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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Measuring business performance correctly rather than conventionally is the key to investment success. Read article.
The following column first appeared in Alan Kohler’s Eureka Report earlier this week…
Reading the headlines lauding Richard Goyder’s “audacious” and now “successful” bid for Coles and the almost lyrical waxing of the turnaround, you’d be forgiven for thinking you should buy shares in Wesfarmers immediately. But rarely is impatience rewarded, so before you rush in consider the following.
The enthusiasm surrounding Wesfarmers’ results last Thursday can only be justified if your sole focus is growth. Coles outpaced Woolworths’ sales growth in the half-year to December for the first time since the early 1990s and volume growth of food and liquor has risen in each of the past five quarters to now exceed 7%. Kmart’s turnaround has been impressive, with returns on invested capital more than doubling, and the liquor business – which includes Liquorland and Vintage Cellars – has delivered the targeted increase in market share and won share from arch-rival Dan Murphy.
But all is not as it seems, and in investing it is always best to be sceptical. Let’s start with the liquor strategy.
The company’s liquor strategy is to win market share by discounting and then improve margins later. Improving margins may involve raising prices, which could lead to a loss of market share. Improving margins can also mean cutting costs.
But keeping overheads low for a retailer should be like breathing is to you and me: automatic. Implementing a cost cutting “strategy” at a later date is akin to deferring breathing – not wise. And while Kmart’s improvement in return on invested capital is impressive, one does wonder how arbitrary the allocation of the invested capital to Kmart is.
More importantly, buying shares in Wesfarmers, buys you a lot more than Coles, Liquorland and Kmart (or a lot less, depending on your perspective). One share of Wesfarmers buys you a (now much smaller) piece of a conglomerate that includes coal, insurance, chemicals and a hardware business.
When all businesses are included it’s difficult to share the market’s enthusiasm. Net profits rose from $871 million to $879 million – less than 1% – and on a per share basis the earnings actually fell 26% from 103.3¢ per share to just 76¢. This is because capital was raised to pay down debt.
Debt reduction via equity issues rarely produce desirable results for shareholders. On the one hand there’s the fact that shareholders are investing capital in a business at a return equal to the interest rate on the debt. This dilutes overall returns on equity and presents shareholders with a very low return for their risk.
On the other hand, the number of shares on issue rises, and for Wesfarmers the number was significant because much of the raising was done at prices less than the equity per share. Using the same share price, buying $10,000 of Wesfarmers’ half-year earnings in 2009 would have cost you about $293,000, for 9680 shares. In 2010, the same share of earnings now costs almost $400,000, for just over 13,100 shares.
Dilution aside, growth is always a component of my calculation of intrinsic value. Sometimes it’s a variable that has an enormous impact and sometimes it has none. More surprisingly, perhaps, is the fact that growth can be both a positive and a negative contributor to the estimate of intrinsic value.
When return on equity is low, growth hurts the investor because profits have to be retained to fund the growth. These profits, however, are being employed at low rates of return that represent an opportunity cost and fail to reflect the risk associated with the investment.
Using the company’s own data, combining Coles, Officeworks, Target and Kmart’s $1.6 billion EBIT and comparing it to the capital invested of $20.4 billion, produces a return of 7.7%, about the same as a five-year term deposit. And while I know the reasons for using EBIT, in reality someone has to pay the interest and the tax and so an owner’s return should look at NPAT. Taking the enthusiastic analysts’ optimistic forecasts for earnings, Wesfarmers returns on equity are forecast to improve from a rather miserly 6.5% this year to just under 9.5% in 2012.
As a result, Wesfarmers’ per share intrinsic value is nowhere near the current price. This year intrinsic value is about $12 per share, rising to about $16.50 next year. With the shares trading today at $30, you may be wondering how the market could be so wrong? Or more likely, how could Roger be so wrong?
When Telstra traded at $9 and my valuation came out at less than $3, or when investors bought Myer at $4.10 and my valuation was under $3, I thought the same thing. In the short term the market is a voting machine – a popularity contest – and for time immemorial it votes with growth. Think ABC Learning, Babcock and Brown, Allco.
Wesfarmers should not be compared to these examples; over the long term however the market is a weighing machine and price follows valuations. Intrinsic value is based on profitability – how many dollars are required to be invested to get that dollar of profit out – rather than profits alone and Wesfarmers’ profitability simply doesn’t justify today’s price.
Roger Montgomery for Alan Kohler’s Eureka Report. www.eurekareport.com.au
Posted by Roger Montgomery, 26 February 2010
Last night on the Sky Business Channel with Nina May, I received a few requests for comments on companies that I hadn’t included in my valuation tables. So here are the valuations for those companies – Worleyparsons (WOR), Brambles (BXB), AGL Energy (AGK), Arrow Energy (AOE), Origin Energy (ORG) and SAI Global (SAI):
| Company Code | Price | Intrinsic Value | Forecast Intrinsic Value
(Above Current Price? / above Current Value?) |
Forecast ROE range
>20% preferred |
Net Debt / Equity
<50% preferred |
| WOR | $24.36 | $17.56 | YES/yes | 18%/21% | 30.2% |
| BXB | $6.99 | $3.76 | NO/yes | 30%/33% | 149% |
| AGK | $13.80 | $7.20 | NO/yes | 27%/32% | 14.4% |
| AOE | $3.33 | $0.04 | NO/yes | -0.6%/2.4% | -9.4% |
| ORG | $16.50 | $6.63 | NO/yes | 6.1%/7.7% | -8.1% |
| SAI | $3.74 | $1.88 | NO/yes | 16%/18.3% | 68% |
*Be sure to read the warnings about intrinsic values. See below.
“Would you buy this stock?” is a question I have fielded innumerable times since selling my funds management businesses and leaving them as well as the investment company I listed on the ASX. I am not in a position to answer it – having had 8 months of R&R since leaving, but I will let you know when I am. The following information comes from an earlier post “What would you say about my portfolio?” where I have listed further intrinsic valuation estimates.
When I am asked on air, sometimes without notice -by the guys at the ABC or Ross Greenwood at 2GB or Peter, Richard or Nina on Sky Business – what I think about a company, I will detail the price, the intrinsic value, the ROE, the debt and whether I believe that the intrinsic value will be rising by a decent clip in coming years. These are the things that I believe are the most important determinants of an investor’s return. Happily investors haven’t had to wait very long to see whether prices head towards the values – both Myer and Telstra are recent examples.
ABOUT INTRINSIC VALUES
We’d all prefer intrinsic values that were cast in stone. Unfortunately, they’re not. The valuation depends on the input so to be safer, I always run my model using two data sets. Importantly, I only run ONE valuation formula. My preferred method of investing would be to buy at a discount to the most conservative valuation but if I can’t get that and valuations are rising strongly in future years I might invest a smaller proportion of my portfolio in first class business at a substantial discount to the upper valuation.
AN INVITATION
I would be interested in hearing what you prefer to see. Would you prefer to see 1) the most conservative valuation only, 2) the valuation based on next year’s earnings forecast 3) based on the continuation of the historical performance of the company, or 4) both? Feel free to vote. What I like to use myself may not be what you want to see.
WARNINGS
Firstly, these valuations can change at any time and I may or may not update them here on the blog. A company, for example, could announce a downgrade and the valuation would drop – potentially precipitously and I will probably busy doing something with my own portfolio(s) so do not under any circumstances rely on or expect these valuations being kept up to date here at all.
Second, valuing a company is not the same as predicting the direction of its shares. Just because a company’s shares are lower than my valuation, does not mean the shares will go up. Conversely, a price that is well above my valuation doesn’t mean the share price is going to fall.
Third, my forthcoming book contains the information you need to calculate intrinsic value the way I do, so rather than ask me how I arrived at a valuation above, please register and wait for the book.
Finally, don’t act on this information (which can and is likely to change without warning and without notifying you) – seek a professional advisor’s recommendation, preferably someone who knows you, your financial circumstances and needs.
(Most importantly, don’t act without first speaking to an advisor who is familiar with your circumstances and needs. You must not rely on my musings – they could change in a moment and anyway, they relate only to me. My thoughts here are “insights” into the way I think about stocks and they don’t have you in mind.)
Posted by Roger Montgomery, 26 February 2010.
Here’s a strategy to hedge against each of the four risks to your prosperity.
Whilst most investors are obsessed with earnings and dividends, Roger Montgomery always considers how much money has been put in to a business to get earnings and dividends out. So what does Roger look at when valuing a business? 1. Equity on the balance sheet how much is there? Make sure it isnt full of accounting hot air (goodwill). 2. ROE how profitable is the business historically and looking into the future? 3. Discount rate what return do you want from the investment? 4. How much money is being retained and compounded by the company, and how much is being paid out. Roger also answers a viewer question about Telstra, valuing the business around $3.00. Watch the interview. Sign up free to Peter Switzer’s latest personal finance and financial planning news at switzer.com.au.
Using a bank account as an example, Roger Montgomery explains to Peter Switzer how to value a business that retains all its earnings, and shares his formula for calculating intrinsic value. Watch the interview. Sign up free to Peter Switzer’s latest personal finance and financial planning news at switzer.com.au.
There are actually five, but Roger saves the fifth for readers of his book, Value.able. So what are his first four? 1.When you are wrong 2.When there are better opportunities 3.When price is far above intrinsic value 4.Deterioration in original reasons for buying In his appearance on Market Moves with Richard Gonclaves Roger also analyses IAG, QBE, Asciano and Virgin Blue. Watch the interview.
Roger Montgomery joins Nina May on Your Money Your Call and answers viewer questions about Fleetwood (FWD), suppliers of the China property boom, identifying companies with durable competitive advantages, ANZ, CBA, Highlands Pacific (HIG), and the key ratio to look at when assessing mining companies.Watch the interview.
