I was thrilled to see so many Value.able Graduates dive in the holiday homework I set just before Christmas. Well done. It is wonderful to see so many Graduates from the class of 2010, and now undergraduates of 2011, keen to continue building on their value investing knowledge in real time.

If you didn’t do your homework, let me remind you of your school days. Homework is a vital part of the learning process (even Buffett has been described as a learning machine). It was through all those nightly exercises and practice that you developed and refined the skills you continue to use today. When it comes to investing, the knowledge that you continue to refine, over time, will empower you to make smarter investment decisions.

So get out your red marking pen, it’s time to check the answers. If you are new to my Insights blog, click here to review to the Holiday Homework I set on 22 December 2010.

Challenge 1, Task 1

Using a Required Return of 11%, calculate the 2010 Value.able intrinsic valuation for The Reject Shop (TRS).

What is your answer? Using the numbers from TRS’s Balance Sheet, Profit & Loss and Dividend statement, I calculated $15.62. Here are my workings (click the image to enlarge):

Of course business is fluid and the most fluid businesses are impossible to get a bead on – so it’s important to constantly review your valuations and inputs based on fresh news and events. Even a quality business like TRS (which I wrote about becoming less enamoured with many months ago) requires this attention and is not immune to earnings downgrades or for TRS more recently, flooding of vital infrastructure that services 90 out of a total 211 stores.

Challenge 1, Task 2

Calculate the 2010 cash flow for The Reject Shop using the method outlined in Value.able on page 152.

What is your conclusion? The numbers tell me… had TRS paid more than $2.6 million in dividends, in addition to the $16.1m dividends already paid, the business would require even more borrowings to fund the dividends.

Challenge 1, Task 3 – C Rated Companies

Use the Value.able Valuation Worksheet to complete the Christmas Holiday Spreadsheet, and then rank the companies by their Safety Margin.

Before viewing these valuations (click the image to enlarge), heed the following lesson from Charlie Munger:

If I taught a course on company evaluation, I would ask the following question on the exam, “Evaluate the following internet company.” Anyone who gave an answer would be flunked.

If you completed the Christmas Holiday Spreadsheet you will know my MQRs for the seven companies listed above – Australian Agriculture, Transurban, Elders, Gunns, Transpacific Industries, Asciano and Photon Group.

MQRs for these businesses range from C4-C5. C4 and C5 represent the lowest quality and poorest performing businesses listed on the stock market. These businesses are not investment grade.

What would I pay for them if I wanted to own a small piece of them? I wouldn’t. These businesses generate sub-optimal and even negative returns – my Value.able intrinsic valuations for all seven businesses is $0.00.

My advice? Move on. Don’t spend another minute conducting your own research. You and your portfolio will be much happier, and you will have more time to spend with family and friends.

Challenge 2

Calculate the historical change in intrinsic value and price over the last ten years. To do this, estimate the Value.able intrinsic value a decade ago (2001) and compare it to the 2011 Value.able intrinsic value.

To do the calculations, I used the ASX website (www.asx.com.au) to access past annual reports.

Prior to 2003 annual reports were published as text documents, which made finding the relevant inputs confusing. So I chose to start at 2003, the first year annual reports were published as PDF documents (click the image to enlarge).

Since 2003, the seven C4-C5 MQR businesses listed in the holiday homework have returned an average share price performance of -20.2% p.a.

With the Value.able intrinsic value of all seven businesses ‘about’ $0.00, the average change in intrinsic value was much worse (even though it could not be calculated using the formula provided).

When Ben Graham said ‘in the long run the market is a weighing machine’, he was spot on. There is indeed a relationship between value and price.

So I present the completed Holiday Homework Spreadsheet. How do your results compare?

Some warnings – very important and must be read by all investors

First, my Montgomery Quality Ratings (MQRs) and Value.able valuations are subject to one constant – change. I can assure you they will change. A business achieving a high MQR (A1-A2) today may become poor quality at anytime and a business currently ranked lower on my MQR scale could become high quality. Moreover my MQRs may not have any bearing on the current market price and the Quality Score (A-C) is NOT a predictor of price. Share prices will move independently of my MQRs, but as you can attest, for these seven businesses, there is a strong relationship between my current poor MQR and share price performance.

Although this is to be expected given the businesses underlying fundamentals and low MQRs, you must not rely on these in any way whatsoever. Consistent with my previous comments, I insist you use my blog as general information and consult your adviser, who will be able to discuss decisions with full awareness of your financial goals, needs, circumstances and risk profile.  I do not have this information and so cannot offer any personal financial advice.

Posted Roger Montgomery, author and fund manager, 2 February 2011.

I’m going to kick off 2011 with two things that I will unlikely repeat. Rather than look at individual companies today – something I am hitherto always focused on (and always will be) – I would like to share my insights, ever so briefly, into what I think are the major and possibly predictable themes for the next twenty years. The second? A 1781 word blog post.

A word of warning… my track record at correctly predicting market direction is lousy. Thankfully this inability hasn’t hindered my returns thus far and probably won’t in the future.

Having provided that requisite warning, I invite you to consider the following thematic predictions (and yes, they are predictions).

1. Higher Oil Prices

The International Energy Agency (IEA), Energy Information Administration (EIA) and Platts Oilgram News have ‘confirmed’ that peak oil (maximum daily global oil production) was reached in 2005/06. With this backdrop, any hint of Chinese demand increasing and drawing down on spare capacity can cause significant price surges. It is interesting that prior to the last oil price spike, and when oil traded at $90/barrel, US unemployment was about 4%. If someone back then had asked you what the oil price should be in 2011 if US unemployment was more than double – you would not guess ‘still $90’.

It strikes me that there is a lot of demand for oil supporting the price that is not contingent on a strong US economy. China is the first that comes to mind. Other analysis reveals the Middle East, driven by the desire to be a global leader in the manufacture of plastic, is using much more oil than in the past.

And as Jim Rogers has regularly noted; if the US and global economies strengthen, demand for oil will increase. What if they don’t? Rogers anticipates the US Federal Reserve will print more money and the price of commodities will go up.

2. Higher Coal and Uranium Prices

Of the 6.8 billion people on Earth, over 3.5 billion have little or no access to electricity. Irrespective of greenhouse gas concerns, rising demand for energy will see coal’s current share increase. China and India will lead the demand. China’s demand shifted the country to net importer status in 2009 and by 2015 will more than triple consumption from 1990 levels. According to some reports, China is commissioning a coal-fired power plant every week.

In India coal generates three quarters of the country’s electricity, yet over 400 million people have no access to electricity. Demand for coal has risen every year for the past ten years. Some expect India will triple its coal imports in the next… wait for it… two or three years. Democracy hinders the ability of the government to install decent transport infrastructure (it can take six or seven hours to travel just 250 kilometers) and one would expect the same issues will prevent any substantial increase in the domestic mining of coal.

Don’t be surprised if there are more takeovers of Aussie coal companies.

Uranium has recently bounced 50 percent from the lows, but remains half the level of 2007 highs.

If the price of coal and oil rises, then the political opposition to uranium that has resulted in underutilisation of this resource (and of course constrained supply) will cause the price to rise materially.

According to the World Nuclear Association (WNA), global demand for uranium is about 68.5 thousand metric tons. Supply from mines is 51 thousand. The Russian and US megatons-to-megawatts program fills the shortfall, but clearly that provides only a short-term band-aid. So there is already a shortfall; currently, nearly 60 reactors globally are under construction and nearly another 150 are on order.

Late last year China increased its nuclear power target for the end of the new decade by 11 times its current capacity. And China plans to build more plants in the next ten years than the US has, ever.

On the supply side, new mines can take more than a decade to go from permit to production and while Australia has the largest reserve in the world, government debate has barely begun.

3. Higher Rubber Prices

Less than 50 people per 1000 own a car in China, and the country already consumes a third of the world’s rubber! The numbers elsewhere are three times that per thousand. It doesn’t matter whether those cars are electric, hybrid, diesel or petrol – the Chinese will need rubber for their car tyres.

On the supply side, rubber comes from trees predominantly grown in Asia.  They take many years to mature and recent catastrophic weather has dented supply.

4. Weather, Weather everywhere

Many years ago my wife gave me a copy of The Weather Makers. In it Tim Flannery predicted the south-east corner of Australia would dry up and the northern states would experience increased rainfall. Whilst it seemed farfetched at the time, it was sufficiently concerning for me to put the purchase of a rural property in the North East of Victoria on hold. The 2009 Black Saturday bushfires and now, the devastating floods being experienced by 75 per cent of Queensland, are enough to convince me that Flannery’s predictions were prescient. The rest of the world has not been spared – the closure of Heathrow and JFK airports are testament to the fact that, irrespective of whether humans are responsible, the climate is changing.

Expect the price of agricultural products and foods to strengthen. This never occurs in a straight line so there will be bumps along the way, but food prices are going to rise and 140 year highs in cotton, for example, may be just the beginning.

Jim Rogers reckons you will be rich if you buy rice, and I would have to agree. Global increases in demand, supply shortfalls and then disruptions due to more violent weather patterns (La Niña notwithstanding) should be expected to dramatically increases prices.

Floods in Thailand (the world’s rice bowl) will cut production, insufficient monsoonal floods will cut production in Vietnam (the world’s second most important rice bowl) and freak weather elsewhere has meant other producing countries now rely more on imports. Rice is the staple for half the world’s population. Riots in 2007, when the price of rice hit a long-term high, offers an insight into how important this food is.

And as Jeremy Grantham said on CNBC: “We’re running out of everything”.

5. Inflation and Interest Rates

With wheat, cotton, pork and oats rising more than 50% last year and copper, sugar, canola and coffee up more than 30%, the inflation train has left the station, so to speak. Then there is the US Federal Reserve’s perpetual printing press – driving yields down and causing a currency tidal wave to flow to emerging countries, like China. Once the funds get there, they seek assets to buy, pushing their prices higher and thus exporting inflation elsewhere.

Despite this, in the US at least, the trend has been to invest in bonds. After being beaten to within an inch of their lives in stocks and real estate, there has been a love affair with bonds. The ridiculously low yields in bonds and treasury notes does not reflect the US’ credit worthiness and has caused some observers -including US Congressman Ron Paul (overseer of the US Fed) in Fortune magazine – to describe US Bonds as being in a “bubble”.

The Fed’s policies are geared towards low interest rates. But artificially-set low rates don’t reflect genuine supply and demand of money – they perpetuate a recession or at best merely defer it. The low rates trigger long-term investment by businesses even though those low rates are not the result of an increase in the supply of savings. If savings are non-existent, then the long-term investment by businesses will produce low returns because customers don’t have the savings to purchase the products the businesses produce. But that is a side issue.

The US, for want of a better description, appears to be bankrupt. A country with the poorest of credit ratings and living off past victories will not forever be offered the ability to charge the lowest interest rates.  And China won’t continue to allow itself to be the sponge that absorbs US dollars either. Indeed at the start of this year, China allowed its exporters – for the first time – to invest their foreign currency directly in the countries they were earned.  No longer do they have to repatriate foreign funds and hand them to the Peoples Bank of China in return for Yuan. This is a solution that Nouriel Roubini didn’t consider in his article – how China may respond to inflows that inevitably drive up its exchange rate, published in the Financial Review late last year.

5a. Expect US interest rates to rise

Inflation in the US has been held down in the first instance, arguably, by some questionable number crunching, but also by the export of deflation by China to the US. Now the inflation train has left the station (coal, uranium, food, agriculture, rubber et. al., Chinese input costs will go up – because its currency hasn’t (to help its exporters remain competitive)) – and the ability of the US to continue to report benign inflation numbers becomes problematic.

If inflationary expectations rise, so will interest rates. Declining bond prices will again dent the investment performance of pension funds that have been pouring into treasury and municipal bonds (they’re another fascinating story – Subprime Mk II). In turn, the ageing US consumer will feel the double impact of poor present economic conditions and poor retirement prospects.

Over in China, even if the government tries and mitigate inflation by simply capping prices, suppliers won’t invest in additional capacity and the resultant restriction in supply will simply defer, but not prevent, even higher prices.

Tying it all together

It’s far easier to invest when the tide is rising and it is also easier to make profits in businesses when your pool of customers is expanding and becoming wealthier. Value.able investment opportunities (extraordinary businesses at big discounts to intrinsic value) will be found in companies that sell products and services to Asia and India (from financial to construction), as well as those that stand to benefit from the ongoing impact of rising demand for, and [climate] effects on, food and energy etc. These opportunities will dominate my thoughts this year and this decade and I believe they should guide yours too.

So now I ask you – the Value.able Graduate Class of 2010 and Undergraduate class of 2011. What are your views, predictions and suggestions? Which companies do you expect to benefit the most? Be sure to include your reasonings.

I will publish my Montgomery Quality Rating (MQRs) and Montgomery Value Estimate (MVE) for each business you nominate in my next post, later this month.

Posted by Roger Montgomery, 13 January 2011.