Paul wrote to me in December, asking for my valuation of Patties Foods.

“I have finally had a look at PFL. Its value is about 80 cents and while it is expected to rise over the next three years, it still won’t get to the current price. The company is thus overpriced. PFL also raised a lot of money in 2007, evidently to pay down some debt, but today the debt is right back up there again. Not a first class business I am afraid either. Of course none of this is a prediction of the share price, which could halve or double. Valuing a company is not the same as predicting the price”.

He subsequently wrote back with the following question… Roger, can I ask how often do you value companies? Following is my reply.

In general terms, I revalue companies constantly. When a company provides an update to its guidance, when interest rates change, when a company makes an acquisition, raises capital or buys back shares, all these things may affect the value. The intrinsic value for whole the company may change or just on a per share basis. And because I am tracking so many companies, there are valuation changes occurring daily. Continue…

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Welcome back. On Christmas Eve, just before I left for my annual family holiday, I said that this year would be fascinating in terms of inflation, interest rates and commodities prices. Interest rates can be ticked off – the topic has already been front page news and I expect the subject to hot up even more over the coming year.

Inflation and commodities however are arguably even more interesting. When money velocity picks up in the US – that is, the speed with which money changes hands – inflation could be a problem. I don’t know whether that will be this year or not, but I do know that at some point the benign inflation and extraordinarily low interest rates will be nothing but a fond memory.

One of the places inflation presents is in commodity prices, and there is no shortage of very smart, successful and wealthy people – Jim Rogers is one – who believe the bull market in commodities is far from over. Continue…

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These iPhones are marvellous things. I can write while preparing dinner for our friends, heading down to the local airport to enquire about flying a sailplane over the southern alps or while sitting at the edge of the Kiewa River. I have seen some great posts and will reply to them all on my return at the end of January.

In the meantime I have heard from my editors that my book is coming along and will be printed right after Chinese new year. If you haven’t registered please do, at www.rogermontgomery.com.  I am going to do my best at running a J.I.T. inventory system. That means I won’t be carrying stock and will only print copies for those that have pre-registered. After that there will be a wait. As the book will not be available in stores you will have to pre-register, so if you are interested in a copy from the first run, let me know by registering through the website. You can click the link on this website which is over on the right hand side of this post under the menu heading called “Blogroll”.

In the meantime, the market still seems expensive, but remember that valuing companies is not the same as predicting their short term share price direction. The market can get more expensive just as an individual share might trade at double its valuation or even higher! Of the shares I own that were purchased below intrinsic value and whose valuations are expected to rise significantly in coming years, I have not sold. Those whose values are flattening out and whose prices are well above intrinsic value – I have sold.

If you are also still on your annual break, I hope you enjoy it and if you have worked through or have returned to work, my sincerest hope that I can do something this year to make your next holiday more philanthropic, more adventurous, more luxurious or more of whatever it is you seek from your own holidays.

Posted by Roger Montgomery, 8 January 2010

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I am away for Christmas and January and will only be publishing thoughts to the blog on a spasmodic basis.

If you go to my website, www.rogermontgomery.com, and register for my book or send a message to me, I will let you know via email when I am back on deck.

I expect 2010 will be a very interesting year on the inflation, interest rate and commodity fronts so stay tuned and focus on understanding what is driving a company’s return on equity and how to arrive at its value.

Before doing anything seek always professional advice, but zip up your wallet if you hear the words “only trade with what you can lose”. I don’t like losing money at any time and neither should you.

Posted by Roger Montgomery, 23 December 2009

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Half of all shareholders in Australia own at least one major bank in their share portfolios. The economics for banks in the last two years have changed dramatically and on several fronts.

First, they are believed to have largely dodged the impact of the GFC. This was predictable, as was the second change – the substantial gain in market share the banks enjoyed as their mortgage origination peers fell like dominoes relying, as they were, on short term wholesale funding and with no deposit base.

For both reasons I mentioned at the end of 2008 and the beginning of 2009 on CNBC that bank prices represented a rare opportunity to own the best businesses you can on an island – a legislated oligopoly that charges people to get their own money in and out.  You can see the video from December 16 here.

There was also another major change that kept analysts on our toes. Dilutionary capital raisings wreaked havoc on the returns on equity and the equity per share for all four majors. Then Westpac, previously the bank with the best business performance, bought St George, and CBA bought ING. NAB has since bid for Axa (at arguably a price that is double the intrinsic value of the Axa) and ANZ…well who knows (read more here)

The effect of all this activity has not changed the fundamental attraction of owning a big four bank on an island of 22 million people who don’t care what you charge them because they cannot be bothered moving to another bank; “they’re all the same”. What has changed however is the future returns on equity for each of the banks and therefore, their intrinsic values.

Here’s my take on each banks’ forecast return on equity range for the next few years and valuation. I have ordered them by profitability in ascending order (ROE range, Intrinsic value):

NAB (11%-15%, $22.08)

ANZ (12.6%-16%, $18.10)

WBC (14.5%-18%, $19.19)

CBA (17.5% – 20.7%, $53.53)

In every case, current prices are well ahead of the current valuation however, I should add that the valuations are based on 2010 estimates and for all four banks, the valuations rise significantly in future years as ROE heads towards the top of each of the ranges given. Given the time frames that I can see, you will be waiting for values to catch up to current prices. NAB and ANZ are the cheapest, but you are buying the new 2^nd tier banks. WBC is a better performing bank than ANZ and NAB but its price reflects it and you will be waiting twice as long as the others to catch up.

Many of you have told me you want to keep this blog a little bit of a secret, but let me tell you we will all benefit if we receive contributions and insights from those closer to the coal face of various industries.  So let me encourage you to post your own thoughts and insights and invite anyone else you know (that owns bank shares for example or works in a company that is a competitor to any of those I mention) to do likewise. Do you think you know anyone that owns bank shares and would benefit from this insight? Spread the link.

http://rogermontgomeryinsights.wordpress.com/

Posted by Roger Montgomery, 23 December 2009

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Commodity prices…  can anyone predict their movements? Driven by supply and demand, and exaggerated by speculation, predicting the price of oil, iron ore, coal, diamonds and titanium is an almost impossible task.  \It is however a task that is required if you are planning to buy shares in a mining company. Ruling out mining exploration companies that make no profit, and whose race to a valuation of zero is only retarded by the amount of cash remaining in the bank and measured by a ratio called the cash ‘burn’ rate, we are left with the producers.

For reasons mentioned above, no mining company is easy to value, however some lend themselves to valuations better than others. The best are those that are large, broadly diversified and relatively stable. BHP immediately comes to mind.  Born as a silver and lead mine in Broken Hill in 1885, BHP, following the 2001 merger between it and Billiton, is now the world’s largest mining company with operations from Algeria to Tobago and everywhere in between.

But even BHP cannot escape the commodity cycle and this can be seen in the swings in its valuations in the past.  BHP’s valuation can be $48 in one year (2008) and $13 the next (2009). This “valuation volatility” is vastly different to JB Hi-Fi, for example, whose value has risen from less than a dollar in 2003 to $20 to $24 today and in a steady ‘staircase’ fashion.

Many of you have asked me for a valuation for BHP. Using the earnings estimates of the rated analysts on the company, there is clearly some optimism about BHP’s prospects. Returns on equity are expected to rise from 17.5% this year to 24% next year, and circa 28% in 2011 and 2012. These numbers however are still lower than the rates of return the company generated between 2005 and 2007. The estimate I come up with for BHP using the actual estimates of the rated analysts is a value of A$36.56, and if the analysts are right, the value rises dramatically in future years.

Warren Buffett doesn’t like businesses that are price takers – commodity type businesses. The reason is that it is impossible to forecast future rates of return on equity with any confidence.  BHP reflects this historically.  BHP is big enough now that in some cases it is calling the (price) shots, but don’t forget we are talking about capital-intensive businesses.

Posted by Roger Montgomery, 23 December 2009

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On the Sky Business Channel with Nina May recently, a caller rang in and asked for my valuation of MacMahon Holdings Limited (ASX Code: MAH).

I ran the numbers and received mixed signals. The return on equity of the company has only exceeded 21% in one year – 2008. In 2006 returns on equity were less than 1% and since 2002 ROE with these two years removed, has averaged just under 14%. This is not a return on equity to get excited about. Disappointingly, the company has also raised $216 million from shareholders, and diluted them by increasing the shares on issue by more than 300% since 2000.

The decline in borrowings between 2007 and today from $169 million to $111 is initially encouraging, as is the reduction of retained losses by $86 million since 2002, but since 2007 the company has raised $78 million through equity raisings. Arguably it is not the performance of the business that is reducing the debt burden and the retained losses simultaneously, but the performance of the company’s PR team. Finally, at a price of 59 cents, all the value investing margin of safety is gone.  Indeed the price today is about my value for this company two years out. I cannot predict what the share price will do – it may double from here, but on present performance expectations, such a move would not be justified.

Posted Roger Montgomery, 23 December 2009

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The following article first appeared in  Alan Kohler’s Eureka Report on December 9, 2009.

Stocks in aggregate are no longer cheap. They were much earlier in the year, but based on the present levels of profitability they are not cheap any more. Those buying today are doing so in a patently perfunctory manner or are simply motivated by the fear of continuing to miss out. In the short term, losses rather than profits are more likely to ensue for those buying today.
Before you go selling your holdings in a fit of panic, remember there are always at least two views about the market’s short-term direction.

In one corner are the bulls, who say that the equity market’s recent strength is the beginning of a multi-year rally that owes its ongoing support to the fact that looming inflation will deliver negative returns from cash, which, combined with the massive expansion of the monetary base, represents a free, low-doc loan from the government.

In this environment many suggest that asset class inflation is assured. Indeed, just under $20 billion a week has been creeping out of the bomb shelters and into assets such as shares and gold.

In the other corner sit the economic bears, such as Nouriel Roubini, David Rosenberg and Marc Faber, who say the same inflationary and expansionary balance sheet policies of the West have given the US dollar an intrinsic value of zero, which will bankrupt America and produce a complete horror show that makes the last downturn look like a picnic.

Yield Curves.

So who was it that said two people looking at the same set of facts could not arrive at vastly different conclusions? Listening to and reading the apologetics and protestations of these extraordinarily successful investors must make the morning chat with your broker about whether AMP is paying too much for AXA seem inane. (Postscript:  AMP was paying too much for AXA – Nab’s purchase is even more ridiculous).

Perhaps more importantly, to whom do you listen? You cannot base that decision on who is smarter because both groups have geniuses in their ranks; nor can you base your decisions on previous successes because both groups have extremely wealthy proponents.

The answer does not lie with replicating the financial and reputational bets taken by the economists, strategists and traders. Indeed, it lies in not taking a view at all but allowing an entirely different group of facts to dictate your actions.

Those facts are the book values or the equity of companies on a per-share basis, the anticipated profitability of those book values, the manner in which profits are currently retained and distributed (in others words, capital allocation by management) and a reasonable required rate of return.

On these measures most companies are no longer cheap and many are downright expensive. This has occurred for two reasons, that combined, reflect the typical short-term focus of both professional and amateur investors.

The first reason is that share prices have obviously risen. They have risen because Australia has sidestepped a recession, interest rates remain accommodative, our output is in demand and overseas markets have recovered.

The second reason is that shareholders who may have stayed on the sidelines, have pumped money into attractively priced dividend reinvestment plans, placements and rights issues as many of Australia’s largest companies collectively raised $90 billion in the 2009 financial year.

And who can blame the investor who bought shares in Wesfarmers at $29 for wanting to bring down their average price and participate in an entitlement offer to buy three more shares at $13.50 when the rest of the shares they own are trading at $16?

But while the reduction of debt, associated strengthening of balance sheets and stag profits are attractive, there is a nasty downside to all of this.

If I have a company with $100 of equity on the balance sheet and 100 shares on issue, each share is entitled to $1 of the net book value of the assets. If, however, my company’s shares are trading at 10¢ because of the global financial crisis and my bankers ask me to reduce my $100 of debt to $50, I may choose to issue 500 shares at 10¢ to raise the required $50.

The first thing that happens of course is that company equity rises by $50 but more disturbing is that there are now 600 shares on issue. Where once each shareholder owned $1 of equity for every share they held, they now own just 25¢ worth of equity.

And if you are a small shareholder from whom the company couldn’t conveniently raise money, your holding has just been diluted because the institutions got the lion’s share of the placement.

Further, the money raised went to pay down debt rather than investment, so the earnings will only increase by the post-tax interest saved. As a result, the return on equity declines as well and because the true value of a company is inextricably related to the profitability of its book value, company valuations decline.

Valuations have thus declined and yet share prices have risen. As Benjamin Graham said, in the short term the market is indeed a voting machine. And I am not talking about one tiny or obscure corner of the market. Rights issues and placements, according to Paterson’s research, now account for more than 6.5% of total market capitalization: the highest level in more than 20 years.  (Postscript:  figures compiled by trade-futures.com show that 80% of small traders are bullish – the same level as when the market peaked in November 2007).

In the current environment, many value investors will succumb to temptation and their lack of discipline and reduce their discount rates. In doing so they try and keep their valuations from looking out of touch with ever-increasing share prices but really they’re playing catch-up. And when share prices fall slightly, value apparently and suddenly appears.

But the margin of safety is illusory and with returns from stocks unlikely to sustain returns so far out of whack from everything else, real value is some distance below. Only a demonstrated track record can prove otherwise.

Posted by Roger Montgomery, 9 December 2009

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On Wednesday this week I wrote in Alan’s Eureka Report:

“Postscript: I note that McMillan Shakespeare, a salary packaging specialist many readers know I have followed for some time, saw its founder sell a significant number of shares. You should know that it is not the quantum of the sale that should pique your curiosity or set off alarm bells, but the timing, coming as it does ahead of the findings of Dr Ken Henry’s first major overhaul of Australia’s tax system in 50 years, which could include potentially adverse changes to fringe benefits tax and thus salary packaging demand.”

“My experience as a fund manager is that when major owners or founders are selling it has sometimes been the start of a negative period for the company and its shares (CCP). At other times, founders and major stakeholders have sold and the shares have gone on to do great things (TRS). In this case I have been leaning to the cautious side – as it seems Anthony Podesta, MMS’ founder has.”

Addendum 16 Dec. 2009:  The facts remain that MMS is a wonderful company with huge cash generation, high rates of return on equity and net fixed assets and a company that up until recently was trading well below its intrinsic value. That intrinsic value value has also been rising significantly in recent years but some caution is warranted ahead of the release of Ken Henry’s tax review and the government’s determination about what recommendations it will adopt.

By Roger Montgomery, 11 December 2009

First published 9 December  2009, www.EurekaReport.com.au

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I had a call yesterday from one of my brokers (who also happens to have become a friend). He informed me that the restrictions have come off all the broker’s so that they are now able to write research about Myer. As you would expect so soon after its widely supported float (A float that lost money for the thousands of investors who sold out in the first weeks), the research has been predictably bullish. It is not however the views of the analysts that is interesting. What is interesting is the reference in several of the reports to a relative P/E. The argument goes that because Harvey Norman and David Jones have a higher P/E than Myer, that the gap should narrow and Myer’s P/E should rise, pulling the price up with it. See any weaknesses in the logic?

Its like saying that there’s a Ferrari and there’s a VW Combi and the VW combi will get faster because the Ferrari is too fast compared to it.  Clearly such conclusions are flawed.

The performance of management, the economics of businesses and their prospects all affect their values and the sentiment towards them, which in turn, affects prices in the short term.

Buffett has frequently said that academics where correct in observing the market was frequently efficient.  In other words, a lot of the time, the price is right and perhaps in the case of Myer it should be on a lower P/E than David Jones.  This post should be read in conjunction with my previous posts on Myer that discuss its intrinsic value.

Roger Montgomery, 10 December 2009.

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