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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Have Australia’s lauded CEO’s earned a good reputation when it comes to the impact of their bigger-is-better ambitions on the shareholders for whom they work?
According to Richard Puntillo; “in theory, publicly traded corporations have shareholders as their kings, boards of directors as the sword-wielding knights who protect the shareholders and managers as the vassals who carry out orders. In practice, in the past decade, managers have become kings who lavish gold upon themselves, boards of directors have become fawning courtiers who take coin in return for an uncritical yes-man function and shareholders have become peasants whose property may be seized at management’s whim.”
When a listed company announces an acquisition, commerciality is often cited as the reason for failure to disclose the purchase price. But with Australia’s corporate graveyard littered with the writedowns of overpriced acquisitions past, it is about time companies treated their shareholders like kings.
I have long advocated the idea that companies should retain profits and reinvest them, provided they can achieve high rates of return on equity. The result? Much higher returns – indeed returns that ultimately match the rate of return on equity being achieved by the company. But the rather worse-than-patchy record of Australian Merger & Acquisitions (M&A) in creating shareholder value, gives shareholders plenty of ammunition in their calls for companies to ‘hand the money back’.
Here’s a couple of examples…
Where, MQR: Montgomery Quality Rating; Value.able IV: Value.able Intrinsic Value; Today: Value.able Intrinsic Value as at today (5 May 2011); Ten Year IV Change: Ten year change in Value.able Intrinsic Value.
Foster’s
MQR: C5; Value.able IV 2001: $2.99; Today: $3.50; Ten Year IV Change: 1.6%p.a.
Foster’s Share Price 2001 $5.71; Today: $5.51
Last week, Foster’s shareholders voted to spin off the company’s wine business. After buying Southcorp for $3.1 billion in 2005 (my valuation using the steps in Value.able was closer to $2.30 per share than the $4.17 Foster’s paid) Foster’s rejected a $2 billion private equity bid for its wine business, saying it “significantly undervalues” the Treasury Wine Estates.
When they bought Southcorp the execs were lyrical in their praise. Trevor O’Hoy said “The combination of our two great companies will create the world’s leading premium wine company”.
If you came to me to buy Southcorp in 2005, the year after it earned just $46 million in profit (the same profit as it earned ten years earlier by the way) and you wanted a margin of safety, I would advise that the right price to pay for Southcorp would be less than 65 cents. Try it yourself – plug 5% return on equity, $1.17 of equity per share and a payout ratio of just over 60 per cent into the Value.able formula. In 2005, when you came to me, the share price was $4.20 and using the price as a reference point, you would have thought I was crazy. The $3.5 billion in writedowns however since then, suggests it is the ‘too-cheap’ price for a copy of Value.able that is crazy!
PaperlinX
MQR: B2; Value.able IV 2001: $2.29; Today: $0.17; Ten Year IV Change: -23%p.a.
PaperlinX Share Price 2001: $4.93; Today: $0.28
On 9 September 2003, PaperlinX announced that it had purchased Buhrmann Paper for $1.1 billion. In June of that year Paperlinx’s share price was $3.77.
At the time, Ian Wightwick, Managing Director of PaperlinX said, “It is very pleasing that the hard work put in by our team undertaking due diligence has confirmed our initial view of the quality of Buhrmann’s Paper Merchanting Division business, its people and its assets. This business has great potential, and we are confident that the acquisition will deliver strong earnings per share growth for our shareholders.”
Ten days after the announcement the share price had shot up to $4.93. My Value.able Intrinsic Value estimation suggests it fell from $2.50 to $1.82! Nine hundred million was borrowed that calendar year and $150 million of capital was raised, to fund the acquisition.
For the year prior to the acquisition, PaperlinX earned $147 million. Since then profits have generally declined every year, and in 2009 PaperlinX lost $197 million and another $29 million in 2010. The share price has fallen from $4.93 to 28 cents today. Worse, there were 447.9 million shares on issue in 2003 and now there are almost 50% more.
AMP
MQR: A3; Value.able IV 2001: $4.01; Today: $3.97; Ten Year IV Change: 0%p.a
AMP (adjusted) Share Price 2001: $13.90; Today: $5.29
AMP launched a cash and scrip bid for AXA Asia Pacific in late 2010. Under the deal with AXA’s French parent, AMP paid more than $4 billion for AXA Asia Pacific’s New Zealand and Australian businesses. The deal valued the entire AXA company at $13.3 billion, but the Value.able intrinsic value of AXA is significantly lower.
AMP bid about $5.40 per share. And just like Southcorp shareholders, AXA shareholders wanted a higher bid. Well of course they did, and as I have said previously, I would rather receive a few million more for my house too. But AXA’s performance doesn’t justify it.
AMP’s chief executive Craig Dunn said that the deal would create an effective competitor to the big four banks and makes AMP the biggest player in all segments of Australia’s $1.2 trillion wealth management sector with 20 per cent market share.
In a bout of déjà vu (reminiscent of PaperlinX), AMP’s shares rallied after the deal was announced.
According to analyst estimates at the time, AXA would generate a return on equity of about 13 percent over the next two years. With the exception of the 2008 loss, the return on equity for the last ten years has ranged between 6.8% in 1999 and 27% in 2003. Based on the forecast ROE and a payout ratio of between 61% and 67%, AXA’s 2010 equity of $2.58 per share is worth a little more than $3.00 per share. At the time of the bid, AXA’s shares traded at $5.84.
When Oxiana and Zinifex merged to form OZ Minerals, the market capitalisation of the two individually amounted to almost $10 billion. Today the merged entity has a market cap of $4.6 billion.
The above examples are not rare. With more space, we could go through many, many more.
Overpaying for assets is not a characteristic unique to ‘mum and dad’ investors. CEOs in Australia have a long and proud history of burning shareholders’ funds to fuel their bigger-is-better ambitions. PaperlinX, Fairfax, Foster’s – the past list of companies and their CEOs that have overpaid for assets, driven down their returns on equity and made the Value.able value of intangible goodwill carried on the balance sheet look absurd, is long.
Nothing gets the blood racing more than a takeover and when blood leaves the head for other regions, common sense usually follows. You should be on your guard when your company announces an acquisition.
Posted by Roger Montgomery, author and fund manager, 3 May 2011.
Overpaying for assets is not a characteristic unique to ‘mum and dad’ investors. CEOs in Australia have a long and proud history of burning shareholders’ funds to fuel their bigger-is-better ambitions. In this interview with Peter Switzer, Roger Montgomery discusses PaperlinX, Fairfax, Foster’s, Zinifex and Oxiana. In Roger’s opinion, the CEOs of these businesses have consistently overpaid for assets, driven down their returns on equity and made the Value.able value of intangible goodwill carried on the balance sheet look absurd. Which Australian business does Roger Montgomery believe has consistently acquired other businesses at the right price? Watch the interview.
When markets rise and your Value.able portfolio rises even more, its difficult not to want to enjoy some fruits. But Roger believes value investors must keep constant vigil and if it’s high-quality smaller companies that suit, there are a few with exposure to oil and gas that your advisor should look at. Read Roger’s article.
Smart people are capable of not-so-smart things. Consider the marriage of Foster’s and Southcorp. On Friday 29 April 2011 Friday Foster’s shareholders voted in favour of a divorce; on 4 May 2011 the Supreme Court of Victoria granted a decree absolute. Companies considering merging should pay attention to Foster’s experience. The next time the board of a company you own makes a bid for one you don’t, do yourself a favour and send them a copy of Value.able! Read Roger’s comments at www.eurekareport.com.au.
Your Easter holiday homework was published mid morning on Thursday 14 April. Two hours later Andrew correctly completed the cash flow component – well done Andrew.
Many Graduates have posted comments here (and sent even more emails to me) asking why Telstra made the cut. Then there’s Aristocrat with all that debt, Fortescue’s recent capital raisings, The Reject Shop’s declining Return on Equity, Coca-Cola’s dwindling competitive advantage…
I’m passing the mic to Rob, a member of the Value.able Post-Graduate elite:
“Roger usually gives us homework which contains a mix of stocks. As he said he used his discretion to come up with 14. He also said “This homework is not about finding cheap stocks – it is about understanding businesses, return on equity, debt, cashflow and identifying extraordinary prospects”. The only way for us to achieve this is to look at some B3s such as Telstra, and as Andrew said early the odd “basket case”. Working through the good and bad can be eye opening but you do need to examine all the stocks to compare how they fair according to the criteria mentioned in the above quote.”
And from Chris B:
“It has been my opinion for a while that it is kind of hard (and almost pointless) trying to assign an estimated value on a business unless you have done a lot of research about the business in question first…”
Leon was the first Value.able Graduate to post his answers, quite late in the evening on April 15. Whilst Leon’s valuations don’t match my calculations exactly, they are close. Remember your primary aim is to buy extraordinary A1 businesses at BIG discounts to your estimate of their Value.able intrinsic value. A difference of twenty cents is neither here nor there if the business is worth $8 and you can buy shares for $5!
The Results
Assignment One: Calculate the 2010 Value.able intrinsic value and 2011 forecast Value.able intrinsic value – download the results
Assignment Two: Re-read Value.able Chapter 9 on Cashflow (from page 152) and analyse the cashflow of each company using the balance sheet method – download the results
Here are Andrew’s insights on the Cashflow homework:
“Based on a simple look, Retail Food group has the best cash position of the three followed by the reject shop and then loads of daylight and then Aristocrat.
However on further digging for RFG I can see that the 85,852 worth of borrowings are now a current liability and therefore will be due in the next 12 months. They do not appear to have the assets or the cash generating abilities to service this and will therefore probably need to raise capital in some form.
Aristocrat is a basket case where cash flow was declining and borrowings rising. Doesn’t take a genius to see what is going to happen here. ROE might be high but it is debt fueled. Kind of get the feeling that Aristocrat is about as lucrative as gambling on one of their machines in the pub.
Therefore the last one standing and my pick of the three overall is actually the reject shop. It is generating positive cashflow and should be able to adequately meet its future needs.
Thank you to all who participated and if your answers where close… well done! It is vital that you continue to practice your technique. With repetition you’ll get to the point where you can simply ‘eye-ball’ Value.able intrinsic value.
Before I sign off, I would like to officially welcome Alex, Yong-Chuan, Matty, Leon, Andrew, Geoff, Justin, Peter and Margaret to the Value.able Graduate Class of 2011. If I have omitted your name, please accept my apologies. I am delighted to welcome you as a Graduate. Please send your photo with Value.able to roger@rogermontgomery.com for inclusion in the 2011 album.
For those wondering, the woman screaming in fright was looking at the stock market on Friday!
Posted by Roger Montgomery, author and fund manager, 3 May 2011.
With the stock market down at the moment, one of Australia’s largest stock brokers put a sell recommendation on commodities. Is Roger Montgomery concerned? No. Roger sees times of gloom as an opportunity to purchase shares in extraordinary A1 companies for less than they’re worth. isn’t concerned at all – he sees this as an opportunity. Presenting opportunity in the long term. Listen to podcast.
If you are new to our Value.able community, Ben Graham’s concepts may be foreign to you. Ben is the author of Security Analysis. He is regarded as the father of security analysis and the intellectual Dean of Wall Street.
I support Ben’s revered status and what he has to say on the subject of investing, but perhaps controversially, I also believe that, had he access to a computer that allowed him to properly test his ideas, he may not have reached all of the same conclusions.
It is exactly one year since I first penned some of my thoughts about Ben Graham on this blog here: http://rogermontgomery.com/should-a-value-investor-imitate-ben-graham/
There are many things that Ben said that not only make sense, but has also made significant contributions to investment thinking. Indeed they have become seminal investment principles. These are the things to which Value.able investors should hold firm.
Ben Graham authored the Mr Market allegory and also coined the three most important words in value investing: Margin of Safety. In fact Ben said this: “Confronted with the challenge to distill the secret of sound investment into three words, I venture the motto: Margin of Safety”
These are two concepts that value investors hold dear and which have, in many different ways, become a formal part of our Value.able investing framework.
Mr. Market is of course a fictitious character, created by Ben to demonstrate the bipolar nature of the stock market.
Here is an excerpt from a speech made by Warren Buffett about Ben Graham on the subject:
“You should imagine market quotations as coming from a remarkably accommodating fellow named Mr Market who is your partner in a private business. Without fail, Mr Market appears daily and names a price at which he will either buy your interest or sell you his.
“Even though the business that the two of you own may have economic characteristics that are stable, Mr Market’s quotations will be anything but. For, sad to say, the poor fellow has incurable emotional problems. At times he feels euphoric and can see only the favorable factors affecting the business. When in that mood, he names a very high buy-sell price because he fears that you will snap up his interest and rob him of imminent gains…
“Mr Market has another endearing characteristic: He doesn’t mind being ignored. If his quotation is uninteresting to you today, he will be back with a new one tomorrow.
Transactions are strictly at your option…But, like Cinderella at the ball, you must heed one warning or everything will turn into pumpkins and mice: Mr Market is there to serve you, not to guide you.
“It is his pocketbook, not his wisdom that you will find useful. If he shows up some day in a particularly foolish mood, you are free to either ignore him or to take advantage of him, but it will be disastrous if you fall under his influence.”
If you have read Value.able you will understand Margin of Safety, know exactly what a suitable Margin of Safety is and also how to apply it to Australian stocks.
Despite the high profile of these two enduring lessons, I believe there is a third observation of Graham’s, which is equally important. Fascinatingly, with the benefit of computers, I can also demonstrate that Graham was spot on.
Graham was paraphrased by Buffett in 1993 thus:
“In the short run the market is a voting machine – reflecting a voter-registration test that requires only money, not intelligence or emotional stability – but in the long run, the market is a weighing machine”
What Graham described is something that, as both a private and professional investor, I have observed myself; in the short term the market is a popularity contest – prices often diverge significantly from that which is justified by the economic performance of the business. But in the long-term,prices eventually converge with intrinsic values, which themselves follow business performance.
Have a look at the amazing chart below.
(c) Copyright 2011 Roger Montgomery
Its Qantas (ASX:QAN, MQR: B3, MOS-44%): – its my ten-year history of price and intrinsic value (and three year forecast of intrinsic value which updates daily). Now right click on the chart and open it in a new tab. Zoom in. Now stand back from your computer screen. What do you see?
First you will notice two intrinsic values – a range is produced. Next you might notice that there have been short term bouts of both optimism and despondency and this is reflected in the short term share price changes. The final observation you might make and which the charts make most powerfully, is that since 2001, the intrinsic value of Qantas, which is based on its economic performance has, at best, not changed. Look closer and you will notice that the intrinsic value of Qantas today (2011) is lower than it was a decade ago. Even by 2013, intrinsic value is not forecast to be materially different from that of 2002.
Just as Ben Graham predicted, the long-term weighing machine has correctly appraised Qantas’ worth. Unsurprisingly, the share price today of Australia’s most recognised airline, is also lower than it was a decade ago. And unbelievably, the total market capitalisation of Qantas today is less than the money that has been ‘left in’ and ‘put in’ by shareholders over the last ten years!
These charts aren’t just easy or nice to look at, they are incredibly powerful. If you can calculate intrinsic values for every listed company, you can turn the stock market off and simply pay attention to those values. Then, during those times that the market is doing something irrational, you can take advantage of it or ignore it, just as Ben Graham advised.
Unless you can see a reason for a permanent change in the prospects of Qantas, the long-term trend in intrinsic value gives you all the information you need to steer well clear of this B3 business.
Now have a look at the second chart. What does it tell you?
(c) Copyright 2011 Roger Montgomery
There have been short-term episodes of price buoyancy, but over the long run the weighing machine has done its work. The intrinsic value has not changed in ten years so, over time, the share price has once again reflected the company’s worth and gradually but perpetually fallen until it reaches intrinsic value. This is my ten-year historical price and intrinsic value chart (and three year forecast) for Telstra (ASX:TLS, MQR: B3, MOS:-32%).
What about an extraordinary A1 business?
Sally Macdonald joined Oroton (ASX:OTN, MQR: A1, MOS:-17%) as CEO in 2005/06. Observe the strong correlation between price and value since Sally’s appointment.
(c) Copyright 2011 Roger Montgomery
I acknowledge that there are critics of the approach to intrinsic value we Value.able Graduates follow. But like me, you should be delighted there are. Indeed, we should be encouraging departure from this approach!
The critics are necessary. Not only do they help refine your ideas, but without them, how else would we be able to buy Matrix at $3.50, Forge at $2.60, Vocus at $1.60 or Zicom at $0.32! And how else would we be able to navigate around and away from Nufarm or iSoft, and not fall into the trap of buying Telstra at $3.60 because the ‘experts’ said it had an attractive dividend yield? If it was universal agreement I was after, I would just keep writing about airlines.
The Value.able approach works. If you have been visiting the blog for a while, you will know this only too well.
The above charts (automatically updated daily – and I have one for every, single, listed company) confirms what Ben Graham had discovered without the power of modern computing; In the short run the market is indeed a voting machine, and will always reflect what is popular, but in the long run the market is a weighing machine, and price will reflect intrinsic value.
If you concentrate on long-term intrinsic values and avoid the seduction of short-term prices, I cannot see how, over a long period of time, you cannot help but improve your investing.
…And in case you are wondering about the link between Ben Graham and the photograph of Comanche Indian ‘White Wolf’… the photo of White Wolf was taken in 1894 – the year Ben Graham was born.
HOMEWORK RESULTS: I will publish the holiday results homework on Monday. Thank you to all who participated. It is vital what you continue to practice your technique. With repetition you’ll get to the point where you can simply ‘eye-ball’ Value.able intrinsic value.
Posted by Roger Montgomery, author and fund manager, 29 April 2011.
I read recently that Kerry Stokes didn’t understand his company’s prospectus. What hope do retail investors have?
Kerry’s revelation emphasises the need for ASIC to intervene and make prospectus documents clear and concise. Last Thursday evening I shared my thoughts with Peter on Switzer TV. If you kept your copy of the Myer prospectus, watch the interview then flick past the first 28 pages of glamorous photography to the Pro Forma balance sheet.
What Value.able IPOs have you uncovered recently?
Posted by Roger Montgomery, author and fund manager, 28 April 2011.
When it comes to company floats, there’s one piece of information Roger Montgomery looks for above all others. Read Roger’s article at www.eurekareport.com.au.
You can’t buy shares in a business and hold them forever. Business is dynamic and unfortunately many of those listed on the sharemarket are destined to be liquidated, or go into receivership or administration. Companies disappoint operationally, their prospects become less bright, they take on too much debt, pay too much for an acquisition, or their share price simply rallies far above any reasonable estimate of value. How then can you hold these shares and expect to do well? Read Roger’s article.
