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Companies

  • Can Ausenco be an A1 again?

    Roger Montgomery
    June 18, 2010

    I was on the Sky Business Channel’s Your Money Your Call a couple of weeks ago. The next day Phil let me know how disappointed he was on my Facebook page – his email wasn’t featured on the show and he couldn’t get through on the phone. I should let you know that until I am hosting a program (don’t get any ideas!), I don’t have a say in which calls are taken and what emails are featured. I did however promise to share my observations on Ausenco with the disclaimer that they are didactic.

    Up until 2008 Ausenco (AAX) was a darling of the market – indeed it had reason to be. It had a track record of being an A1 business and in 2007 was generating a profit $41.5m on only $56m of equity – a stellar 95% return. A 2007 estimate of AAX’s intrinsic value would be something like $15.07.

    But with the share price now trading around $2.33 and my current valuation at $1.54, something has changed. Why has Ausenco fallen on such tough times?

    In 2007-8 Ausenco went on somewhat of a buying binge. To diversify away from the operations of mining and minerals processing, PSI, Vector and Sandwell were added to Ausenco’s business. Looking at the share price today, compared to two years ago it appears Ausenco paid a very high price for this strategy.

    At the end of 2007 a significant portion of Ausenco’s $56m of equity was cash. The business had only $7m of debt. Up until that time shareholders had grown the business by simply investing $11.5m of their own equity and retaining a cumulative $45.7m in profits. A nice position and in my opinion, very attractive. Ausenco was a small, highly profitable, organically-grown and well-run business.

    By the end of 2008 growth was turbocharged. The combination of substantial acquisitions however saw an additional $106.6m of equity raised and debt jumped to $66. In other words, shareholders equity ballooned by 325%, to $182m, compared to the previous year.

    With this aggressive growth came a host of challenges. Running a focused small business is a much easier task than steering a larger ship that has diversified into a ‘pit to port’ engineering business.

    And by 2009 the numbers agreed. A profit of $20.3m was reported, but $260m was needed to produce it. So the profit was lower than 2007, but significantly more money had been contributed.

    Ausenco was far more valuable as a small business than it is as a larger one, as anyone holding the shares through this period can attest.

    As an investor, you should ask questions when a small, highly focused and highly profitable business becomes enamoured with the idea that bigger is better. Some may argue that the GFC is partly to blame. My response is to take a look at another business in the same sector, Monadelphous – one of my A1s and a business that has never attempted to grow beyond what Buffett refers to as its circle of competence.

    Unlike Monadelphous, Ausenco has slipped from an A1 to an A4. Yes its still high quality (A), but with a performance rating of 4 (5 being the lowest), its predictability is not something to be excited about.

    Posted by Roger Montgomery, 18 June 2010

    by Roger Montgomery Posted in Companies, Energy / Resources.
  • QBE – Does it eat twisters and floods for breakfast?

    Roger Montgomery
    June 11, 2010

    In March this year I shared my insights about QBE with readers of Alan’s Eureka Report. Since that time QBE’s share price has fallen from over $22.00 to $19.00 – a decline of around 15%. That may explain why I have received a few requests asking for an updated estimate for QBE’s value?

    If you take your cues from price action, you would probably conclude something might be wrong with the company.

    Open up a newspaper, flick on the TV, or do both on your new iPad and you will be overwhelmed with the events in the US, the debacle that is the Euro zone, and BP’s oil spill – one of man’s greatest catastrophes.

    With 40% of gross written premiums being derived in the US and a further 40% from London and Europe, it is likely QBE is exposed, somewhere.

    Even at home the company appears to be right in the firing line of the Lennox Head twister, Victoria’s bushfires and recent floods.

    It’s not all bad news though – the declining Australian Dollar ensures QBE’s overseas earnings are now worth more.

    So is there something wrong at QBE? Or is the market just reacting to bad news? Buffett says you pay a high price for a cheery consensus, so maybe bad news is just what’s needed to make QBE attractively priced…

    You have to remember that QBE is in the business of forecasting and betting against bad news – it exists to manage risk and spread it around when there is too much for it to shoulder alone. And given its successful decade-long track record of doing so, I can strongly argue that it performs this activity significantly better than many, if not most, of the other insurers listed on the ASX.

    Things that you and I perceive as negatives are usually positives for insurance companies. Think of the last time you had to make an insurance claim. Did your premium rise the next time you chased around for a better price?

    In March this year a sensible price to pay for QBE was $19.83. Now a sensible price is $19.92. So even with all the negative news and natural disasters, the only thing that appears to have changed is the market price.

    The truth is that the business operations that make up QBE’s brand have been moving much slower than its share price would suggest, and the rising valuation suggests things are believed to be improving.

    While the price was well above the estimated valuation three months ago, I couldn’t have predicted the share price would fall below it.

    I did say that “With a gun to my head and forced to make a decision, I would bet with Frank O’Halloran at QBE every time”. That remains the case today.

    I do get excited when the market, in its wisdom, decides that it temporarily dislikes great businesses. The result is a fall in the share price. Who doesn’t like to buy more of a good thing for less? The price however may not have declined far enough to provide the sort of Margin of Safety Ben Graham said should be required in Chapter 20 of his Intelligent Investor – arguably one of the two most important teachings in investment history.

    There are a bunch of insurance businesses listed on the ASX. Some are pure insurers and some have insurance divisions within the business. I am interested to hear what you think of any of them. Have you had to deal with them and have you had a good or not so good experience? Do you work in the industry? Can you shed some light on who you think is the best and why? Share your thoughts by clicking Leave a Comment below.  AND REMEMBER – YOU MUST OBTAIN PERSONAL PROFESSIONAL ADVICE BEFORE CONDUCTING ANY TRANSACTION OF ANY KIND IN ANY SECURITY IN THE MARKET.

    Posted by Roger Montgomery, 11 June 2010.

    by Roger Montgomery Posted in Companies, Insightful Insights, Insurance.
  • Toothpaste and lounge chairs – which is the easier investment decision?

    Roger Montgomery
    June 5, 2010

    “Roger, would you buy Nick Scali (NCK) over the likes of TRS, ORL and JBH?” This last week, its been a frequently asked question.

    Let me start by saying that I consider Nick Scali to be a high quality business. While the business listed in May 2004, I have run my ruler over the business financials since the year 2001. In every single year its been an A-Class company and an A1 in most. This is impressive. Few businesses have such an excellent track record, which speaks highly of management.

    Indeed, given my tough quality and performance criteria, NCK would be in the top 5% of all companies listed on the ASX.

    But are high quality financials and a good track record of performance enough to justify buying a business?

    Let’s consider the businesses of NCK and The Reject Shop – another high quality retailer.

    NCK is engaged in sourcing and retailing of household furniture and related accessories. The Company’s product portfolio includes chairs, lounges, outdoor, dining, entertainment  – what are called ‘big-ticket’ items as well as and furniture care products. It has 28 showrooms located in New South Wales, Victoria, Queensland and South Australia under the Nick Scali brand, and additional showrooms in Adelaide under the Scali Living and Scali Leather brand.

    TRS on the other hand is engaged in discount variety retailing. Its footprint of around 187 ‘convenience’ stores is focused on low price points, offering a wide variety of merchandise. Stores are spread throughout Australia.

    TRS has an exceptional history of quality and performance, and in that respect is not dissimilar to NCK.

    While NCK and TRS both have top tier fundamentals, there is one major difference; their business models. And this is the important difference that puts TRS far ahead of NCK in my mind from an investor’s perspective.

    Consider the economic cycle and the impact it could have on each business; NCK is a retailer of ‘big ticket’ items and TRS is a retailer of ‘low price point items’. Cast your mind back just a few years to when the stock market was crashing, and depression talk filled the media. Do you think spending on big-ticket items like a sofa or a $2 tube of parallel imported toothpaste selling at a cheaper price than a major supermarket, would have been reined in first? This is where TRS offers arguably a more stable and slow-changing revenue stream. TRS of course has its own issues and risks, just as any business has, but the stability of earnings is perhaps superior to that offered by NCK.

    TRS has positioned itself as providing ‘low price points’ on everyday goods. Things you always need – daily essentials. I’m guessing you wouldn’t stop brushing your teeth, even during a credit crunch, but you may defer the purchase of that new sofa or outdoor furniture. TRS gets you in by offering really low prices on the daily essentials and then tempts you to fill your basket with other cheap items that have a higher margin for the retailer.

    The problem for investors deciding between TRS and NCK is therefore not the quality of each business – they are both very high quality and have excellent management teams – it lies in the cyclical nature of NCK’s earnings.

    After determining the quality and risks for a business, the next step is determining its intrinsic values. If you don’t complete this step, you are not investing, you are speculating.

    Now to me, investing in a business like TRS is a fairly straight-forward decision. An investment decision in NCK on the other hand requires much more thought about consumer sentiment toward big-ticket discretionary purchases and how susceptible leveraged households are to increases in interest rates. Buffett once said find the one-foot hurdles that you can step over.

    I’m not saying I would never buy shares in NCK. There is always a time and a price at which even a cyclical business is cheap, provided its of the highest quality of course.  I just prefer to stick to the one-foot hurdles rather than trying to jump over seven footers.

    I’m off to brush my teeth. Don’t forget to leave your thoughts.

    Posted by Roger Montgomery, 5 June 2010.

    by Roger Montgomery Posted in Companies, Consumer discretionary.
  • Whose Intrinsic Values will rise the most?

    Roger Montgomery
    May 15, 2010

    It was as a young boy that I became enamoured with the outdoors and the unique landscape of Australia. I discovered the easiest way for me to experience it was by participating in cubs and scouts. I will never forget the motto “be prepared”. It has served me well in many ways, and while nothing is ever failsafe, it is sound advice when it comes to investing.

    The market and its associated commentary is on tenterhooks. You can attribute that to the supertax’s contribution to a foreign investing exodus, nerves surrounding the property bubble in China, rising interest rates, or whatever else seems to be fashionable on the day with which to attribute the market’s conniptions to. I believe however, quite simply, that prices are generally expensive compared to my estimates of intrinsic value. That means that the performances of the underlying businesses do not justify current prices.

    Of course if you are a trader of stocks valuations don’t matter. You will sell on the emergence of the Greek storm-in-a-teacup and buy the day after, when another bail-out package is revealed. Alternatively, you will buy when one newsletter says the coast is clear and sell when yet another contradicts it. The people pointing out worries about China today are those that said the banks would rise to $100 before the GFC hit. One of the easiest things to observe in the markets is that predictions of a change in direction are far more frequent than they are accurate. And anyone can explain what has happened, but few seem to be able to look far enough ahead to be positioned well.

    With arguably the exception of my warnings earlier this year about the impact of a decline in infrastructure spending in China (thanks to an unsustainable commercial property and capital investment scenario) on the demand for Australian resources, I don’t try to predict the direction of markets or the macro economic determinants. I simply look at whether there are many or any good quality businesses available to purchase below intrinsic value. If there aren’t many or any great businesses to buy cheaply, the only conclusion must be that the market is not cheap.

    I cannot predict what the market will do next, but its worth being prepared. When the market is expensive compared to my valuations, one of two things can happen. On the one hand, share prices can drop. That is more likeley to be the case if values don’t rise – which of course is the second scenario. Valuations could rise and make current prices represent fair values (or even cheap if values rise substantially).

    In the event that prices fall (remember I am NOT making any predictions), I thought its worth looking at some of the big cap stocks (not necessarily A1’s) and how much their current intrinsic values are expected to rise over the next two years. These estimates of course can change, and its worth noting that none of the companies are trading at a discount to their current intrinsic value.

    Big names and their estimated changes in intrinsic value
    Company Name Current Margin of Safety Estimated change in intrinsic value 2010-2012
    RIO Tinto No 8% p.a.
    Commonwealth Bank No 16% p.a.
    National Aust. Bank No 22% p.a.
    Telstra No 2% p.a.
    Woolworths No 7% p.a.
    QBE No 10% p.a.
    AMP No 9% p.a.
    Computershare No 5% p.a.
    GPT No 3% p.a.
    Leightons No 13% p.a.

    My estimates of intrinsic value  don’t change anywhere nearly as frequently as share prices, but they do change. I expect some adjustments to start flowing through as companies begin what is called ‘confession season’ – that period just ahead of the end of year and the release of full year results, when companies either upgrade or downgrade their guidance to analysts for revenues, market shares and profits. These adjustments could, in aggregate, make the market look cheap, but that will require 2011 valuations to rise significantly.

    If prices fall (I am not predicting anything), and one is not overly concerned about quality, then one strategy (not mine) may be to buy the large cap companies expected to lead any subsequent recovery. Many investors and their advisers still subscribe to the idea that ‘blue chips’ exist and are safe. They tend to think of the largest companies as blue chips (I don’t) and if they are going to buy any after a correction, we might expect they will buy those whose values are going to rise the most. Of course, they may not know nor care about my valuations, nor do they know which companies are going to rise the most (in intrinsic value terms), but over the long term, the market is a weighing machine and prices tend to follow values. It follows on this basis then that Telstra’s value increase of just a couple of percent per year over the next two years may not put it in an as attractive a light as, say NAB.

    I think you get the idea. To share your thoughts click “Leave a Comment”.

    Posted by Roger Montgomery, 15 May 2010

    by Roger Montgomery Posted in Companies, Investing Education.
  • Do these three companies represent the last of good value?

    Roger Montgomery
    May 4, 2010

    Fifteen months ago I was shouting it from the rooftops; “we will look back on this time as one of rare opportunity”.  Since then, and as the All Ordinaries Accumulation Index rallied 61 per cent, there has been a fall in my enthusiasm for the acquisition of stocks.

    Now, let me make it very clear that I have no idea where the market is going, nor the economy. I have always said you should never forego the opportunity to buy great businesses because of short-term concerns about those things. Even my posts earlier this year about concerns of a property bubble in China need to be read in conjunction with more recent reports by the IMF that there is no bubble in China. Take your pick!

    My reluctance to buy shares today in any serious volume comes not from concerns about the market falling, or that China will cause an almighty slump in the values (and prices) of our mining giants. It comes from the fact that there is simply not that many great A1 businesses left that are cheap.

    So here’s a quick list of companies that do make the grade for you to go and research, seek advice on, and on which to obtain 2nd, 3rd and 7th opinions.

    * Note: Valuations shown are those based on analyst forecasts and a continuation of the average performance of the past.


    In addition to these companies, investors keen to have a look at some lesser-known businesses, that on first blush present some attractive numbers, could research the list below. I have not conducted any in-depth analysis of these companies, but my initial searches and scans are suggesting at least a second look (I have put any warnings or special considerations in parentheses).

    • CogState (never made a profit until 2009)
    • Cash Convertors (declining ROE forecast)
    • Slater&Gordon (lumpy earnings profile)
    • ITX (trying to identify the competitive advantage)
    • Forge (Clough got a bargain now 31% owner and a blocking stake)
    • Decmil (only made a profit in last 2 years and price up 10-fold)
    • United Overseas Australia (property developer).

    What are some of the things to look at and questions to ask?

    • Is there an identifiable competitive advantage?
    • Can the businesses be a lot bigger in five, ten, twenty years from now?
    • Is present performance likely to continue?
    • What could emerge from an external force, or from within the company, to see current high rates of return on equity drop? For example, could a competitor or customer have an effect or are there any weak links in the balance sheets of these companies?

    Of course I invite you again – as I did in last week’s post entitled “What do you know?” – to offer any insights (good, bad or in-between) that you have about these or any other company you know something about, or even about the industry you work in.

    Posted by Roger Montgomery, 4 May 2010

    by Roger Montgomery Posted in Companies, Consumer discretionary, Investing Education.
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  • What do you know?

    Roger Montgomery
    April 27, 2010

    I took an Anzac-weekend break from analysing companies and valuations.

    It’s the 20th anniversary of the launch of the Hubble Telescope, which provided the world with new insights into life, the universe and everything. Insights are what this blog is all about, and many of you have insights that are extraordinarily valuable and worth sharing.

    Around October last year I received a tip to look at Decmil and Forge. That’s all that was said; “Roger, you should have a look at Forge and Decmil”

    So I did. And the rest, as they say, is history. It turned out Forge qualified as an ‘A1’ company and Decmil was right up there too. Both were trading at large discounts to their intrinsic values. That’s two from two.

    Another contributor has insights into healthcare stocks, benefiting everyone who visits this blog. And a CEO or two have provided clarity about their business models and their competitive positions.

    A frequent question I am asked is: “Roger, thank you for providing these insights for free…but why do you do it?”

    Well, first, I want you to see that valuing companies works better. If I can demonstrate that to you, you will have some confidence in doing it yourself, of course sticking to the steps outlined in Value.able. The second reason is that Warren Buffett described himself once as 85% Ben Graham and 15% Phil Fisher. Fisher is the author of Common Stocks and Uncommon Profits and liked “scuttlebutt “– insights from customers, employees and competitors. I would like to see you’re your insights published here.

    If you are reading this post, let me assure you are not alone. – value investing, it seems, is much more popular in Australia than I anticipated. So instead of shooting your question or insight to me privately in an email, post it here.

    If you don’t want me to publish your thought, just say so and I will refrain. When you write something, it doesn’t automatically pop up. It sits in my inbox awaiting my approval. I have to click PUBLISH before anyone will see it. If you ask me not to, I won’t.

    I have been positively amazed at the insights, views, opinions and questions I have received via email and most are worthy of posting here. So don’t hold back.  Click LEAVE A COMMENT at the bottom of this post.

    This blog is seen by CEO’s, MD’s, CFO’s and the PR people representing some of Australia’s largest public companies, so go ahead and share your thoughts. Please refrain from defamatory or judgemental language. Remember that every time you buy a share, you are purchasing from someone who quite likely disagrees with you, so don’t worry about a difference of opinion or even the risk of being wrong. As Francis Bacon said: “truth emerges more readily from error than from confusion”. We learn more from knowing we were wrong than from never knowing.

    Let me kick things off by asking a few questions. Feel free to answer any or all:

    • What industry do you work in?
    • Who do you regard as the best company in that industry?
    • What do you think makes them the best?
    • Could anyone eventually knock them off the perch? Who do you think is the most likely to?
    • What other industry(ies) do you like? Why?

    And use any of these to get our conversation going:

    • Do you receive tips?
    • How do you test them?
    • Do falling shares prices make you freeze?
    • Does your share portfolio have so many shares that it looks more like a museum? How did that happen?
    • How do you track your portfolio’s performance?
    • How do you go about analysing a company?
    • What’s has been your process for investing?
    • What stock do you like the most? Why?

    I hope you will take up my invitation to share your thoughts here and eagerly await commencing our dialogue. Start by clicking the LEAVE A COMMENT link just to the lower right of this post.

    Posted by Roger Montgomery, 27 April 2010.

    by Roger Montgomery Posted in Companies, Insightful Insights.
  • Can a bubble be made from Coal?

    Roger Montgomery
    April 19, 2010

    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.

    China.

    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.

    by Roger Montgomery Posted in Companies, Energy / Resources, Insightful Insights.
  • Is there any value in Property Trusts?

    Roger Montgomery
    April 9, 2010

    The other day, Andrew Robertson interviewed me for ABC’s Lateline Business Program about property trusts (you can find the transcript in the Media Room, On TV). I thought you might benefit from an expanded précis.

    For a very long time, property trusts were described rather derisorily as the investments of widows and orphans – boring, uneventful and staid. Then with the advent of a name change to REITS (Real Estate Investment Trusts), cheap credit and a healthy dose of me-too-ism, property trust managers trotted down the path that took them to near extinction.

    Managers of today’s REITS are falling over themselves to once again describe themselves as staid boring old property trusts. But don’t be fooled, while a decade of stable returns and the life savings of so many are gone, many of the managers responsible are not.

    With some basic arithmetic, let me explain what has occurred. Company A has $10 of Equity per Share that is returning 7% to 11%  year-in and year-out.  Somewhere between 2005 and 2006, like a kid at a toy shop screaming “I want one too”, the managers of property trusts started expanding in a debt-fuelled binge to get bigger.

    Arguably led by Westfield a year earlier in 2004, and as one might expect, the increased debt produced rising Returns on Equity. But it didn’t last.

    The party’s last song may have been August 29, 2007. That’s when Westfield was leading again. It sold a half share of Doncaster Shoppingtown for $738 million to one of the world’s largest property managers, LaSalle, on a yield of 4.7% – a record low. Westfield also sold half of its Westfield Parramatta centre for $717 million at a time when Centro, for example, was still loading up on debt. It sold another $1.3 billion in property-linked notes, launched a UK wholesale fund into which it sold $1.3 billion of its inventory, and sold more than A$750 million of US assets. And while it was selling assets, it was raising $3 billion of capital through a rights issue ostensibly to acquire more assets.

    Unfortunately for many investors, the managers of other property concerns thought they were smarter than the Lowys. Have a look at the debt to equity ratios in 2007 and compare them to the corresponding ratios in 2004. And the US was reported to be heading into recession.

    While it would be some time before the revelers turned into pumpkins and mice, the band had packed up and gone home.

    If you want to set your kids on the road to financial success, tell them this:  “If you can’t afford to buy it with cash, you don’t deserve to have it.” Its harsh, but I grew up on that advice. There were a few lay-buys for Christmas, but there wasn’t a single card in my Mother’s glomesh purse.

    The lesson however was lost on the property trust managers, and it wasn’t their money anyway!

    Eventually everything did turn to pumpkins and mice, and what happened next saved the entities and protected many of the executive jobs but arguably did far fewer favours for the unit holders.

    In 2008 Company A writes down its properties, triggering loan covenants and LVR limits. Debt to equity ratio explodes. Bank tells Company A to sort it out.  Company A’s share price falls to meaningless price and far below even the written down NTA. Company A conducts a capital raising anyway and issues hundreds of millions of new shares at a discount to the price and in complete annihilation of the equity per share, as the following tables demonstrate.

    The result of all this activity, quite apart from the corporate finance fees it generated, was a dilution of Equity per unit, Earnings per unit and Return on Equity.

    GPT’s, ING’s and Goodman’s Returns on Equity are expected to average 5 per cent or less for the next two years – that’s less than a bank account. Stockland and Dexus are expected to average 7 or 8 per cent – a little better, but nothing to write home about.

    And finally, you can’t dilute Equity per Share, Earnings per Share and Returns on Equity without a reduction in the intrinsic values of these entities, and that’s precisely what has happened.

    Stockland’s intrinsic value has fallen from $4.00 in 2008 to $2.16 today. Westfield from $8.25 to $6.71, Dexus from $2.74 in 2007 to 15 cents today and GPT, from $4.10 in 2007 to 30 cents today. Those intrinsic values aren’t going anywhere in a hurry either, unless Returns on Equity can rise significantly, but with debt now substantially lower that appears less likely.

    Posted by Roger Montgomery, 9 April 2010.

    by Roger Montgomery Posted in Companies, Property.
  • What company valuation did you ask for this Easter?

    Roger Montgomery
    April 1, 2010

    Heading into Easter, I received an enormous pile of valuation requests and while many were little mining explorers burning through $500,000 of cash per month and with just $3 million in the bank, quite a few were solid companies that hadn’t been covered before.

    And to confess, some of the requests were quite rightly keeping me accountable and making sure I post the company valuations I said I would, when I have appeared on Sky Business with either Nina May, Ricardo Goncalves and Peter Switzer.

    What are they, I hear you ask? Forge Group (FGE), Grange Resources (GRR), Arrow Energy (AOE), Cabcharge (CAB), Coca Cola (CCL), Data 3 (DTL), Hutchison (HTA), Incitec Pivot (IPL), Metcash (MTS), Sedgeman (SDM) and UXC (UXC)

    I am really impressed by the frequency with which I am now receiving emails containing insights I didn’t know about companies that I have covered.

    As a fund manager it was not unusual for me to adopt Phil Fisher’s ‘scuttlebutt’ approach to investing. By way of background, Warren Buffett has previously described his approach to investing as 85 per cent Ben Graham and 15 per cent Phil Fisher. Fisher advocated scuttlebutt – talking to staff, to customers and to competitors.  I did the same and would often end my interview of a company’s CEO or CFO with I’d learned from reading Lynch; “if I handed you a gun with one silver bullet, which one of your competitors would you get rid of?” The answers were always revealing. Sometimes I would get; “there’s noone worth wasting a silver bullet on”, but most of the time, I would find out a lot more about the competitive landscape than I had bargained for. Occasionally, I would learn that there was another company I really should be researching.

    Back to your insights, they are amazing. Now you know why I enjoy sharing my own insights and valuations with you as much as I enjoy the process of investing.

    One thought for you; Many of you are sending your best work via email. I would really like to see everyone benefit from the knowledge and experiences you all have so hit reply and if you have some insights (as opposed to an opinion), just click on ‘REPLY’ at the bottom of this post and leave as much information as you would like.

    So here are a few more valuations to ponder over Easter. I hope they add another dimension to your research. And before you go calling me about coal seam gas hopeful Arrow Energy, note that the valuation is a 2009 valuation based on actual results. The forecasts for Arrow for the next two years are for losses, and using my model, a company earning nothing is worth nothing. Of course Royal Dutch Shell and Petro China think its worth more and perhaps to them it is, but as a going concern its worth a lot less for some time to a passive investor.


    I hope you are enjoying the Easter break and look forward to reading and replying to your insights.

    Posted by Roger Montgomery, 1 April 2010

    by Roger Montgomery Posted in Companies, Consumer discretionary, Health Care, Insightful Insights.
  • Which businesses excel in the business of wellbeing?

    Roger Montgomery
    March 25, 2010

    I am guessing from the many emails I received this week about healthcare stocks that the quantity may have something to do with the sector being in the headlines (remember it is an election year)?

    Government numbers show that spending on healthcare is expected to nearly double as a proportion of GDP over the next 40 years. With fewer babies being born and people living longer, it is inevitable that the population is ageing. In the next thirty years, the proportion of the population aged over 65 will double to 22% and in the next forty years, the number of Australian’s aged 85 and over is expected to increase from 1.8% of the population to 5.1%.

    Government estimates show that this will exact a heavy toll on the cost of providing health and the following chart reveals where those costs for the government and opportunities for healthcare companies lie.

    Using government estimates for GDP growth, the above charts suggests the government will spend $38 billion on medicare and $68 billion on the PBS in 2040. Figures such as these have provided the large community of buy-and-hold investors with a sound investment theme to pursue. But in some cases this theme has led to some extremely irrational pricing, as we will discover.

    There are more than 20 healthcare stocks listed on the ASX that essentially fall into two categories.

    1. The provision of care and related services. This can mean pathology companies such as Sonic Healthcare, private hospitals such as Ramsay Healthcare, and providers of specialist ancillary services, such as software provider iSoft.

    2. Research and development. This can mean companies that produce generic pharmaceuticals, such as Sigma, or research into and development of cancer drugs, such as Sirtex.

    Like another exploratory industry, the mining sector, the size of these companies can vary from the very small, such as Capitol Health with a market cap of just $15 million, to global blood products and plasma giant CSL, which has a market cap of about $20 billion.

    The ideal combination of characteristics for a healthcare company that an investor would seek out is no different to those that should be sought more generally; a very high quality balance sheet, stable performance, a high Return on Equity, little or no debt and a discount to intrinsic value.

    So what do I think are the superior businesses? Following is a table of my findings.

    Using a combination of 15 financial hurdles, I note that the best quality companies, but not necessarily the cheapest in the sector, are CSL, Cochlear, Sirtex, Biota and Blackmores.

    Do you see that Search box to the right, just under my photo? You will need to scroll up. Type CSL, Cochlear or Blackmores into the box and click GO to read my past insights. And if your appetite remains unsatisfied, visit my YouTube channel, youtube.com/rogerjmontgomery, and search there too (there are many videos in which I talk about CSL and Cochlear).

    I should point out that each of the remaining three – Sirtex, Biota and Blackmores – are generating high Returns on Equity and has manageable or no debt.

    The lowest ranked by quality are Primary Healthcare, Sigma, Australian Pharmaceuticals and Vision Group. I won’t be buying these at any price and their Returns on Equity are less than those available from a risk-free term deposit.

    Alchemia, which manufactures a generic treatment for deep vein thrombosis and pulmonary embolism, Phosphagenics, with its patented transdermal insulin delivery system, and Capitol Health are also low in terms of quality and also highly speculative because they are yet to report profits. Analysts, however, are forecasting profits for all three in 2011 and 2012 and Alchemia is forecast to earn more than 30% Returns on Equity after a loss in 2010.

    In between this group are companies whose quality is neither compelling nor frightening; these are businesses that if I was forced to by I might only if very large discounts to intrinsic value were presented and in some cases, only if I was happy to speculate – which generally I am not. Sonic, Ramsay (search RHC for more analysis), iSoft, Pro Medicus, Healthscope, Halcygen Pharmaceuticals, ChemGenex, Acrux and SDI fall into this band.

    I have ranked all of the healthcare companies by their safety margin: a measure of their discount or premium to the current year’s intrinsic value. This reveals that some companies are trading at discounts to intrinsic value. As an investor you need to be satisfied that the companies you choose also meet your quality criteria, which should mimic your tolerance for risk.

    Take a close look at Biota, for example. Its price of $2.38 is significantly lower than the estimated intrinsic value, however you will also see that the return on equity is forecast to fall from 50% to 11%. There will be a commensurate decline in intrinsic value in coming years and the apparent discount will no longer exist, meaning that unless return on equity improves considerably in a few years it will cease to be a good investment.

    If my portfolio approach were to include some exposure to healthcare then my first choices would be CSL and Cochlear. These are both well managed, large-cap businesses with stable returns on equity and zero or low levels of gearing.

    My next preferred exposure would be pathology and radiology operator Sonic, alternative medicine distributor Blackmores, and liver cancer treatment marketer Sirtex

    Finally, if I was comfortable speculating on stocks then the companies I would seek to conduct further research on would be the two pharmaceutical minnows, Halcygen and cancer drug developer Chemgenex. Both companies are forecast to generate attractive rates of return on equity in 2011 and 2012 and have little or no debt. Halcygen is also currently trading at a discount to its estimated intrinsic value.

    REMEMBER… Before making any investment decisions, my comments should only be seen as an additional opinion to the essential requirement to conduct your own research and see a qualified financial professional.

    Everyone is capable of being terrific investors, you just need to remember that there is serious work to be done by YOU in the business of investing.

    Posted by Roger Montgomery, 25 March 2010

    by Roger Montgomery Posted in Companies, Health Care.