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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Mark Twain (1835 – 1910) said; “I Am Not So Concerned With The Return On My Money As The Return Of My Money.” It may surprise you to know he was quite the investor and liked to make comment about his observations. His quips always revealed a deep understanding of the nonsense that goes on in the stock market. What fascinates me is that the mistakes Twain observed during his lifetime are being repeated today.
I am occasionally asked why I spend so much time offering my insights when many observe that there is neither an obligation nor financial need. The reason is quite simple, I enjoy the process and of course, the proceeds of investing this way. I find it reasonably undemanding and so I have a little time to share my findings. And there’s the ancillary benefit of seeing hundreds of light-bulb moments when people ‘get it’. I note Buffett’s obligations and financials are even less necessitous and yet he has devoted decades to educating investors and students. I really enjoy my work. It is fun and thank you for making it so.
Investing badly in stocks is both simple and easy. But while investing well is equally simple – it requires 1) an understanding of how the market works, 2) how to identify good companies and finally, 3) how to value them – investing well is not easy.
This is because investing successfully requires the right temperament. You see you can be really bright – smartest kid in the class – and still produce poor or inconsistent returns, invest in lousy businesses, be easily influenced by tips or gamble. I know a few who fit the “intelligent but dumb” category. Because you are bombarded, second-by-second, by hundreds of opinions and because stocks are rising and falling all around you, all the time, investing may be simple but its not easy.
Buffett once said; “If you are in the investment business and have an IQ of 150, sell 30 points to someone else”.
Everyone reading this blog is capable of being terrific investors. But it is important to know what you are doing and to do the right things.
To this end I have asked a couple of investors with whom I have corresponded for permission to discuss their correspondence because it provides a more complete understanding of the research that’s required before buying a share.
I regularly warn investors that what I can do well is value a company. What I cannot do well is predict its short-term share price direction. Long-term valuations (what I do) are not predictions of short term share prices (what I don’t do).
Generally the scorecard over the last 8 months is pretty good. The invested Valueline Portfolio, which I write about in Alan Kohler’s Eureka Report, is up 30% against the market’s 20% rise. I have avoided Telstra and Myer, bought JBH, REH, CSL and COH. Replaced WBC with CBA last year and enjoyed its outperformance. Bought MMS and sold it at close to the highs – right after a sell down by the founding shareholder – avoiding a sharp subsequent decline.
But this year, there have been a couple of reminders of the inability I admit to frequently, that of not being able to accurately predict short term prices. And it is understanding the implications of this that may simultaneously serve to warn and help.
Even though I bought JB Hi-Fi below $9.00 last year, its value earlier this year was significantly higher than its circa $20 price. And the price was falling. It appeared that a Margin of Safety was being presented. And then…the CEO resigned and the company raised its dividend payout ratio. The latter reduces the intrinsic value and the former could too, depending on the capability of Terry Smart.
The point is 1) You need a large margin of safety and 2) DO NOT bet the farm on any one investment – diversify.
You can see my correspondence about this with “Paul” at http://rogermontgomery.com/what-does-jb-hi-fis-result-and-resignation-mean/
The second example is perhaps more predictable. Last year, Peter Switzer asked me for five stocks that were high on the quality scale; not necessarily value, but quality. We didn’t then have time to reveal the list, so I was asked back, in the second half of October 09. By that time, the market had rallied strongly, as had some of the picks. The three main stocks were MMS, JBH and WOW.
But because I didn’t have five at that time, I was asked for a couple more. I offered two more and warned they were “speculative”. “Speculative” is a warning to tread very, very carefully – think of it as meaning a very hot cup of tea balanced on your head. You just don’t need to put yourself in that position! But I was aware that viewers do like to investigate the odd speculative issue. A company earns the ‘speculative’ moniker because its size or exposure (to commodities, for example) or capital intensity render its performance less predictable or reliable, earning it the ‘speculative’ moniker. Nevertheless, based on consensus analyst estimates they were companies whose values were rising and whose prices were at discounts to the intrinsic values at the time – a reasonable starting point for investigative analysis. ERA was one and SXE was the other. Both speculative and neither a company that I would buy personally because their low predictability means valuations can change rapidly and in either direction.
My suggestions on TV or radio should be seen as an additional opinion to the research you have already conducted and should motivate investors to begin the essential requirement to conduct their own research. Unfortunately, I have discovered to my great disappointment, that some people just buy whatever stocks are mentioned by the invited guests on TV. Putting aside the fact that I have said innumerable times that I cannot predict short-term movements of share prices, it seems some investors aren’t even doing the most basic research.
As I have warned here on the blog and my Facebook page on several occasions:
1) I am under no obligation to revisit any previous valuations.
2) I may not be on TV or radio for some weeks and in that time my view may have changed in light of new information. Again, I am not obligated to revisit the previous comments and often not asked. Only a daily show could facilitate that. An example may be, the suggestion to go and investigate ERA because of a very long term view that nuclear power is going be an important source of energy for a growing China followed by a more recent view (see the previous post) that short term risks from a Chinese property bubble could prove to be a significant short-term obstacle to Chinese growth.
3) I don’t know what your particular needs and circumstances are.
4) I assume you are diversified appropriately and never risk the farm in any single investment
5) The stocks that I mention should be viewed, in the context of other research and your adviser’s recommendations, as another opinion to weigh up – to go and research not rush out and trade…rarely is impatience rewarded.
There are further warnings that are relevant and described in the correspondence related to the post you will find at http://rogermontgomery.com/what-does-jb-hi-fis-result-and-resignation-mean/
One investor wrote to me noting he had bought ERA and it had dropped in price. This should not be surprising – in the short run prices can move up and down with no regard or relationship to the value of the business. But like JBH before it, ERA had of course made a surprise announcement that would affect not only the price but the intrinsic value. In this case, it was a downgrade and a rather bleak outlook statement relating to cash flows. Analysts – whose estimates are the basis for forecast valuations here – would be downgrading their forecasts and as a result the valuations would decline just as they did when JB Hi-Fi increased its payout ratio. Over the long-term the valuations in ERA’s case, continue to rise (these valuations are also based on earnings estimates – new ones but which it should be noted are themselves based on commodity prices that are impossibly hard to forecast), but all valuations are lower than they were previously.
Our correspondence reminded me to regularly serve you with NOTICE that there is serious work to be done by you in this business of investing. In a rising market you can pretty much close your eyes and buy anything but you should never conduct yourself this way. If you work appropriately during a bull market, you will be rewarded in weaker markets too. And while many may complain when I say on air “I can’t find anything of value at the moment”, I would rather you complain about the return ON your money than the return OF your money.
Posted by Roger Montgomery, 5 March 2010.
On 4 March 2010 Roger Montgomery’s YouTube channel, www.youtube.com/RogerJMontgomery, ranked as the #19 Most Viewed Guru Channel. Following is a message from Roger
“Yesterday I was looking for a video on my YouTube channel and noticed what looked like a ribbon I used to receive as a child at school carnivals. It turns out my channel has become more popular than I would have ever imagined. Yesterday I was ranked # 53 for Most Viewed category of Guru in Australia. And today… I am #19! I would not have achieved this success without your encouragement and support, and for that I would like to express my sincere thanks. Roger”
On 3 March I shared my thoughts about the future of Australian companies that supply directly or indirectly, the Chinese building industry, or have more than 70% of their revenues or profits reliant on China with subscribers of Alan Kohler’s Eureka Report. Following are my insights…
Glancing over yet another set of numbers as reporting season draws to a close, my mind started to wander as I wade through forecasts for one, two and three years hence. I began to consider what might happen that could take the shine off these elaborate constructions and which companies are in the firing line. Consider Rio Tinto, which, in an effort to make itself “takeover proof” back in 2007, loaded itself up with debt up to acquire the Canadian aluminium company Alcan. It paid top-of-the-market multiples just 12 months before the biggest credit crunch in living memory forced it to sell assets, raise capital and destroy huge amounts of shareholder value. Do you think they saw that coming?
Before I elaborate on events that could unfold, allow me to indulge in a bit of history and take you back to the mid-1990s when I was in Malaysia and the Kuala Lumpur skyline was filled with cranes because of a credit-fuelled speculative boom. It was the same throughout the region.
A year or so after my visit, the Asian tiger economies were in trouble and the Asian currency crisis was in full flight. These are the returns that are produced by unjustified, credit-fuelled “investing” unsupported by demand fundamentals.
In December 2007, as I travelled to Miami, I experienced a distinct feeling of déjà vu as I once again witnessed residential and commercial property construction fuelled by low interest rates and easy credit, unsupported by any real demand.
These are not isolated incidences. Japan, Dubai, Malaysia, the US. Credit fuelled speculative property booms always end badly.
So what does this have to do with your Australian share portfolio? Australia’s economic good fortune lies in its proximity – and exports of coal and iron ore – to China. Much of those commodities go into the production of steel, one of the major inputs in the building industry.
In China today there is, presently under construction and in addition to the buildings that already exist, 30 billion square feet of residential and commercial space. That is the equivalent of 23 square feet for every single man, woman and child in China. This construction activity has been a key driver of Chinese capital spending and resource consumption.
About two years ago if you looked at all the buildings, the roads the office towers and apartments under construction the only thought to pop into your head would be to consider how much energy would be required to light and heat all those spaces.
But that won’t be necessary if they all remain empty. In the commercial sector, the vacancy rate stands at 20% and construction industry continues to build a bank of space that is more than required for a very, very long time.
Because of this I am more than a little concerned about any Australian company that sells the bulk of its output to the Chinese, to be used in construction. That means steel and iron ore, aluminium, glass, bricks, fibre cement … you name it.
Last year China imported 42% more iron ore than the year before, while the rest of the world fell in a heap. It consumes 40% of the world’s coal and the growth has increased Australia’s reliance on China; China buys almost three-quarters of Australia’s iron ore exports – 280 million of their 630 million tonne demand.
The key concern for investors is to examine the valuations of companies that sell the bulk of their output to China. Any company that is trading at a substantial premium to its valuation on the hope that it will be sustained by Chinese demand, without a speed hump, may be more risk than you care for your portfolio to endure.
The biggest risks are any companies that are selling more than 70% of their output to China but anything over 20% on the revenue line could have major consequences.
BHP generates about 20%, or $11 billion, of its $56 billion revenue from China; and Rio 24%, or $11 billion, from its $46 billion revenue. BHP’s adjusted net profit before tax was $19.8 billion last year and Rio’s was $8.7 billion.
While BHP’s profitability would be substantially impacted by any speed bumps that emerge from China, the effect on Rio Tinto would be far worse.
According to my method of valuation, Rio Tinto is worth no more than its current share price and while the debt associated with the $43 billion purchase of Alcan is declining, the dilutive capital raisings (so far avoided by BHP) have been disastrous for its shareholders.
As a result, return on equity is expected to fall from 45% to 16% for the next three years. Most importantly the massive growth in earnings for the next three years is driven by the ever-optimistic analysts who are relying on China’s growth to extend in a smooth upward trajectory.
Go through your portfolio: do you own any companies that supply directly or indirectly, the Chinese building industry, have more than 70% of their revenues or profits reliant on China and are trading at steep premiums to intrinsic value?
Make no mistake: Australia’s future is written inside a fortune cookie – some companies’ more than others.
Subscribe to Alan’s Eureka Report at www.eurekareport.com.au.
Posted by Roger Montgomery, 4 March 2010
Rio Tinto’s fortunes are so closely tied to China that any ‘speed bumps’ in Chinese demand would hit the company hard. Read online.
Focusing on price leads to speculation, and speculation is not investing. Read online.
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.
