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.
