For some reason over the last few weeks I have received an influx of requests for a valuation on Caltex. I guess it must have something to do with the share price declines.

Let me start by saying, you are on a hiding to nothing, trying to value this company. Like any business, the true value of Caltex has nothing to do with its share price and is instead determined by its equity and the profitability of that equity. As you are probably already aware profitability (return on equity) is going to be heavily impacted by input costs and revenues which for Caltex are fast changing. To better understand Caltex profits, have a look at what goes into the price of a litre of petrol that it sells.

To determine an Australian refiners’ profits you must start with the Singapore refiners’ price for petrol. This is because Australia’s local oil refineries compete with imported petroleum products from refineries in Asia, regardless of the cost of importing and refining crude oil. Consequently, the price of petrol at Australian refineries is based on international petrol prices. If local prices were higher than international prices, imports of petrol would displace local production. The result is “import parity pricing” – in other words, what it would cost to land fuel from Singapore refineries into Australian terminals. In turn, this price includes the Singapore benchmark price for refined petrol or diesel, the addition of an Australian “quality premium” (dubious but said to take into account Australia’s “high fuel standards”), plus shipping costs and cargo insurance. The result is then converted from US dollars per barrel into Australian cents per litre (1 Barrel = 159 litres).

So, starting with the Singapore petrol price (which is itself prone to wild swings),we have to add shipping (variable), quality premium, shipping insurance (variable), covert to Aud (variable), then add port costs (relatively stable), then add wholesale and retail margins (variable) and freight (variable) and then after GST and the Governments fuel excise we have a retail price for petrol.

You can see that there are many factors that are out of Caltex’s control and will determine its profitability and I haven’t addressed the factors that will influence the Singapore refiner’s margin, although the cost of crude oil has the most impact in the long term.

Feel like a break yet?

The result is that Caltex’s profitability is volatile and this is evident in the numbers. In 2001 Caltex’s return on equity was -20%, while it was 40% in 2004. Based on some of the research I have seen, return on equity is expected to be around 10% for the next three years. Really? Who knows? How could you know? It will depend on the price of oil. In the 2007 year (Caltex has a December year end) oil prices traded between US$49.90 and US$99.29 and Caltex’s return on equity was 24%.  n 2008 the oil price began at US$96, rallied to US$147 and fell to US$32.40. Caltex’s return on equity that year was 1.3%.

If we assume that the analysts are right with their forecasts of a 10 percent return on equity, then the value of Caltex is somewhere between $8 and $9. My valuation actually comes in at $8.74 but for the reasons I described above, I would not even consider a purchase unless the shares were at a very substantial discount to this valuation.

You should be aware that if you are trying to value Caltex, you are punting and making a plain old bet. Its a bet you might get right, but it is speculating not investing. Perhaps if you can buy Caltex at a 50% discount to a conservative estimate of intrinsic value it would be a safer bet but even then it is still a bet.

Posted by Roger Montgomery, 10 December 2009

by rogermontgomeryinsights Posted in Companies, Energy / Resources.

• 5 Comments
• save this article
• 5
• POSTED IN Companies, Energy / Resources.

Another viewer question I would like to share…

Roger,

A few questions (assume for all questions below that I am referring to stocks with low debt and high return on equity):

1) If you see the market as overvalued and most stocks you look at above their intrinsic value, do you just stay in cash until they become cheaper, even if you could be waiting years (like the 2003-2007 period)?

RM – I look at individual companies rather than the market. If there are no individual companies that are cheap, the answer is yes.

2) I know you like stocks that pay no dividends, but what happens if management does something stupid and the stock price plummets? At least you have got something from your investment if you have received dividends.

RM – You have misunderstood my stance on dividends, which is quite a common misunderstanding. My position is that all things being equal, a company with a high ROE that can retain its profits and compound them at a high rate is worth more than a company with the same ROE but paying some proportion of its earnings out as a dividend.

I am quite happy to buy companies that pay dividends – I bought Fleetwood earlier this year on a dividend yield of more than 20% – but the price I must pay for them is lower.

On the second part of your question, you are right. The assumption is that if management is going to retain profits they must generate high returns on those retained earnings. The track record of management doing stupid things however is long so I can understand shareholder reticence towards management hanging onto the cash.

3) Do you have any concerns about buying a stock that has low liquidity (as it could be difficult to sell if something goes wrong)

RM – Even when managing more than $100 million I bought shares with low liquidity, but I was right in those cases and their superior performance eventually attracted increased liquidity. Had I been wrong then yes, the illiquidity would have been a problem. They key is to worry more about being right, then you don’t have to worry about the liquidity.

Posted by Roger Montgomery, 3 December 2009

by rogermontgomeryinsights Posted in Companies, Insightful Insights.

• 7 Comments
• save this article
• 7
• POSTED IN Companies, Insightful Insights.

Yesterday an investor who likes his commodities, James, posted the following comment to the blog:

Hi Roger,

Following you on the TV shows is really helpful to my investment decisions, so thanks very very much.

I’d also like to have your view on current commodity bull trend. I understand that you like to value companies based on ROE, RR, etc, but do you ever try to reasonably predict the metal / commodity / gold price for next year? While you may say that is speculation, but a reasonable prediction based on supply / demand would also help in determining the company value?

James

Following is my response:

I am interested in commodity companies.

There’s something in the fact that billionaire Jim Rogers has been saying expect new highs in virtually all commodities over the next decade. There’s also something ominous in Warren Buffett’s purchase of a railroad company. Both men believe that oil prices will rise substantially.

I think its impossible to predict prices of anything in the short term, however I do believe that over longer periods there are supply/demand considerations that are easier to discern.

With regards to taking advantage of this, I have so far been biased to investing in the commodity itself rather than stocks. Companies that mine, plant or otherwise produce a commodity have risks associated with them that are unrelated to the commodity’s price itself.  For example for an exploration company, there are funding risks and execution risks, not to mention management risk and stock market risk.

It is quite possible that you believe that the gold price is going up, but the gold explorer whose shares you have just bought doesn’t find any gold! You may believe that the oil price will rise and yet the particular company you have bought shares in has an environmentally  catastrophic spill.  The wheat or corn price may be going to go up, but the farm you just bought had its crop wiped out by a flood resulting in no revenue and a higher future capital expense. There are simply risks that aren’t related to the commodity price.

For these reasons, where I have had a view about a commodity, I have thus far taken interests in the commodities directly rather than through stocks.

Posted by Roger Montgomery, 3 December 2009

by rogermontgomeryinsights Posted in Energy / Resources, Insightful Insights.

• 3 Comments
• save this article
• 3
• POSTED IN Energy / Resources, Insightful Insights.

A long-term value investing friend, Pauline, recently asked me: Do you value CSL at all?

The short answer is yes – I wrote an article on November 4 for Alan [Kohler] about CSL.

Click here to read my thoughts.

Posted by Roger Montgomery, 3 December 2009

by rogermontgomeryinsights Posted in Companies, Health Care.

• save this article
• POSTED IN Companies, Health Care.

Today I had an interesting piece of correspondence from ‘Victor’.  Victor writes:

You talk about value of a Company, but reality is the value of an asset is what a buyer will pay for it, so is it not true that at any moment in time, the value of a Company is what the market is willing to pay for it. During the .com days, that was all that counts, there were no intrinsic value at all.

What Victor is suggesting that the value of an asset is simply what someone else will give you for it.  In other words the price. But an asset is not worth what someone else will pay you for it.  What someone else will pay you for something is the Price.  Price and Value are two different things.  Go and research the company NetJ.com.  Its IPO price was 50 cents, it listed in November of 1999 on the OTCBB in the US around $2 and at the peak of the internet bubble traded at a price of more than $8.00 but according to its prospectus, it actually “conducted no substantial business activity of any description” and “had no plans to conduct any substantial business activity of any description”.  So was NetJ.com ever worth $2, or $8.00?  Of course not.  The price was $8.00 but the value was much, much lower.

Price is not value. Your job as an investor is to buy great businesses when their price is less than the value you receive.  The difference between a price that is lower than the value, is known as the Margin of Safety.  Warren Buffett and Benjamin Graham argue that those three words are the three most important words in investing.

Posted by Roger Montgomery, 3 December 2009

by rogermontgomeryinsights Posted in Insightful Insights.

• 3 Comments
• save this article
• 3
• POSTED IN Insightful Insights.

Last week I invited those of you who have registered to receive emails from me to let me know what headline grabbing events you would like me to comment on. I am currently collecting all the requests on this page and those that are the most popular, I will put up on my blog over the comings months.

by rogermontgomeryinsights Posted in Insightful Insights.

• 195 Comments
• save this article
• 195
• POSTED IN Insightful Insights.

I find investing intellectually and financially stimulating, and being able to share the process equally rewarding.

A large number of investors, financial planners, stockbrokers, and a very observant plumber have emailed me requesting the various insights that I mentioned on Market Moves with Richard Gonclaves and Nina May’s Your Money Your Call on the Sky Business Channel.

Many of you have also asked for individual stock recommendations or how I might be able to advise you. Here is the official response…

As you can imagine, I have received innumerable requests to manage funds, provide share market advice, review and establish share portfolios and the like. Having recently resigned (June 30) from the financial services and funds management businesses I founded, listed on the ASX and sold, I am not currently able to assist with these requests, however, with your permission, I will keep your details and let you know when I am in a position to assist.

In the meantime you can follow my thoughts by tuning in to Ross Greenwood’s Money News program on 2GB (NSW), ABC Statewide Drive (NSW) with John Morrison, watching the Sky Business Channel, reading my weekly Value Line column in Alan Kohler’s Eureka Report and visiting my blog, Roger Montgomery Insights.

If you have registered your details at my website, www.Rogermontgomery.com, I will contact you when my guide book to showing you how to identify great businesses and value them is available for purchase in late February or early March.

Until then, I have written an eight-page note on how to construct a share portfolio using my approach to identifying great businesses and valuing them.

I have also uploaded an article I recently wrote for Alan Kohler’s Eureka Report about airlines and why their accounting will make you sit up and take notice.

Enjoy your reading and investing and keep in touch.

Roger

Posted by Roger Montgomery, 30 November 2009

by rogermontgomeryinsights Posted in Companies, Insightful Insights.

• 10 Comments
• save this article
• 10
• POSTED IN Companies, Insightful Insights.

While chatting with Nina May on her Sky News program Your Money Your Call, a viewer called in to ask about Crane Group (ASX: CRG).

My curiosity was piqued because somewhere back in 2006 I owned the shares, but shortly after I changed my mind and never looked at them again. When my valuation model spat out the numbers I could immediately see why it hadn’t come up on my radar again.

Ten years ago the business was generating 10.4% returns on its equity – nothing to write home about. In 2012 it is forecast to earn the same, up from about 7.5% today.

For anyone reading my Roger Montgomery Insights blog for the first time, an ROE of 7.5% is not much better than you can get in the bank, and given the risks associated with owning a business and the fact that there are businesses we can invest in that are generating 20%, 30% even 40% and trading at small multiples of their equity (and without vast amounts of debt or accounting goodwill), it makes no sense to sell something in my portfolio that is first grade for something that is not.

CRG was worth about $6.00 ten years ago and today its worth about $5.00. If the analysts are right with their earnings forecasts, my value of the business will not rise much more than 7.5% in 30 months time to just under $5.40.

With the price today at almost $9.00, there is no incentive to buy the shares.

For new visitors to my blog, a caveat and a little background: My valuation is not a price prediction. I do not know what the price is going to do. Whilst I can tell you the value of a share with a high degree of confidence, I cannot accurately predict the future price. The price could rise or fall substantially and I simply cannot know.

My objective instead is to buy high quality businesses – those with little or no debt, high returns on equity and sustainable competitive advantages – at prices well below their intrinsic values. If, after buying the price falls and I still have confidence in my valuation, then the fall represents an opportunity rather than a reason to be fearful and sell.

For the year to June 30, the funds I founded and ran (I have since sold and resigned from these businesses) returned 3% to 11% in a year that the market fell about 21%. Since June 30, my portfolios (you can track them in Alan Kohler’s Eureka Report and Money Magazine) have risen 26% and 31% respectively, whilst the market is up 19%.

Posted by Roger Montgomery, 30 November 2009

by rogermontgomeryinsights Posted in Companies, Insightful Insights.

• save this article
• POSTED IN Companies, Insightful Insights.

Corporate Australia has a rich history of overpaying for the right to be big, bigger, the biggest. While size may help fatten the wallet of the steward steering the ship, it is often the case that investors, particularly those late to the party, see their wallets lose weight.

When ABC Learning bought all those centres and Wesfarmers bought Coles, it was obvious that the prices being paid were much higher than a rational and patient value investor would pay. Justified with promised synergies however, many acquisitions can be made to look good, disguising the real he’s-got-one-so-I-want-one-too motivation.

Turning to the AMP/Axa deal I should first point out that I am not suggesting either company is in the same boat as ABC Learning. What I will say though is that ultimately a business is worth some multiple of its equity and that multiple must be related to its profitability. Talk surrounds the possibility that Axa could be the recipient of another bid – although none has been forthcoming and with wealth management being a key growth strategy for the banks, there is also talk that ANZ might bid for AMP. The hunter becomes the hunted. Ignoring the cliches, the rumours and share price gyrations, we can value Axa and decide whether we like AMP management’s capital allocation strategy. We can also value AMP and decide, if ANZ make a bid, what we think of them.

Turning first to Axa; AMP has, with cash and shares, bid about $5.40 per share. Unsurprisingly Axa shareholders want a higher bid. Well of course they do. I would rather receive a few million more for my house too. But Axa’s performance doesn’t justify a higher bid and AMP needs to be prudent.  According to analyst estimates of EPS, Axa will generate a return on equity of about 13 percent over the next two years. With the exception of the 2008 loss, the return on equity for the last ten years has ranged between 6.8% in 1999 and 27% in 2003. Based on the forecast ROE and a payout ratio of between 61% and 67%, Axa’s 2010 equity of $2.58 per share is worth a little more than $3.00 per share. The market believes AMP will bid more and so the shares are trading at $5.84.

With AMP at $6.35 – up from its lows earlier this year of $3.52 – the price does not reflect the actual value of the business which is between $4.53 and $5.24. Should ANZ bid even more than the already optimistic price, it would reflect a genuine me-too strategy over at ANZ.

Nothing gets the blood racing more than a takeover and when blood leaves the head for other regions, common sense usually follows.

By Roger Montgomery, 23 November 2009

by rogermontgomeryinsights Posted in Financial Services, Insurance.

• 4 Comments
• save this article
• 4
• POSTED IN Financial Services, Insurance.

Some time ago Peter Switzer invited me on to his program to discuss five stocks for the long term that met my criteria for quality at least, and value if possible.

We didn’t end up with enough time to cover them so I was asked back on October 28. By that time the market had rallied hard so the three I could find were MMS ($3.99 back then) now $4.44, JBH (then $21.50) now at $22.96 and WOW (then $28.82) now $28.42.

The other two I mentioned, to satisfy the more speculative viewers, were ERA (then $24.70) now $24.46 and SXE ($1.62) now $1.63.

The 2009 valuations for MMS, JBH, and WOW are $4.69, $25.76 and $27 respectively. For ERA and SXE the 2009 valuations are $33 and $1.97 respectively.

At all times I have deliberately based these valuations on consensus analyst’s estimates so that there is no favouritism. But keep in mind analysts estimates are prone to change and therefore so are the valuations.  Further, it is worth remembering that when I run my aggregate valuations over the market, it tells me that the market as a whole is about 15 percent above its valuation.  In other words the market in aggregate is no bargain and may be a little expensive.

Also keep in mind that if you go and transact in any security in any way based on these opinions, you do so at your own risk. I really do mean it when I recommend that you seek advice from a professional adviser, broker or planner that knows your financial circumstances.

By Roger Montgomery, 19 November 2009

by rogermontgomeryinsights Posted in Companies, Insightful Insights.

• 12 Comments
• save this article
• 12
• POSTED IN Companies, Insightful Insights.