The announcement that Roger Corbett will become the coxswain of Fairfax, the esteemed publisher of titles such as The Age, The Sydney Morning Herald and The Australian Financial Review, had me wondering; when a manager with a reputation for brilliance gets involved with a business with a reputation for poor economics, is it the business whose reputation remains intact?

Your performance in the share market is more a function of the business boat you get into than who is rowing it.  Even the ‘oarsome’ foursome will sink if their boat has a leak.

Newspapers have had to change dramatically as readership and classified revenues decline. Other major advertising revenue is also under pressure as the vast tracts of broad-acre advertising real estate is replaced by the cheaply created, high density and high-rise internet.  Even Warren Buffett, once the most vocal exponent of the toll bridge like virtues of owning the only newspaper in town, has more recently declared that he now would not buy newspapers at any price.

The Rocky Mountain News, founded in 1859, printed its final edition on Feb. 27 this year. Its former editor, John Temple, now writes a disarmingly frank blog in which he first observes; “we didn’t fully believe in the value of the web” and “Denver.com was available but the $50,000 price tag was considered too steep.”

As a fund manager I cannot comment about the execution of Fairfax’s online media strategy, however I can comment on the performance of the business, the irrational book value of its intangible assets and its intrinsic value.  For me, these are the things that are relevant in determining whether it is worth buying.

Fairfax’s reported profit before abnormals of $217 million for 2009 is less than the profit reported 5 years ago and has grown by less than 3% over the last nine years.  This latter statistic suggests, even without looking at the share price, that after inflation Fairfax owners have gone backwards.

Even more concerning however is the decline in return on equity from 15.5% in 2000 to 4.6% this year. If 4.6% seems exciting for you, there are plenty of bank deposits on offer through which such salubrious returns are available at much less risk.

Such a low rate of return on equity indicates that the assets, and in particular the $3.6 billion of intangibles and $2.3 billion of accounting goodwill, are unsustainably overvalued on the balance sheet.  If return on equity does not improve substantially, the auditors must surely ask how they can justify such high valuations.

Finally, it is worth noting that investors have injected $4 billion into the business, on top of the $600 million the company had a decade or so ago. In total, investors have put in and left in $3.8 billion over the last decade and yet the total market value of the company is only $200 million more. And so I repeat my initial question… when a manager with a reputation for brilliance gets involved with a business with a reputation for poor economics, is it the business whose reputation remains intact?

By Roger Montgomery, 15 October 2009

by rogermontgomeryinsights Posted in Media Companies.

• 3 Comments
• save this article
• 3
• POSTED IN Media Companies.

The US stimulus may have been great for global markets, including our own, but have the benefits to the ‘real’ economy been just as dramatic?

The impact of stimulus packages on the real world appears to be wearing off. By the end of September next year, 70 per cent of the 2009 American Recovery and Reinvestment Act’s $787 billion will have been spent.

According to economics forecaster Moody’s, US stimulus packages contributed ¼% in the first quarter of calendar 2009, 3% in the second quarter, 3.5% in the third quarter (now), and is forecast to contribute ¾% in the next quarter, 1½% in the first quarter of calendar 2010 and ¾% in the second quarter of 2010.

Translation? The Obama stimulus package is having its maximum impact on the ‘real’ economy right now. Data showing the recovery taking root is simply a function of this stimulus. According to Moody’s, this quarter is as good as it will get. The bad news is that from here-on-in, the stimulus will start to wear off.

Now, I am no economist. But there are several prominent experts, like Jim Rogers, who are warning another slowdown is about to occur that will make the recession the US just experienced look like a picnic.

I am equally poor at forecasting stock markets – you will discover over time that it just hasn’t been an essential ingredient in my own investing. But a friend of mine who picked the last market high and low to within a couple of days (please don’t ask me who he is or how he does it), tells me that markets have just seen their medium term highs and have begun another sell-off. This may or may not transpire of course, but he has always impressed me with his uncanny ability to get it right.

So we have some economic forecasters saying be careful, we have a market forecaster saying watch out and now here is my contribution…

I can tell you what a business is worth. I can also tell you that in the short run the stock market is a popularity contest, but in the long run share prices follow values. That’s why it is essential you know the value of the companies you are buying shares in.

When I aggregate all the company values I have estimated, I arrive at an estimated valuation for the All Ordinaries Index of just under 4000 points. This compares to a market that is 600 points, or 15 per cent, higher. That alone however doesn’t mean the market is going down. Valuing a company is not the same as predicting its price, and the reality is that Australia has over 3000 funds chasing less than 2000 stocks. This has the effect of creating a ‘normal’ state that sees the market above its valuation.

But above its valuation it is. So while I am very optimistic about Australia’s future and will never let short-term concerns about the economy or the market stop me from buying shares of great businesses when they are offered at attractive prices, right now I can’t find many great companies that are cheap enough to buy. And some people I have great respect for suggest I should be even more cautious in my optimism. Perhaps you should too.

By Roger Montgomery, 6 October 2009

by rogermontgomeryinsights Posted in Insightful Insights, Market Valuation.

• save this article
• POSTED IN Insightful Insights, Market Valuation.

This blog is for viewers of Nina May’s Your Money Your Call program on Sky Business Channel last week who requested a valuation for Lemarne Corporation Limited (LMC).

LMC’s history is a lumpy one. It is no JB Hi-Fi or The Reject Shop in terms of its economic performance. This makes the process of valuing the company more subjective.

ROE over the last 10 years has averaged 14%, varying between -1.2% to 25.8%. Since a capital return that reduced equity, and the sale of C10 Communications, ROE has been higher.

Cash flow is good (exceeds reported profits) and the balance sheet is debt free. Debt free, an attractive ROE and good cash flow are desirable characteristics, particularly when they appear in concert. Management have also shown they are owner-oriented, buying back shares last year at depressed prices equivalent to 10 per cent of today’s market cap, and plan to also provide a capital return through an unfranked dividend of 50c.

But this a small company, and I have done no work identifying whether any competitive advantages (the ability to regularly raise prices without a loss of sales volume) exist. They often don’t in small businesses. If they do, they tend not to be small for long. The focus is now on one business – Lemtronics. On first impressions, it is not the most memorable of brands.

My estimate of value is $4.00 – $4.50, but there are plenty of other companies whose businesses I know better.

By Roger Montgomery, 1 October 2009

by rogermontgomeryinsights Posted in Companies.

• 17 Comments
• save this article
• 17
• POSTED IN Companies.

I’m not talking about the front cover.

The current owners, including TPG and the Myer family, plan on raising $1.9b to $2.8b to exit the business. (Yes, the Myer family indicate on Page 33 that they may sell 100% of their shares).

$315 million will be used to pay down debt and $100 million odd are frictional costs associated with the float. The rest will go to Private Equity and the Myer Family.

Upon listing, the business will trade with a market capitalisation of somewhere between $2,282m and $2,768m.

What, however, is the business worth?

With all the relevant data to value the business now available and using the pro-forma accounts supplied in the prospectus, I value the company at between $2.67 and $2.78, substantially below the $3.90 to $4.90 being requested. It appears to me that the float favours existing shareholders rather than new investors.

Investing safely in the share market requires a wonderful business and a rational price. Myer is arguably now a much better business than it was, but the price being requested is even hotter than the cover.

By Roger Montgomery, 28 September 2009

by rogermontgomeryinsights Posted in Consumer discretionary.

• 2 Comments
• save this article
• 2
• POSTED IN Consumer discretionary.

My portfolio is full of businesses that dominate their market. Is yours?

Businesses with sustainable competitive advantages not only dominate their market, they are also able to produce significantly better returns using the same amount of capital and effort. Such businesses make great assets if you are trying the build an investment portfolio full of only the best stocks.

Businesses with a competitive advantage can charge higher prices for their products and services because people are willing to cross the road for them, even though the guy on the other side charges less (think iPhone).

Why? The service may be so intimately involved with the daily business of another company or the daily lives of consumers that they cannot possibly leave (Reckon or the banks), or it may be that they are the lowest cost provider and competitors simply cannot match their prices (think JB Hi-Fi). What is the competitive advantage of each of the stocks in your portfolio?

Competitive advantages are a critical recipe for continued high levels of profitability for a business. The next time you are shopping for vitamins, consider why Blackmores products are priced at a premium to their competitors. Maybe its because BKL has a competitive advantage?

By Roger Montgomery, 24 September 2009

by rogermontgomeryinsights Posted in Insightful Insights.

• 5 Comments
• save this article
• 5
• POSTED IN Insightful Insights.

Like me, your Myer One card entitles you to pre register for a prospectus for the forthcoming float of Myer. Should you take the next step and buy the shares?

The answer to that question depends on three things. First, does the business have bright prospects? Second, what is the business worth? Third, at what price is it being offered?

Clearly, Bernie Brookes is the talk of the town, and his work in turning Myer around is fast becoming legend.  But is the talk about Bernie’s ability to improve returns on sales from 2 cents in the dollar to 7 cents, or is the talk because a private equity firm bought a business with $400 million of equity and $1 billion of debt then, in the first year, paid themselves back their equity – essentially getting the business for free and then a few years later still, floated the business for what many analysts believe will be $2.5 billion?

Myer may be a better business than it was and it may be that earnings next year will be higher again, but this is not a JB Hi-Fi, able to roll out another 100 highly profitable stores with short payback periods. This is a department store.

It is, I confess, now a highly profitable business and highly profitable businesses are the sorts of businesses to own. But what should you pay for it?

To value a company, we need to know a few things. How much is reasonable to expect the company to earn on its equity going forward? What will be the equity going forward? And what will be the policy for the distribution and retention of earnings? In other words, what portion of its earnings will the company pay in dividends?

The company earned $109 million on beginning equity of about $300 million. That is a return on equity of 36.3%. If we assume the company and its management earn another 30% next year, pay half out as a dividend, and if we assume that we require a twelve percent return, the business is worth about $2.4 billion.

But there’s a catch, the company will not earn 30% on its equity, particularly if its equity keeps growing as half the profits are retained. In reality, if the company kept retaining profits, the equity would rise and the return on equity would fall. As the business matures, it will have to pay an increasing proportion of its earnings as a dividend.

Now that probably means that the business’ value will not grow significantly after about three to five years.

Investors who are considering buying shares in the float need to consider what the true value of the business is and what it will do in the future. And also keep an eye on how much goodwill is added to the balance sheet and how much tangible equity is taken out prior to the float.

By Roger Montgomery, 17 September 2009

by rogermontgomeryinsights Posted in Consumer discretionary.

• save this article
• POSTED IN Consumer discretionary.

Nothing beats living on an island and nothing beats living on an island and owning the only bank. The cozy banking oligopoly that exists on the island of Australia as well as high switching costs for customers has produced all the benefits associated with a wide competitive advantage.

Are you going to bother moving if your bank charges you a few cents more for each ATM withdrawal, EFTPOS transaction or EFTPOS cash-out? With 70 million ATM transactions per month, 150 million EFTPOS and EFTPOS cash out transactions per month and 30 million debit card accounts, a few extra cents charged per transaction and account is a valuable revenue generator for banks with very little additional work or cost and virtually no risk of customer loss.

In the past the banks were all the same from an investors perspective too, but there’s a change in the air. The recent capital raisings have done significant damage to the value of three of the major four banks in Australia.

When ANZ, NAB and WBC were raising capital to shore up their balance sheets, CBA was raising capital to take advantage of opportunities in a distressed market, and acquired BankWest. It shored up its profitability in the process and now has the highest ROE of all the banks at 19% and based on consensus estimates will return 21% on its equity for the next 2 years. This compares favourably with the ANZ (11%), NAB (12%) and WBC (13%).

After two decades, a clear leader for investors has emerged in Australian banking.

By Roger Montgomery, 9 September 2009

by rogermontgomeryinsights Posted in Financial Services.

• 2 Comments
• save this article
• 2
• POSTED IN Financial Services.

It seems the profits to be made by TPG on the re-listing of Myer will be outsized beyond what has been reported thus far. When a TPG-led consortium purchased Myer and the Bourke Street store, they paid $1.4 billion. Of that total, just shy of $450 million was equity – the contribution by the new owners and $1 billion was debt. Here’s the interesting part… in the first year of ownership, the owners held what you might recall was a massive clearance sale. They also sold the Bourke street store. The sale of the store netted around $600 million and the clearance sale, about $160 million. With the excess cash generated by these activities, the owners received a dividend of almost $200 million and a capital return of $360 million and hey presto, the owners bought Myer and got all their money back in the first year effectively buying Myer for nothing! Whatever the company lists for, subtract a billion to pay down the debt (assuming Myer is listed debt free) and the rest goes straight to the vendors – an infinite return on equity. What will be even more intriguing is whether the company is IPO’d with any debt. The more debt left on the balance sheet, the more of the float proceeds go to the vendors and remember they bought Myer for free.

By Roger Montgomery, 9 September 2009

by rogermontgomeryinsights Posted in Consumer discretionary.

• 3 Comments
• save this article
• 3
• POSTED IN Consumer discretionary.

While most buyers and sellers of shares focus on earnings and earnings growth, ‘investors’ take a wide berth around the Profit and Loss Statement and focus instead on the business’ cash flow.

Why? Cash is not the same as profits. I recall the completion of my first year in business and the accountants handed me my first annual report.  Smiling, they said that I should be proud because I had ‘made’ a substantial profit.  Pulling my trouser pockets inside out, I declared “well where is it?”

For many businesses, profits are an accounting construct.  They are the accountants ‘best guess’ about what the true picture of the business is. But business cannot spend accounting profits, it can only spend cash. When a customer buys a product on June 28 the accounts record it as sales revenue. But if the sale was made on 14 days terms, the cash will not be received until the next tax year and even then, only if the debtor doesn’t skip town. So don’t be tricked by a business reporting accounting profits – it can be losing cash at the same time.

If you own shares in a business that reports a profit but does not generate cash on a continual basis, the only thing you need to understand is that you should be concerned.

Take the recently collapsed Timbercorp (ASX:TIM) as an example. Despite the business reporting accounting profits year on year, it was actually losing money for four years in a row.

Many years ago I received a recommendation from a broking-firm’s analyst to buy shares in Southern Dental at around $2.60. The report went on to say that it represented one of the best value plays in the market at the time. Unfortunately, its cash flow materially less than its reported profits so I passed up the opportunity to buy the shares which proceeded to fall below 90 cents.

To avoid these types of businesses compare a business’ reported profits to the Cash Flow Statement. A business that continually pays out more cash than it receives will have negative operating cash flows. If this situation occurs over a number of financial periods then, depending on the cash balance, the cash outflow will need to be supported by borrowings or raising fresh capital. The first increases the risk of the business and the latter dilutes your ownership. Rarely are either positive developments.

Without continued support from bankers or shareholders, a business that continually spends more than it earns cannot survive.

To ensure the ongoing health of your portfolio and avoid companies with an elevated level of risk, seek out businesses that generate positive cash from their operations equal to or greater than the profits being reported.

By Roger Montgomery, 2 September 2009

by rogermontgomeryinsights Posted in Insightful Insights.

• 1 Comments
• save this article
• 1
• POSTED IN Insightful Insights.

One of the most common questions asked by investors, aside from what stock to buy, is; “is the market cheap or expensive?”

So how can investors estimate what the true value of the market is today and where it might be heading in the future?

Who you ask will determine the answer you receive. Some market commentators, experts, advisers and other ‘helpers’ use the P/E Ratio as their measure of fair value, some use charts to show support and resistance levels and some just make an ‘educated’ guess. It is easy to see why many investors become confused and lose confidence in the views of financial professionals, particularly since the aforementioned approaches have such a poor track record of reliability.

Just as I estimate the values of businesses, you can estimate the value of the All Ordinaries Index. That’s because an index is simply a collection of businesses weighted by their market capitalisation.

Applying the same methodology that I consistently use to value individual businesses to the All Ordinaries Index, I get a fair value for the market of around 4,100 points. At the current market price of around 4,510 points, I conclude that the market is not extremely expensive at 10 percent above fair value but nor is it a bargain.

Knowing this doesn’t help me predict where the market is going to go.  Placing a value on the market or any business for that matter is not the same as predicting its price but without a valuation you’re flying blind and merely hoping the shares you buy don’t go down.  That’s not investing, that’s speculating.

Knowledge of what the All Ordinaries might reasonably be worth today provides confidence about how to act.  If the news is plastered with stories of losses in the stock market and all looks like doom and gloom, and if the price of the All Ordinaries index is substantially lower than its estimated value, its probably time to buy.

By Roger Montgomery, 1 September 2009

by rogermontgomeryinsights Posted in Market Valuation.

• save this article
• POSTED IN Market Valuation.