Companies

Roger Montgomery discusses why excessive focus on High Yield stocks is likely to yield disappointing returns in this Australian article published on 23 June 2012. Read here.

by Roger Montgomery Posted in Companies, In the Press, Investing Education.

• save this article
• POSTED IN Companies, In the Press, Investing Education

Amid news of Qantas’ latest conniptions and Spain’s arrival on the set of the great euro drama (Italy and France to enter stage right shortly), one Aussie company is quietly going about its business.

That business is ARB Corporation (ARP), and its compelling fundamentals are the reason we have held the company’s shares in the Montgomery Private Fund since inception.

Those fundamentals have also helped to produce acceptable results for Montgomery investors (See Figure 1) amid an otherwise manic, depressive market.

Guided by its founder, Roger Brown, ARB designs, manufactures and distributes accessories for 4WD and light commercial vehicles – something it has focused on solely and successfully for almost as long as I have been alive.

And while producing and selling accessories for 4WDs doesn’t sound like an overly exciting business, consider the fundamentals over the past 10 years.

Since 2002, ARB has managed to grow its after tax earnings from $8.36 million to $37.8 million – a compound growth rate of 18.25% per annum. This is a fantastic achievement and largely organic because it has required just $133.5 million of retained profits and equity – the latter from the issuance of options.

In 2002, $8.36 million profit was generated on $31.2 million of shareholders’ equity, generating a return to owners of 26.8%. Fast forward to 2011 and returns are equally impressive. $37.8 million is being generated on $129.3 million or 29.2%. Many businesses have also grown their profits over the same period of time, but it is far more often that growth has been ‘acquired’ and declining return on equity suggests those acquisitions have been expensive.

Fig. 1 Results are net of all fees.

As the business has grown and developed its economies of scale, returns have actually improved. This is a rare achievement in practice and a development which creates significant value for shareholders.

If you were a part owner of the business in 2002, your shares would have grown steadily in value (not share price) from $1.91 to $8.09. If you believe Benjamin Graham’s observation that in the long run, the market is a “weighing machine’, then you must agree that prices follow valuations over the long run. Provided you can see which businesses are able to increase their per share intrinsic value, there is no longer any need to try and predict share prices! Simply buy high-quality businesses – with rising intrinsic values – at discounts to that intrinsic value.

Figure 2 reveals the change in the ARB’s valuation mapped against its share price over the last decade.

Fig. 2  Skaffold Line ARB and its Intrinsic value 2002-2014*

*Source:  www.Skaffold.com 2012-2014 valuations are estimates
(If you have been thinking about becoming a Skaffold member, having a chart like Fig 2 above for every listed Australian company and a chart that is updated automatically and daily coming up to a Greek election, a Spain bailout and a very crucial reporting season is more than just a little helpful. I find it essential. So if you are thinking about a membership to Skaffold, go to www.skaffold.com and take advantage of the 13-months-for-the-price-of-12 “It’s Time” celebration promotion (and be sure to chat to your accountant about any pre-June 30 tax benefits)).

This represents a total value increase over the period of 353.93%. Including $1.76 in fully franked dividends, the business has generated a total return over the past 10 years of 446.1%. Suddenly selling bull bars gets a whole lot more exciting doesn’t it?

Fig. 3

ARB Corporation’s rising valuation and share price clearly reflect the high-quality nature of the business and superior investment fundamentals. You can understand why it’s something we have been attracted to for some time.

Last week we asked whether Thorn Group’s (TGA) recent outperformance was sustainable. The reason to ask is because it’s not the results of the past that will deliver returns to new shareholders, but whether the future matches that which is currently estimated.

To some extent, this question was answered for ARB by its management at the start of May – “The Board expects sales for the full year to be up by about 4% and for profit after tax to be in line with the previous year.”

While it is a slightly disappointing development – the market was expecting more – we think that any growth sans acquisitions in the current economic climate is not something to sneeze at. The business has faced challenging conditions this year following the Japanese earthquake, tsunami and Thailand floods, which together dramatically impacted the supply of new 4WDs. The key risk ahead is what proportion of their sales is impacted by declining iron ore prices feeding into a lower level of capex by mining companies.

Conversely, there is pent-up demand from a lack of vehicles being available for sale in the first half. May car sales data continued to show a strong rebound and indeed a record 38,000 new 4WDs sold out of a total 96,000 in total new cars in Australia. A record and, of course, ARB’s most important business segment.

Add to this the associated pent-up demand of accessories to fit out these new vehicles and what ARB is faced with is a current order book heading into the last three months of the financial year where demand is outstripping supply. An enviable position to be in.

Coupled with a highly capable management team who have not only controlled the businesses operating expenses at a time where sales and revenues were severely impacted, but have also used their conservatively managed and high quality balance sheet to continue expanding their production and distribution capacity to support future growth plans, we think the business has not hit its straps. And remember there are less than 50 stores worldwide.

Until our view changes, which is currently unlikely, this remains to us a business that is already succeeding in expanding overseas, a business that we will happily hold and a business for whom any share price weakness (provided intrinsic value’s remain unchanged) is a signal to accumulate more.

Posted by Roger Montgomery, Value.able author, Skaffold Chairman and Fund Manager, 14 June 2012.

by Roger Montgomery Posted in Companies.

• 36 Comments
• save this article
• POSTED IN Companies

With a downgrade in forecast profit of 90%, what should investors be thinking? Share Roger Montgomery’s insights into this latest bad news for Qantas in this interview of ABC Radio’s The World Today broadcast 5 June 2012. Listen here.

by Roger Montgomery Posted in Airlines, Companies, Investing Education, Radio, Value.able.

• save this article
• POSTED IN Airlines, Companies, Investing Education, Radio, Value.able

In this edition of ABC1’s Inside Business Roger Montgomery discusses his insights into the causes of the recent market losses and how Value Investors should be interpreting the changes – Roger appears commencing 3:27. Watch here.

This program was broadcast on 3 June 2012.

by Roger Montgomery Posted in Companies, Investing Education, TV Appearances, Value.able.

• save this article
• POSTED IN Companies, Investing Education, TV Appearances, Value.able

Learn Roger’s insights into the near-term future for Fairfax Media (FXJ) as Gina Rinehart increases her shareholding in this discussion with 2GB’s Ross Greenwood broadcast 30 May 2012.  Listen here.

by Roger Montgomery Posted in Companies, Investing Education, Market Valuation, Radio.

• save this article
• POSTED IN Companies, Investing Education, Market Valuation, Radio

In writing Value.able I wanted to explain return on equity  almost as much as I wanted to introduce the idea of future intrinsic value estimates and Walter’s intrinsic value formula.

From Value.able, PART TWO, The ABC of Return on Equity:

Return on equity is essential for value investors for so many reasons and Wesfarmers purchase of Coles was a great case study:

“In 2007, Wesfarmers had Coles in its sights. In that same year, Coles reported a profit of about $700 million. In its balance sheet from the same year, Coles reported about $3.6 billion of equity in 2006 and $3.9 billion of equity at the end of 2007. For the purposes of this assessment we will accept that the assets are fairly represented in the balance sheet. Using only these numbers we can estimate that the return on average equity of Coles was around 19.9 per cent.

Importantly, Coles has been around a long time, is stable, very mature and established and supplies daily essentials. While its prospects may not be exciting, there is the possibility that Wesfarmers may improve the performance of the Coles business.

So the target, Coles, is a business with modest debt and $3.9 billion of good-quality equity on the balance sheet that generated a 19.9% return. The simple question is: What should Wesfarmers pay for Coles? If it gets a bargain, it will add value for the shareholders of their business. If it pays too much, it will do the opposite – destroy value and perhaps its reputation.

Now, if you were to ask me what to pay for $3.9 billion of equity earning 19.9 per cent (assume I can extract some improvements), I would start by asking myself what return I wanted. If I were to demand a 19.9 per cent return on my money, I would have to limit myself to paying no more than $3.9 billion. If I was happy with half the return, I could pay twice as much. In other words, if I was happy with a 10 per cent return, which I think is reasonable, I could pay $7.8 billion, or two dollars for every dollar of equity. And finally, if I think that I could do a much better job than present management, I could pay a little more, $9.75 billion perhaps.

Now suppose you consider yourself much better at running Coles than the present Coles management. Remember, this is one of the motivators for acquisitions. Suppose you believe that you can achieve a sustainable 30 per cent return on equity. Assume you were seeking a 10 per cent return on your investment – a modest return by the way, but justified by the risks involved.

The basic formula to calculate what you should pay for a mature business, like Coles, is:

Return on Equity/Required Return x Equity
Using this formula the estimated value of Coles is:
0.3/0.1 x 3.9 = $11.7 billion

Even if I thought I was a brilliant retailer, I would not want to pay more than $11.7 billion for Coles. Given the risks, I may want a higher required return than 10 per cent. If I demanded a 12 per cent required return, I would not pay more than $9.75 billion (0.3/0.12 x 3.9 = $9.75).

I will explain this formula, which represents the work of Buffett, Richard Simmons and Walter in more detail in Chapter 11 on intrinsic value.

Of course, if we think that the balance sheet is overstating the value of the assets, the result would be a lower equity component and a higher return on equity. As Buffett stated:

Two people looking at the same set of facts, moreover – and this would apply even to Charlie and me – will almost inevitably come up with at least slightly different intrinsic value figures.

The result will be modestly different but the conclusion will be the same.

With around 1.193 billion shares on issue, the above estimates suggest Coles might have been worth between $8.17 and $9.80 per share.

Now, what did Wesfarmers announce they would pay for Coles? The equivalent of about $17 per share!

What do you think would happen to your return on equity if you paid the announced $22 billion for a bank account with $3.9 billion deposited earning 19.9 per cent? Your return on equity would decline precipitously to around 3.5%.”

With that in mind I wonder whether the comments Wesfarmers were reported today to have made to The Financial Review (see image, I subscribe and think its great) were complete.  Of particular interest is the paragraph; “The way we create value to shareholders is to increase return on capital.  There’s no doubt when we bought Coles we bought a very big business with very low return on equity and that reduced the return on equity for the company.”

Assuming the comments and statistics are correct, I would argue that the reason for the decline in Wesfarmer’s Return on Equity is not because Coles had a low ROE – as Wesfarmers are reported to have suggested – but because Wesfarmers simply paid too much for Coles. Do you agree or disagree?

What are your thoughts?

Posted by Roger Montgomery, Value.able author, Skaffold Chairman and Fund Manager, 28 May 2012.

by Roger Montgomery Posted in Companies, Consumer discretionary, Skaffold, Value.able.

• 20 Comments
• save this article
• POSTED IN Companies, Consumer discretionary, Skaffold, Value.able

Investors don’t have to have astronomic IQ’s and be able to dissect the entrails of a million microcap startups to do well.  You only need to be able to avoid the disasters.

In an oft-quoted statistic, after you lose 50% of your funds, you have to make 100% return on the remaining capital just to get back to break even.  This is the simple reasoning behind Buffett’s two rules of investing.  Rule number 1 don’t lose money (a reference to permanent capital impairment) and Rule Number 2) Don’t forget rule number 1!  Its also the premise behind the reason why built Skaffold.

Avoiding those companies that will permanently impair your wealth either by a) sticking to high quality, b) avoiding low quality or c) getting out when the facts change, can help ensure your portfolio is protected.  Forget the mantra of “high yielding businesses that pay fully franked yields” – there’s no such thing.  That’s a marketing gimmic used by some managers and advisers to attract that bulging cohort of the population – the baby boomers – who are retiring en masse and seeking income.

Think about it;  How many businesses owners would speak about their business in those terms?  “Hi my name is Dave.  I own an online condiments aggregator – ‘its a high yielding business that pays a fully franked yield’.  You will NEVER hear that from a business owner.  That only comes from the stock market and from those who have never owned or run a business.

They key is not to think about stocks or talk stock jargon.  Just focus on the business.  Thats what we did when Myer floated in 2009.  And with the market value of Myer now 50% lower than the heady days of its float, it might be instructive to revisit the column I wrote back on 30 September 2009, when I reviewed the Myer Float.

And sure, you can say that the slump in retail is the reason for the slump in the share price of Myer (I am certainy one who believes that the dearth of really high quality companies means multi billion dollar fund managers are bereft of choice meaning that a recovery in the market will make all stocks rise – not because they are worth more but because fund managers have nothing else to buy). But the whole point of value investing is to make the purchase price so cheap that even if the worst case scenario transpires, you are left with an attractive return.

It would be equally instructive to review the reason why we didn’t buy the things that subsequently went well (QRN comes to mind) so we’ll leave that for a later date.

Here’s the column from September 2009:

“PORTFOLIO POINT: The enthusiasm surrounding the Myer float is good reason for a value investor to stay clear. So is the expected price.

With more than 140,000 investors registering for the IPO prospectus, everyone wants to know whether the float of the Myer department store group will be attractive. This week I want to focus exclusively on this historic offer.

At present it is suggested the stock will begin trading somewhere between $3.90 and $4.90.

The prospect of a stag profit draws a self-fulfilling crowd. But if chasing stag profits is your game, I would rather be your broker than your business partner, for history is littered with the remains of the enthusiasm surrounding popular large floats.

Popularity, you see, is not the investment bedfellow of a bargain and being interested in stocks when everyone else is does not lead to great returns. You cannot expect to buy what is popular, travel in the same direction as lemmings and generate extraordinary results. Conversely thumb-sucking produces equally unattractive returns.

Faced with these truisms, I lever my Myer One card, obtain a prospectus and open it for you.

The Myer float is one of the hottest of the year and I am not referring to the cover adorned by Jennifer Hawkins! If those 146,000 people who have apparently registered for a Myer prospectus were to invest just $20,000 at the requested price, the vendors will have their $2.8 billion plus the $100 million in float fees in the bag.

A word about the analysis: It is the same analysis I have used to buy The Reject Shop at $2.40 (today’s close $13.35), JB Hi-Fi at $8 ($19.86), Fleetwood at $3.50 ($8.75), to sell my Platinum Asset Management shares at more than $8 on the morning they listed (at $5), and to warn investors to get out of ABC Learning at $8 (they were 54¢ when ABC delisted in August 2008) and Eureka Report subscribers to get out of Wesfarmers as it acquired Coles.

I don’t list these to boast but merely to demonstrate the efficacy of the analysis; analysis that is equally applicable to existing issues and new ones.

By way of background, TPG/Newbridge and the Myer Family acquired Myer for $1.4 billion three years ago. They copped flack for paying too much, but “only” used $400 million of their own capital; the remainder was debt. Before the first anniversary, the Bourke Street, Melbourne, store was sold for $600 million and a clearance sale reduced inventory and netted $160 million. The excess cash allowed the new owners to reduce debt, pay a dividend of almost $200 million and a capital return of $360 million. Within a year the owners had recouped their capital and obtained a free ride on a business with $3 billion of revenue. Good work and smart.

But I am not being invited to pay $1.4 billion, which was 8.5 times EBIT. I am being asked to pay up to $2.9 billion, or more than 11 times forecast EBIT. And given the free “carry”, the bulk of the money raised will go to the vendors while I replace them as owners. Ownership is a very good incentive to drive the performance of individuals.

And driven they have been. In three years, $400 million has been spent on supply chain and IT improvements, eight distribution centres have been reduced to four and supply-chain costs have fallen 45%. Amid relatively stable gross profit margins, EBIT margins improvement to 7.2% and a forecast 7.8% reflect disciplined cost identification and management. Fifteen more stores are planned for the next five years and the prospectus notes that trading performance improved significantly in the second half of 2009 and into the first half of 2010. The key individuals have indeed performed impressively, but with less skin in the game they may not be incentivised as owners in future years as they have been in the past.

And what value have all these improvements created? The vendors would like to believe about $1.4 billion, and if the market is willing to pay them that price, they will have been vindicated, but price is not value and I am interested simply in buying things for less than what they are worth.

In estimating an intrinsic value for Myer, I will leave aside the fact that the balance sheet contains $350 million of purchased goodwill and $128 million of capitalised software costs. This latter item is allowed by accounting standards but results in accounts that don’t reflect economic reality. Historical pre-tax profits have thus been inflated.

I will also leave aside the fact that the 2009 numbers and 2010 forecasts have also been impacted by a number of adjustments, including the addition of sales made by concession operators “to provide a more appropriate reference when assessing profitability measures relative to sales”; the removal of the incentive payments to retain key staff – not regarded as ongoing costs to the business; costs associated with the gifting of shares to employees; and, most interestingly, the reversal of a write-off of $21 million in capitalised interest costs – all regarded as non-recurring.

Taking a net profit after tax figure for 2010 of $160 million and assuming a 75% fully franked payout, we arrive at an owners’ return on equity of about 28% on the stated equity of $738 million, equity that could have been higher after the float if $94 million in cash wasn’t also being taken out of retained profits. Using a 13% required return, I get a valuation of $2.90.

Looking at it another, albeit simplistic way, I am buying $738 million of equity that is generating 28%. If I pay the requested $2.9 billion for that equity or 3.9 times, I have to divide the return on equity by 3.9 times, which produces a simple return on “my” equity of 7.2%. For my money, it’s just not high enough for the risk of being in business.

Importantly, the return on equity – based on the simple assumptions that three stores, each generating $40 million in sales will be opened annually over the next five years and that borrowings will decline by $60 million in each of those years – should be maintained. But the end result is that the valuation only rises by 6% per year over the next five years and delivers a value in 2015 of $3.90: the price being asked today.

My piece of Myer seems a bit hot for My money.”

That was 2009.  Has anything really changed?  Has the following chart reveals.  Myer is now trading at close to Skaffold’s current estimate of its intrinsic value.  Before you get too excited (although the shortage of large listed high quality retailers means even this company’s shares may go up in a market or economy recovery) take a look at the pattern of intrinsic values in the past and the currently anticipated path of forecast intrinsic values;  Past intrinsic values have been declining (generally undesirable unless forecasts for a recovery are correct) and forecast intrinsic values are flat.

Fig.1. Skaffold Myer Intrinsic Value Line

And as the Capital History chart reveals, 2014 profits are not expected to be better than 2010. That 4 years without profit growth.  Question:  Would you buy an unlisted business (as a going concern) that was not forecasting profit growth for four years?

Fig. 2. Skaffold Myer Capital History Chart

Finally the cash flow chart reveals the company has produced what Skaffold refers to as a Funding Gap.  Its cash from operations have not been enough to cover the investments it has made in others or itself plus the dividends it has paid.  In other words for 2010 and 2011, the two financial years it has registered as a listed company, it appears from Skaffold’s data that the company has had to dip into either 1) its own bank account, or 2) borrow more money or 3) raise capital (the three sources of funds available if a funding gap is produced) to cover this “gap”.

Fig. 3. Skaffold Myer Cash Flow Chart

I’d be interested to know if you are a loyal Myer shopper or not and why?  If you don’t shop at Myer, why not?  If you do shop at Myer, what do you like about the company, its stores and the experience?  And I am particularly interested to hear from anyone who DOES NOT shop there but DOES own the stock!

Posted by Roger Montgomery, Value.able author, Skaffold Chairman and Fund Manager, 27 May 2012.

by Roger Montgomery Posted in Companies, Consumer discretionary, Value.able.

• 14 Comments
• save this article
• POSTED IN Companies, Consumer discretionary, Value.able

Do Jumbo Interactive (JIN), Seven West Media (SWM), Matrix Composites (MCE), Toll Holdings (TOL), Blackmores (BKL), Seek (SEK), Silverlake resources (SLR), Paladin Energy (PDN) and Qantas (QAN) make Roger’s coveted A1 grade?  Watch this edition of  Sky Business’ Your Money Your Call broadcast 22 May 2012 to find out.  Watch here.

by Roger Montgomery Posted in Airlines, Companies, Investing Education, TV Appearances, Value.able.

• save this article
• POSTED IN Airlines, Companies, Investing Education, TV Appearances, Value.able

In Radio National’s PM program Roger Montgomery provides his Value.able insights into the short-term economics of the Australian airline industry to the ABC’s David Taylor. Read/Listen here.

This program was broadcast on 22nd May, 2012.

by Roger Montgomery Posted in Airlines, Companies, In the Press, Radio.

• 3 Comments
• save this article
• POSTED IN Airlines, Companies, In the Press, Radio

In TheBull.com.au Roger Montgomery discusses his insights into the outlook for Australian commodities share prices over the near future.  Read here.

by Roger Montgomery Posted in Companies, Energy / Resources, In the Press.

• 1 Comments
• save this article
• POSTED IN Companies, Energy / Resources, In the Press