petition in Pakistan’s High Court has called for the expulsion of the US ambassador.
Its waning imperialism is also reflected in recent news that major Australian miners are taking an interest in China’s promotion of its local currency, the Yuan, for trade settlement.
These are the first furtive steps towards a switch away from the US Dollar. Global reserve currency is moving towards the Chinese Yuan. Once hedging is made easier, the floodgates will be open and the Yuan’s appreciation will ensure the tide cannot be stopped.
China will continue to leverage its massive foreign reserves – reflecting fiscal power – and its military might, whenever old ties between the US and others flounder. As regime change in the Middle East continues, new leaders look to China rather than the superpower that funded and abetted their old foes.
India’s PM (and a US ally) recently visited Afghanistan, offering half a billion dollars for development while simultaneously saying “India is not like the United States”.
We are witnessing history. Sure there will be speed bumps and set backs, but the die has been cast.
In the absence of a World War, the US influence and more worryingly, its role as global cop and providore of reserve currency, appears now to have commenced a drawn-out death spiral.
As Jim Roger’s noted; “the 19th century was the era of the British Empire, the 20th belonged to the US Empire but the 21st will be the era of the Chinese Empire.”
The impact of this shift cannot be overstated.
Meanwhile, back at the ranch…
Last year Lakshman Achuthan explained his Economic Cycle Research Institute’s view that A) a US slowdown is already a done deal and B) the US faces the unfortunate prospect of more frequent recessions over the next decade.
Evidence of a slowdown is now emerging and Achutan was recently interviewed on the subject here and here.
Let me say at the outset, I am not an economist. And don’t worry, I’m not turning into one. Indeed, even if I was, it still may not help me invest any better than I can following the Value.able methodology.
I have, however, been trying to find a reason to expect to find value sometime soon.
And thanks to Lakshman Achuthan, I have found a reason to become a little optimistic, if not about the economy, then about the prospect of finding value, soon.
Longer-term, Achuthan thinks more frequent US recessions are a given.
In economics, a recession is a business cycle contraction or a general slowdown in economic activity. During recessions, economic indicators such as production – as measured by Gross Domestic Product (GDP) – employment, investment spending, capacity utilisation, household incomes, business profits and inflation all tend to fall. Conversely, unemployment tends to rise, along with the number of employers no longer able to afford them.
In a 1975 New York Times article, economic statistician Julius Shiskin suggested a definition for a recession. In Australia we seem to have adopted it; two quarters of negative growth and a recession is in place.
Because of the stigma for a political party associated with a recession, not to mention the economic hardship associated with one, recessions are something best avoided.
The two ways to do it are to either to raise the trend rate of growth, such that the dips in the business cycle never fall into the area of growth below zero, or lessen the peaks and troughs of the business cycle itself.
Raising the trend rate of growth, however, does not appear to be an option (for the US at least) because the trend rate of growth in employment, GDP, personal income and industrial production has been down since the end of World War II. As the trend rate of growth declines, and heads closer to zero, the dips in the business cycle need not be very severe to dip below zero.
Reducing the peaks and troughs of the business cycle such that the dips never result in an economic ‘backward step’ has been claimed as a new norm by economic managers who believe the use of monetary policy has been perfected, and also by those who have put their faith in economic globalisation. Monetary policy however is a rather blunt tool and its success in helping us avoid recessions may just be blind luck.
With trend growth declining for 50 years, each dip in the business cycle gets closer to regularly falling below zero. And with luck largely determining the success of policies attempting to smooth out the business cycle, its likely luck will run out, just as the globalisation of the supply chain causes the business cycle to whip even more violently than ever before.
Governments usually respond to recessions by adopting expansionary macroeconomic policies. They can increase the money supply, increase government spending and decrease taxation. But with a flood of US dollars that only Noah could survive, and government deficits already at historic extremes, these measures would only make the situation worse.
If you are investing in equities, the message is simple. Only buy the best quality businesses. And only when large discounts to your estimate of their Value.able intrinsic value are present.
The Value.able recipe is simple and it works. And you don’t need to be an economist to make it work. Whether the idea of more frequent recessions is right or not, the dearth of value suggests one should applaud the fact that markets may react to the risk of more frequent recessions, offering the best stocks for prices less than they’re worth in the process.
Posted by Roger Montgomery, author and fund manager, 1 June 2011.
