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Can a bubble be made from Coal?

Can a bubble be made from Coal?

Serendibite is arguably the rarest gem on earth. Three known samples exist, amounting to just a few carats. When traded at more than $14,000 per carat, the price is equivalent to more than $2 million per ounce. But that’s serendibite, not coal.

Coal is neither a gem nor rare. It is in fact one of the most abundant fuels on earth and according to the World Coal Institute, at present rates of production supply is secure for more than 130 years.

The way coal companies are trading at present however, you have to conclude that either coal is rare and prices need to be much higher, or there’s a bubble-like mania in the coal sector and prices for coal companies must eventually collapse.

The price suitors are willing to pay for Macarthur Coal and Gloucester Coal cannot be economically justified. Near term projections for revenue, profits or returns on equity cannot explain the prices currently being paid.

To be fair, a bubble guaranteed to burst is debt fuelled asset inflation; buyers debt fund most or all of the purchase price of an asset whose cash flows are unable to support the interest and debt obligations. Equity speculation alone is different to a bubble that an investor can short sell with high confidence of making money.

The bubbles to short are those where monthly repayments have to be made. While this is NOT the case in the acquisitions and sales being made in the coal space right now, it IS the case in the macroeconomic environment that is the justification for the  purchases in the coal space.


If you are not already aware, China runs its economy a little differently to us. They set themselves a GDP target – say 8% or 9%, and then they determine to reach it and as proved last week, exceed it. They do it with a range of incentives and central or command planning of infrastructure spending.

Fixed asset investment (infrastructure) amounts to more than 55% of GDP in China and is projected to hit 60%. Compare this to the spending in developed economies, which typically amounts to circa 15%. The money is going into roads, shopping malls and even entire towns. Check out the city of Ordos in Mongolia – an entire town or suburb has been constructed, fully complete down to the last detail. But it’s empty. Not a single person lives there. And this is not an isolated example. Skyscrapers and shopping malls lie idle and roads have been built for journeys that nobody takes.

The ‘world’s economic growth engine’ has been putting our resources into projects for which a rational economic argument cannot be made.

Historically, one is able to observe two phases of growth in a country’s development.  The first phase is the early growth and command economies such as China have been very good at this – arguably better than western economies, simply because they are able to marshal resources perhaps using techniques that democracies are loath to employ. China’s employment of capital, its education and migration policies reflect this early phase growth. This early phase of growth is characterised by expansion of inputs. The next stage however only occurs when people start to work smarter and innovate, becoming more productive. Think Germany or Japan. This is growth fuelled by outputs and China has not yet reached this stage.

China’s economic growth is thus based on the expansion of inputs rather than the growth of outputs, and as Paul Krugman wrote in his 1994 essay ‘The Myth of Asia’s Miracle’, such growth is subject to diminishing returns.

So how sustainable is it? The short answer; it is not.

Overlay the input-driven economic growth of China with a debt-fuelled property mania, and you have sown the seeds of a correction in the resource stocks of the West that the earnings per share projections of resource analysts simply cannot factor in.

In the last year and a half, property speculation has reached epic proportions in China and much like Australia in the early part of this decade, the most popular shows on TV are related to property investing and speculation. I was told that a program about the hardships the property bubble has provoked was the single most popular, but has been pulled.

Middle and upper middle class people are buying two, three and four apartments at a time. And unlike Australia, these investments are not tenanted. The culture in China is to keep them new. I saw this first hand when I traveled to China a while back. Row upon row of apartment block. Empty. Zero return and purchased on nothing other than the hope that prices will continue to climb.

It was John Kenneth Galbraith who, in his book The Great Crash, wrote that it is when all aspects of asset ownership such as income, future value and enjoyment of its use are thrown out the window and replaced with the base expectation that prices will rise next week and next month, as they did last week and last month, that the final stage of a bubble is reached.

On top of that, there is, as I have written previously, 30 billion square feet of commercial real estate under debt-funded construction, on top of what already exists. To put that into perspective, that’s 23 square feet of office space for every man, woman and child in China. Commercial vacancy rates are already at 20% and there’s another 30 billion square feet to be supplied! Additionally, 2009 has already seen rents fall 26% in Shanghai and 22% in Beijing.

Everywhere you turn, China’s miracle is based on investing in assets that cannot be justified on economic grounds. As James Chanos referred to the situation; ‘zombie towns and zombie buildings’. Backing it all – the six largest banks increased their loan book by 50% in 2009. ‘Zombie banks’.

Conventional wisdom amongst my peers in funds management and the analyst fraternity is that China’s foreign currency reserves are an indication of how rich it is and will smooth over any short term hiccups. This confidence is also fuelled by economic hubris eminating from China as the western world stumbles. But pride does indeed always come before a fall. Conventional wisdom also says that China’s problems and bubbles are limited to real estate, not the wider economy. It seems the flat earth society is alive and well! As I observed in Malaysia in 1996, Japan almost a decade before that, Dubai and Florida more recently, never have the problems been contained to one sector. Drop a pebble in a pond and its ripples eventually impact the entire pond.

The problem is that China’s banking system is subject to growing bad and doubtful debts as returns diminish from investments made at increasing prices in assets that produce no income. These bad debts may overwhelm the foreign currency reserves China now has.

Swimming against the tide is not popular. Like driving a car the wrong way down a one-way street, criticism and even abuse follows the investor who seeks to be greedy when others are fearful and fearful when others are greedy. Right now, with analysts’ projections for the price of coal and iron ore to continue rising at high double digit rates, and demand for steel, glass, cement and fibre cement looking like a hockey stick, its unpopular and decidedly contrarian to be thinking that either of these are based on foundations of sand or absent any possibility of change.

The mergers and acquisitions occurring in the coal space now are a function of expectations that the good times will continue unhindered. I hope they’re right. But witness the rash of IPOs and capital raisings in this space. Its not normal. The smart money might just be taking advantage of the enthusiasm and maximising the proceeds from selling.

A serious correction in the demand for our commodities or the prices of stocks is something we don’t need right now. But such are the consequences of overpaying.

Overpaying for assets is not a characteristic unique to ‘mum and dad’ investors either. CEO’s in Australia have a long and proud history of burning shareholders’ funds to fuel their bigger-is-better ambitions. Paperlinx, Telstra, Fairfax, Fosters – the past list of companies and their CEO’s that have overpaid for assets, driven down their returns on equity and made the value of intangible goodwill carried on the balance sheet look absurd is long and not populated solely by small and inexperienced investors. When Oxiana and Zinifex merged, the market capitalisations of the two individually amounted to almost $10 billion. Today the merged entity has a market cap of less than $4 billion.

The mergers and takeovers in the coal space today will not be immune to enthusiastic overpayment. Macarthur Coal is trading way above my intrinsic value for it. Gloucester Coal is trading at more than double my valuation for it.

At best the companies cannot be purchased with a margin of safety. At worst shares cannot be purchased today at prices justified by economic returns.

Either way, returns must therefore diminish.

Posted by Roger Montgomery, 19 April 2010.


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.

This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.

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  1. Hi Roger,
    With CSL dropping 8% in a day on the back of a US competitor advising lower earnings – is now a good time to buy?


    • Hi Mark,

      Put CSL aside for a minute. The best time to buy is when the shares of a wonderful business are placed under pressure by an event or announcement whose impact is of a temporary nature.

      Back to CSL and I have previously discussed CSL’s intrinsic value here so you should be able to type into the search box on the right hand side of the home page and find previous posts where I discuss CSL. An 8% drop in the price is not of itself, the trigger to buy, unless that drop takes the price sufficiently below its intrinsic value to provide a good margin of safety.

  2. Hi All
    I was in Macau for a few hours today, gamblers seemed to operate about 30% of the machines – mainly ten cent machines. The expensive machines seemed idle little construction taking place, half empty buses ferrying people to and through. Also semi finnished buildings – an abandoned one neighbouring Crown (not a nice sight). Depressing.
    Shenzhen based property developer Kaisa Group has launched a us$350 mill 5 year bond paying 13.5%, an IPO in December raised around a half billion US dollars for them
    and last week Evergrande real estate issued a US$600 mill bond paying 13%. It must be noted pricing is higher for these companies as they have a shorter track record.
    Local onshore banks are not allowed to extend short-term credit to pay land premiums and 50% of land premiums must be paid upfront, with the balance within a year.
    These borrowing measures leave the companies with exchange rate risks.

    • Hi William,

      Thanks for the insight. Yes, the wheels fell off – some time ago I believe – when it was revealed that a number of ‘high rollers’ were in fact mainland officials – many now jailed I believe.

    • On an unrelated subject, another ‘investor experience’ I have been asked to share with everyone is from Edward V. He had trouble posting a message so emailed me instead. He writes:

      Hi Roger,

      I thought I’d leave you with a second-hand impression of what my brother experienced recently at an “investment seminar”. I’m hoping you’ll publish this for others to read.

      I’ll be ordering two of your books, one for myself and one for my younger brother who (surprisingly for me) attended a “free” seminar held by “a company I won’t name” the other night in Brisbane. My brother’s not anyone’s fool and he was gobsmacked by the blatant sales pitch to buy their two-day course for almost $7,000 ! (No, he didn’t sign-up and I’m surprised he’d bother attending in the first place).

      With your book, my intention is to introduce him to value-investing, steer him completely away from a speculative mindset and get him to focus on investment in businesses rather than the movement of stock/option/CFD

      My brother told me that the presenter was very polished shoes, wore lots of jewelery, and had slicked-back hair. It was such a blatant sales pitch and promotion of the ‘appearance’ of wealth it was laughable. Unfortunately, a lot of others in the audience seemed to be taken in by it and he saw quite a few people signing up for the two-day course. There was a lot of upside in the presentation but unfortunately no mention of the risks or downside.

      Anyway, we’re looking forward to your book and will stick to common-sense and intelligent investing, rather being sucked in by the promoters of speculation.

      Thanks Roger.

  3. Hi Roger

    How long does it take you to value a stock you have never seen before?


    • and one other thing.. you were on Switzer and said ORL was below it’s intrinsic value but did not give any valuations. Can I ask what values you had it at moving forward. Cheers.

      • Hi Mark,

        Over $8.00 this year and more than $10 in a few years time – provided of course they meet their earnings estimates, which in turn will depend on the company maintaining return on equity above 75% for the next three years and ensuring they don’t damage the brand proposition by cutting quality to save costs.

    • Hi Mark,

      It used to take an hour or more to extract all the data that I needed from the annual reports and estimates. Then I put some macros into my spreadsheets and provided the laptop is not slowed by performing too many other functions, it can now be done in a matter of seconds. You have to appreciate that there is a mountain of work that goes into knowing what to look for. Only then can you take minutes or seconds to run a company through the process. It reminds of the cliche; ‘overnight success’. Rarely is the effort by the recipient expended ‘overnight’. There may be months and even years of effort put in to becoming an overnight success. Valuing companies is a little like that. Buffett has perfected the science and art of what to look for and can now talk about making decisions to buy multi billion dollar businesses “customarily within five minutes”

      Importantly, it is not just the valuation that you need. You need to now about the capital allocation history of management, the track record of earnings, the quality of the balance sheet and the stability or predictability of earnings. Thats what I mean when I am referring to A1’s. These are businesses with very strong balance sheets and stable track records of profitability. The valuations for these businesses I tend to consider to be more reliable. Of course at any time, the values could change.

  4. Hi Roger

    Cant wait for the book. I’m interested to see your formula for valuing businesses. I’ve heard you mention from time to time that about 20 businesses fit your A1 category. When your book is published it would be handy for you to release several at the time so we can compare our math to yours to make sure we are doing it correctly. Matt

    • Thats a great idea Matt! Thank you.

      I will put something up on the blog when I release the book, for everyone to come back and compare their calculations to.

  5. Roger

    I’m a resource investor from Canada. I have been following you on youtube for awhile and think your insights are extremely valuable. Congrats on the new book, I was wondering if it will be available for purchase for people in the great white north?!

    Keep up the wonderful work.



    • Hi Mark,

      Thanks for the great white north compliment! Yes, you will be able to order the book online and have it shipped to Canada. Each geographic region has a separate shipping code to work out the postal rate so there will be no problem sending it to you. There are quite a number of Australian investors buying copies to send to their overseas relatives.

  6. Hi roger love your work

    Can’t wait for the book

    I noticed journalists report on 16 April saying china will solve thier property bubble but producing more lower costs housing Quote
    “On Thursday, the Ministry of Land and Resources said it
    would more than double residential land supply in 2010 to about
    180,000 hectares, or 1.8 billion square metres, from 2009, with
    more space dedicated to building small-unit apartments.”

    When I read this I thought it must have been printed a decade ago. Economics 101 sugests that to solve a bubble by producting more and cheaper items in the bubble will end in tears

    Love your thoughts on this

    • Hi Ashley,

      I agree. I have that article with me. I am reasonably certain the Chinese understand that it will stop the bubble from expanding further. And they may indeed know that it could end in tears. China’s oversight committee for government assets has ordered China Petroleum & Chemical Corp and 77 other state run enterprises to pull out of the real estate businesses they built through channelling billions of their monopoly-driven revenues into property development rights. Any turmoil in the real estate would have an impact on the balance sheets of these companies. It looks like the government is ‘getting out’.

  7. Hi Roger, keep up the good work.

    I was wondering if you could share with us your views on the two major casino companies (Tabcorp and Crown). I have always been intrigued by the casino business, it just seems like the perfect business as Mr burns says in the simpsons “People come in, spend all their money and then scuttle off”. They are monopolies within their market (although with an element of i guess oyu could say soverign risk).

    Both companies are undertaking large capex projects to expand their premises through renovations and new hotel towers, what type of effect do you expect this to have on the intrinsic value of each company?

    Big picture wise, I think in Tabcorps case the Star City renovation project needed to be done and actually overdue, the casino needed a face lift and needed to become more a location like Crown in Melbourne is rather than just a place for gamblers. I think it will result in more people visiting the venue who i feel will go for a flutter on a table or machine as well as add a couple of other earning streams.

    Also, what are your views of Crown’s expansion into Macau (which i think the jury is still out on) and America (which i think has been a bit of a disaster)?

    • Hi ANdrew,

      There are some useful answers that will come out of addressing these questions. I will try and get to them in the next few weeks. I am a little snowed working on a couple of other pressing obligations but don’t worry, its coming. You have to think about competition here too. Barriers to entry, population size, currency etc…

  8. Hi Roger,

    PTM, RKN, DTL, WOR, LEI, QBE, WTF look good fundamentally and they appear to have good prospects.

    However, would you consider any of the above companies to be A1 companies?


    PS. I am really looking forward to reading your book.

    • Hi Bill,

      In short, yes. Worley for example is an A1 and Platinum is very close to it. Lei and QBE are not, but for different reasons.

  9. Roger,

    Thankyou -Yes your logic does appear to hold water in just about all that you write. However does China hold a large amount of gold which has yet to be sent to market in order to save the day?

    For that matter I have always had the (perhaps uneducated and niave) view that America may resort to offloading gold to cover overspending and Australia- well – Uranium is quietly waiting in the background to save ours.I believe that even the “not in our backyard brigade” would support putting it in other country’s backyards if they desperately needed to save their own. With this in mind I have been slowly aquiring uranium stocks with a very long term view and watching gold carefully. It screams danger to me as a number of bubbles may be over stretching and Gold bullion seen as the immediate answer for those economies.


    • Hi Georga,

      Well I just don’t know about China’s gold reserves. You could well be right. As long as you are operating within your circle of competence (this is outside mine) then keep going.

  10. Hi Roger
    I have been following your blog and i find it very informative as a new to the trading game. would you care to give a valuation on a stock like REA since this thread has a lot of property talk.

    • Hi Danny,

      I know REA reasonably well. Perhaps not as well as the directors but pretty well. The companies intrinsic value has risen substantially over the last few years from 76 cents in 2004 to more than $8.00 now. There are risks of course that Google may offer a similar service for free and of course the share price is well above its intrinsic value, even looking out a few years.

  11. Roger, as a whole, I avoid stocks in the coal sector and go for the ‘service suppliers’ – not from any ethical standpoint, but to me, there is far too much long-term risk attached to the sector from the point of view of ‘carbon reduction schemes’ being thrown around by the pollies. I see the same thing happening right now as did in CSG companies about 12-18 months ago – speculation on consolidation.

    One day it’s coal, the next day it’s uranium which is the baddie.

    However, coal is (so far) an absolutely fundamental part of the steel making process due to the carbon input.

  12. Bonnie Cardiff

    Hi Roger,
    I am interested in the Hastie Group HST, Could you tell me
    if this company has any potential (if you dont mind) their share price has dropped and wonder if this is a good buying opportunity and what would be the stop loss be. This Company is one of our leaders in our industry and seem to have acquired very good businesses . ( cant wait till your book comes out, )


  13. Manny Sorbello

    Hi Roger,

    You are very kind in sharing your expert analysis without charging for it on your blog, I take it you make your money from investment income as opposed to subscription income. I think what you have to say on the business channel is more beneficial to the public compared to technical analysis advice. Those guys look like clowns sitting next to you talking hocus pocus stuff making recommendations based on share price movements, while you talk the real deal.. congratulations on that.

    In fact I have seen you put to shame some of the “fundamentalist” brokers too. Especially on the Telstra front. That dog should not be recommended to anyone. Its profits have gone nowhere in 10 years and its payout ratio is too high. It should slash its dividend let its share price crash and use the “strong cashflow” to buyback shares… But we both know that companies like that prefer to buy back shares on a PE of 30 instead of 10 or less right? I am appalled at hearing brokers recommend Telstra as part of a portfolio for the yield, when it is obvious that it can’t be sustained.

    I would like to share some of my humble analysis with you.

    Net Working Capital Ratio (NWCR) = (Current Assets – Total Liabilities * 100)
    Most of the companies that I would rate as A1 have a a Net Working Capital Ratio of 100% or greater. Obviously most companies with no debt would fall in this category but companies with debt do too. Thought this might interest you:

    2009 data
    A1s with a NWCR of 100% or greater:

    ARP and IRE 200%plus

    FWD 140%
    MND, JBH, HVN, BBG, ORL – Circa 100%

    Ok, thats not to say that all A1 companies have a Net Working Captial Ratio of 100% or greater because WOW only has 48% and CPU 34% but their EBIT Interest Cover are both greater than 10X..

    2007 data
    As the GFC took hold, I used this metric to determine which companies were likely to go bust or do massive capital raisings. Looking at CNP and ABC learning 2007 Annual Reports you will see that their NWCR were only 29% for CNP and 18% for ABS. I also concluded before it happened that a few other dogs would go bust… same story, (AFG, TIM, CDR etc). I am sure you accurately predicted this too with the knowledge that you have.
    Also noteworthy is their Interest Cover were also low – for CNP only 2.13X and ABS 3.61X. Not much margin of safety on their banking covenants, usually 3X is a breach isn’t it?

    You may also recall buy calls going out on CNP at $5 a few months before it bust same for ABS and AFG, the metrics were easy to work out reading the publicly available 2007 annual reports.

    Conclusion a low NWCR combined with a low Interest Cover = disaster. A low NWCR with a Interest Cover greater than 10x is good. A Net Working Capital Ratio around 100% or greater with no debt is gold.
    Intersted in your view on this.

    How about Worley Parson, its grown very fast with debt growing 10 fold from $60m in 2006 to $635m in 2008. The NWCR ranged from 80-90% and Interest Cover remained above 14X, ROTC above 15% and ROE 24%. A good growth company with manageable debt in healthy shape.

    When I identify A1s, I don’t exclude companies with debt otherwise I may overlook WOW, CPU and maybe WOR. In terms of price I think currently WOW is priced reasonably CPU is not, but last year at $7 and under CPU was a good buy.

    In terms of the numbers, I mainly look at the NWCR, ROTC, ROE, EBIT Interest Cover and a depreciation metric.

    What are your thoughts on the Net Working Capital Ratio metric? I know you have read the Intelligent Investor from Benjamin Graham, he used it to identify companies trading less than their Net Working Capital…. I just use it as a ratio to help determine balance sheet strength.

    After you look at CPU, please let me know if you think it is an A1, I have researched 20 years of history on this one and think there are many reasons why it is an A1. Chris Morris has done a fantastic job in growing this once small time business into an international one. BTW I don’t own it.

    I only monitor about 25 companies and most of the ones I am really keen on you have classed as your A1s. These are a sea of green on my calculations using NWCR, ROTC, ROE and EBIT Interest Cover. I also look closely at depreciation, identifying companies that don’t charge enough or charge more than needed, depreciation is very revealing, as illustrated with IRE.

    Please look at IRE and CPU when time permits.


    • Hi Manny,
      Thank you for posting this terrific note. I am on the road at present in Coffs Harbour giving a brief presentation at a CPA conference so give me a day or two and I will answer your questions more thoroughly.

      I have no problem using ROTC, but the very best companies – those with truly valuable competitive advantages, have little need for debt unless they are acquiring other businesses and generally I prefer to buy companies that grow organically. The very best businesses do indeed have interest cover that is sufficient to service the debt, but they throw off so much cash, they usually pay it down quickly or never needed it.

      In valuing a business, I am valuing the equity, not the debt, so I can’t use the ROTC number in my valuation. I will get the right valuation for CPU by valuing the equity and using 30%. I will write about its valuation in the near future on my blog.

      You are right about IRE, FWD and MND’s status as A1’s today. They are all A1’s on my list. Of course that hasn’t always been the case for Fleetwood and it can change again in the future, but for now A1’s they are.

      I think you will love my book because it will get you thinking about the drivers of high returns. You have the number crunching down pat. Its the sustainability that is interesting to contemplate in light of debt and balance sheet structure.

      Thanks for the compliment by the way. I am not so quick to dismiss the chartists as I am sure there are a few making very high returns from it. I do suspect they are very careful however about divulging their technique, because there is no room when such precise entries and exists are involved for multiple participants and so much of the more popular methods don’t seem to produce consistent results.

  14. Gday Roger,

    Thanks for the (as always) insightful comments. What is your current intrinsic value for Oroton, and what is this rising to over the next few years?

    PS Ever thinking about starting a LIC again? Im sure you’d have plenty of interested investors..

    • Hi Adam,

      Thanks for those encouraging compliments. ORL’s intrinsic value is above $8.00 at the moment. That is however based on Sally being able to sustain a return on equity of more than 75% which seems ambitious. The value does continue to rise in the next two years, provided it can meet earnings expectations.

  15. Hi Roger,

    This bubble is everywhere. In my business, which is pesticides, we have seen a shrinking or flatlining of the global market for glyhosate in the past 2 years yet a doubling of Chinese capacity over the same time. The global market is now significantly oversupplied and this shift in the supply curve has had a dramatic effect on all our earnings (witness NUF). It has been complemented by significant increases in the credit terms that we can now get – 180 days right through to consignment with limited if any credit cheques, which more then offsets any domestic tightening. And they are still expanding capacities. The issue to come in this market will be near perfect compeition – low prices and easy credit ex China will allow an exponential growth of competitors into this market and bring long term margins back to zero for all of us who import or manufacture using Chinese raws.

    • Hi Sean,

      Excellent insights into the realities of increasing supply and the long term costs of an entirely uncompetitive labour market here in Australia. If anyone else would like to provide insights into their industry please do.(Sean’s comment is very helpful when thinking about companies like Nufarm. Nufarm’s 2010 forecast earnings per share are little changed on the 45 cents the company earned ten years ago. The 2010 earnings are also significantly down on the 2008 earnings per share of 85 cents, but perhaps most importantly analysts are forecasting growing earnings in 2011 and 2012 – which Sean’s comments suggest might be optimistic)

  16. Roger

    When you say “I don’t make investment decisions based on macro factors,” the comments about China are a cause for concern and do impact on our decisions. Therefore is it that you counter that risk by the wider margin of safety to buy a share that has a larger China exposure. Or can we consider that estimates of future ROE have in some way taken into account some of the potential macro factors, whether that is the world economy, exchange rates, or other factors.

    The other question or concern is that if we look at the impact of a China bump on some of the companies on the ASX, in particular flowing on to the mining related companies it becomes huge and extends well beyond just RIO and BHP. It is easy for your portfolio to look China heavy.

    • Hi Peter,

      Thanks for your questions. I relation to the first one; exactly! I require a wider margin of safety and if I haven’t sold down any holdings that are above intrinsic value, it may cause me to do that. A reappraisal of the future valuations occur when ROE’s are adjusted. If those valuations reveal a decline over time or even a less than attractive rate of increase AND the shares are above value, then a sale may be in order. There are no hard and fast quantitative rules here and if I find an A1 business trading at a substantial discount to its intrinsic value, I won’t pass up the opportunity to buy it because of short term concerns about the market or the economy. Generally, my entry price provides a significant buffer and weakness is an opportunity to buy more. If you buy only the very best quality businesses, you will produce less volatile returns but continuing to hold does mean you will see declines in the short term. Quite frankly if you aren’t prepared to see the market price of your portfolio drop and sometimes substantially, you should not be in the market. Producing positive returns through the GFC was not achieved without the portfolio dropping in the interim. It was achieved by continuing to buy the best businesses at the biggest discounts to intrinsic value as prices fell. When they eventually recovered, they rallied faster and further.

  17. Hi Roger,

    The real estate bubble in Australia worries me – I think the Chinese have imported their real estate bubble here with the FIRB rules being relaxed. I don’t know when (or if) it will be popped, but I think that it is going to start hurting the economy, especially discretionary retailers.

    My reasoning is that if people have to commit higher & higher percentages of their income to servicing mortgages, they therefore have less money to spend on discretionary items. House prices continually climbing at the rate they have been are bound to problems, especially with the Government (hence FIRB rule relaxation, FHOG, etc.), property investors, spruikers & other vested interests trying to keep it going at all costs to the detriment of other, more productive sectors of the economy.

    I’d hate to be born today and try to buy a house in Australia in 25-30 years with the seemingly hellbent attitude here to have continual 7-10% capital growth p.a. Do these people realise how their kids are going to afford a house if that happens? Haven’t we learnt from what happened in the US/UK?



    P.S. When is Switzer going to do all of us value investors a favour and give you your own show on Sky Business?! Would be great to see you have your own show!

    • Hi Ross,

      Thanks for sharing your thoughts. I do wonder to whom all the big family homes of the baby boomers will be sold to in 25-30 years. If there is a younger generation of people who cannot afford a house now, at what price will the baby boomers sell their homes? Perhaps as you propose international buyers will leap frog the younger generation of Australians. If correct its a huge societal cost for perpetuating internationally uncompetitive labour policies.

      • I hope this news article may offer something useful to add to this discussion.

        There is a lot of wasted land in the cities at the moment. For a global city, we are consuming ever-growing living space per capita. Furthermore, many households do own or are invested in more than one property. http://www.smh.com.au/news/opinion/housing-crisis-we-did-it-ourselves/2007/07/24/1185043114408.html?page=fullpage#contentSwap1

        Present prices do not reflect the actual cost of rebuilding on an existing property or preparing new land for a new home. A lot of it is good old fashioned speculation, and it just so happens houses are back to being a perennial favourite over say, garlic. http://blogs.wsj.com/chinarealtime/2009/11/26/chinese-garlic-market-reeks-of-speculation/tab/article/

        Supply is being constricted one side by property owners’ willingness and ability to temporarily bear the cost of keeping the asset in between instances of capital gain, and on the other side by legal & administrative impediments to the transfer of home ownership (between owners or from land releases to new owners).

        Glenn Stevens and the RBA crew are rightly trying to act on the cost side of the equation by raising interest rates. However, I don’t see this as effective if the property sentiment continues to be supported by unleveraged, cashed-up “haves” (e.g. wealthy baby boomers, foreign investors).

        Perhaps a new tax & rebate scheme is in order – imposing a tax on square feet per person per legal residence together with means-tested rebates & hardship/dependents clauses. But that’s a political solution. The economic solution is to simply not buy into the property market at present prices and look through one’s personal contacts for a suitable place to rent at an affordable rate. I feel that negative gearing is a lobster trap that many will struggle to escape simultaneously at the worst moment in the coming months.

  18. Hi Roger,

    Thanks for your article, the reference to the Krugman paper is very timely indeed! Arguably the smartest economist in the world today. My question is how if at all do these macro issues impact on the asset allocation decision i.e. How much to invest in stocks vs bonds vs cash etc. If macro issues are not a factor, then what else do you use as a guide to alter your exposure to stocks vs the other asset classes?


    • Hi Vishal,

      Thanks for your post. I am a ‘bottom up’ investor rather than a ‘top down’ investor. Ultimately I am content to have the vast majority of my portfolio in businesses. if I can’t find truly great businesses (my “A1’s”) trading at good discounts to intrinsic value, then the safest place for the funds is in cash. I don’t want inferior investments. If I can’t find superior ones, the money sits in the bank. The asset allocation is therefore determined by the performance of businesses, the level of intrinsic value and the presence of a margin of safety.

  19. Steve Moriarty

    Hi Roger,

    I saw the Chanos video on Charlie Rose and it is truly frightening. If you see this and also read GMO’s “Red Flags” article, then there is little doubt that a bubble exists. However, I was wondering what the impacts on our stockmarket might be, if in addition to China’s bubble bursting that Australia too has a decline in house prices (because I think we are also in bubble territory)?

    This would be a “double whammy” for our economy. I would have thought that this would be extremely devastating for our market?


    • Hi Steve,

      The thesis does appear to be gaining traction. Soros has also commented and China’s own ministers are saying this is the last phase of madness. Supply of cheap housing is planned and banks are being asked to curtail their lending by increasing the LVR (admittedly from 40% already).

      As You know I am not a speculator. In answer to your question, I think the most risk is in the sectors for which forecasts look the most like hockey sticks. That means western companies that supply raw materials for the building and construction industries in China.

  20. Hi Roger,

    Given the prospect of a crash in China (of property, the economy, commodity prices etc) and the likely impact that will have on Australia, how do you take that into account when selecting stocks to invest in? (apart from avoiding resources stocks).
    Do you hedge your bets and keep some cash out of the market?

    • Hi Mike,

      I don’t make investment decisions based on macro factors. What I do is look at the portfolio and ask myself; what do I own who’s prices are now above their valuations and for whom I will have to wait the longest for the value to catch up. The real risk here is to those companies that have seen massive share price appreciation on the back of a thesis about China that does not entertain the possibility of a speed hump. Once again; I do not speculate and will continue to make investment decisions based on the prospects for an individual company, its intrinsic value and its economic performance. I might however increase the margin of safety I require to buy. I do this by increasing the required return.

  21. Hi Roger,

    I am sure you are busy finalising the printing of your book, however if you get a chance I would like to know if you have a valuation for LYL & SMX. They has a good stable ROE, debt levels are relatively low and increasing net operating cash flow over past 4-5 financial years.

    Thanks for your ongoing insight and education


    • Hi Ryan,

      The book is about to hit the print machine and you will soon be able to pre-order it online. Keep in mind that I am printing only enough copies for those who have pre-registered. It will sell out.
      Well done on your stock suggestions – both are A1’s or very close to it. The time to have bought SMX of course was in early 2009 when the value was $4.61 but the price was under $2.00. Since 2005 its been an A1 or very close to it. Based on my earnings estimates of 48 cents in 2011 and 53 cents in 2012, its looks like the intrinsic value will rise from $5.05 currently to $6.88 in 2 years and 2 months. So there is no margin of safety at present. Lycopodium has been an A1 or close to it since 2003. Again its not cheap.

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