Companies

Week after week our email inbox is filled with investor’s questions: A reasonably frequent one is about the performance of a portfolio of stocks that I wrote about last year filled with companies whose revenues had a large recurring component to them. If you know anything about the recurring patterns in fractal geometry, you know how beautiful the recurring theme can be.

The lift in the market over recent months has heightened anticipation. Today I will outline the performance of the six stocks I chose at the start of October last year.

But first: do you remember what we wrote about back then? The market was down 20% and radio news programs led with stories of large losses overnight in foreign markets. Shortly afterwards the market officially entered a “bear” market.

And then it promptly bounced. I remember this period because it was when we started a new Sub-Portfolio with six stocks that had one thing in common: a high percentage of recurring revenue. We called it the Recurring Value.able Portfolio.

As I wrote back then: “All the companies selected enjoy high rates of return on equity; they all have manageable, little or no debt; and they all enjoy the benefits of low levels of capital intensity, helping to generate copious cash.

“But what really marks these companies: Hansen, Iress, REA, Reckon and M2 Communications as a little special is the significant levels of recurring revenue. Iress (ASX: IRE, MQR: A1), enjoys close to 80% recurring revenue through the supply of its information and trading platforms; Hansen (HSN, A1) close to 70% through the supply of billing platforms and software; Reckon (RKN, A1) close to 60% through its provision of online accounting, personal finance and practice management software; and M2 Telecommunications (MTU, A1) close to 67% through telecommunications and internet access plans.

“Think of the advantages of running a business that begins each year with a material amount of its revenue locked in for the next 12 months. It is these recurring revenue streams that help derisk a company through strengthening balance sheets. The solid financial position then enables a business to comfortably expand current operations and take maximum advantage of other opportunities as they arise.”

A year ago I wrote that a portfolio constructed from high recurring revenue businesses and purchased at prices representing a margin of safety, should outperform the index. It was on that basis that I created a second Value.able portfolio called the Recurring Value.able Portfolio. Sitting within the Value.able portfolio its purpose is simply to demonstrate to you the relative performance of these holdings compared to the market.

You may recall I also overweighted the stocks that were trading at the largest discounts to my then estimate of intrinsic value and said: “I don’t believe the level of recurring revenue will change materially if Greece defaults and even if equity risk premiums increase because of more frequent recessions in the US” …adding “these holdings should perform as true defensives”.

Since I penned those thoughts, what has been the performance of each of the six companies’ shares? Hansen, Thorn Group and M2 were all trading at discounts to our then estimate of intrinsic value and M2 at the largest, while Iress, Reckon, and REA Group, were all at premiums to intrinsic value. The following table shows the share price increases and decreases for each of the six.

What I have done, is grouped those same companies by premium or discount to intrinsic value.

Those that were cheap are in the top half of the table, and produced a simple average return of 11.01%. Those that were expensive produced an average simple return of 7.63%. In other words, those with a high level of recurring income that were also cheap outperformed the All Ordinaries index; while those with a high level of recurring income but were expensive, on average, underperformed the All Ords.

Now, if you’ve been reading my column here long enough, you’ll know that a short period is not long enough to measure relative or absolute performance and neither is a small sample, but nevertheless, we have to start somewhere and the reality is we have plenty of experience to support the notion that quality and value combined leads to outperformance over the long run.

As an update to our October piece on this subject, find following the Skaffold intrinsic value line charts for each of the six companies. They describe where the current price is compared to Skaffold’s estimate of intrinsic value and whether, based on current forecast earnings, intrinsic value is expected to rise materially in coming years.

What are your favourite recurring revenue companies?  By thinking laterally you may discover a couple of companies that wouldn’t normally be thought of as enjoying recurring revenues.  To leave a comment click on the link below and enjoy reading the two further new posts below.

Posted by Roger Montgomery, Value.able author, Skaffold Chairman and Fund Manager, 15 March 2012.

by Roger Montgomery Posted in Companies, Investing Education.

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Making winches and bullbars for four-wheel drives sounds boring, but the latest figures from ARB offer exciting reading.

I am most excited about companies that are in boring industries. You might recall my column (here) enthusiastically discussing Embelton, a manufacturer and distributor of … wait for it … hardwood flooring. Since that article the stock has surged to new all-time highs. Great companies that are run by reliable and trustworthy managers can produce returns that are anything but boring.

Right now, retail and other sectors such as property have declined in prominence in the various indices. As a result, fund managers worried about their “tracking error” don’t need to own as much of these companies’ shares, which in turn means brokers don’t receive sufficient brokerage fees to warrant an analyst covering them. The net result is that analysts are made redundant, and coverage of the stocks declines along with the price multiples being asked for the shares. For a long-term value investor, this is bliss.

And with that we turn to the results of another of my candidates for most boring industry award: ARB Corporation. ARB manufactures and distributes 4WD aftermarket accessories. Think bull bars, snorkels, fridge-freezers and winches (among other items) manufactured in Thailand and Kilsyth and distributed around the world, now through 43 stores (16 company owned – think of the long-term store rollout potential!) from Africa and the Emirates to Mongolia.

Strong local demand has protected ARB from the impact of Thai floods on vehicle supply and a very strong previous corresponding period (thanks to a large order). And just as local demand in January (holidays) and February (job losses) will trim sales, a restoration of car manufacturing supply chains offshore will offset it.

In the most recent half, ARB increased sales 2.3% to $132.1 million, maintained its EBIT of $24.9 million, increased its net profit by 1.6% to $18.3 million and its earnings per share by 1.6% to 25.2¢. The interim dividend also rose by one cent to 11¢ a share.

Many investors might be concerned about the flat EBIT. Don’t be. This reflects increased staffing and in particular staff in the research & development department. It’s this department that is responsible for the company’s innovative product lineup that included the release of the Sahara bull bar range (2000), the Emu Dakar leaf springs (2005), the recovery strap range (2007) and the fridge freezer (2008). While the cost is expensed, investors should think of it as an investment in the future. EBIT was also flat thanks to store expansion and the NPAT increase merely reflected an increased interest income item. Like I said, don’t get too excited!

Some of our “informers” have, however, explained that price rises have been possible and if you have read my book Value.able (click here), you will discover just why I think this is the most valuable competitive advantage.

The resource boom in Queensland and WA is having a positive impact on smoothing the company’s revenues and earnings in addition to the obvious direct impact on aftermarket product sales. The company’s production facilities have been running full-tilt and this appears to have resulted in some buildup of inventory, which in turn has had an impact (not material) on cash flows and the value of materials and consumables used compared to sales.

Full capacity production facilities add to inventory that has become backlogged as a result of slow vehicle throughput, due to the Thai floods and Japanese earthquake. I expect the inventory will run down again as deliveries of post-flood vehicles overseas ramps up.

I am encouraged by the Thai facility being at full production so soon after commissioning, because it suggests that management were unduly conservative in their estimation of their global reputation. I expected more cash to be needed for an upgrade or expansion and that has been announced. With returns on equity the envy of their listed peers, I am delighted to see the company invest more.

At an ASX seminar I presented yesterday, one attendee asked about the impact of currency on the company. This was a very good question: It’s important to note that for ARB there are two impacts. The first is a strong Australian dollar is great for margins when inputs are purchased from overseas. The flipside is that marked-up revenues earned offshore are impacted negatively as the dollar strengthens and those revenues are repatriated.

Historically, the company has a record of paying special dividends and, with $32 million in the bank, it is understandable that many analysts would use this line to woo investors into the stock (as an owner of the stock; “go for it” I say!). But the large cash balance is partly the result of $7 million raised in 2010 (through an underwritten DRP if I recall correctly) and special dividends will also be dependent on the level of investment the company makes in plant:

Such an outcome is not beyond the realms of possibility but neither is a permanently higher dividend payout ratio. The latter of course reduces the intrinsic value of the company – better that MD Roger Brown keeps the money in ARB and reinvests it at near 30% returns on equity.

At the current price of about $8.63, ARB is trading just above its 2012 intrinsic value estimate (see above Skaffold chart). With only 43 stores globally and only 16 company owned, fully utilised production facilities however suggest the company has plenty of scope to grow while sustaining high rates of return on incremental capital for decades – notwithstanding management’s energy to do so. It seems boring but slow and steady seems to be winning the 4WD race.

Posted by Roger Montgomery, Value.able author, Skaffold Chairman and Fund Manager, 15 March 2012.

by Roger Montgomery Posted in Companies, Insightful Insights.

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QBE shares are trading at their lowest price since 2007, and they’re trading at Skaffold’s estimate of Intrinsic Value. They could be a compelling investment if premiums rise, US bonds collapse (interest rates therefore rise) and return on equity improves.

The release yesterday of QBE’s 2011 financial results, along with news of its planned $500 million capital raising ($450 million of which has now been raised from institutional investors), reminded me that there are many investors who may not understand the machinations of an insurance company. With that in mind, I thought some practical help in this regard would benefit those investors trying to make a decision about whether the lowest prices in QBE shares since 2007 represent good value.

Insurance companies can generally be divided up into two main businesses: underwriting, which is the practice of writing and collecting premiums on insurance policies, and paying claims on some of them; and the investment of those premiums – also known as ‘float’ or reserves – for the benefit of the companies’ owners.

It may surprise you to know the insurance business is relatively easy to understand, if you think about it from your own perspective. You pay an insurance company money to cover you for the risk of something undesirable befalling you. The amount of money you pay to the insurance company is the premium. Thousands of customers do exactly the same thing but not all of them will make a claim on their insurance policy. So the company attempts to make a profit from collecting and aggregating the premiums, paying commissions and expenses to the staff and resellers who market the insurance policies and then paying some portion of those premiums back out in claims.

At any period in time, there are insurance policies just written, insurance policies about to mature and insurance policies anywhere in between – and some of them will receive claims against them. At any point in time there is a pool of money that can be invested. These represent the unclaimed premiums on policies that are yet to mature. The income or profits earned from investing this, as well as claimed and immature premium revenue, is the second source of an insurer’s profit.

Many investors find analysing a balance sheet and profit and loss statement challenging. Analysing the reports of an insurance company is made doubly difficult by the fact that insurance companies use unique language to report their results.

Typically, insurance company results are displayed in two ways: there is the underwriting result, which is the result that excludes investment returns, and the insurance result, which includes investment returns.

The first line of an insurer’s profit and loss statement is the gross written premium. This is the total amount of money the company received in the form of payment for insurance policies for that year.

Now you may recall I mentioned earlier that at any period in time there are insurance policies just written, insurance policies about to mature and insurance policies anywhere in between. There are different contingent liabilities associated with the time remaining to maturity of a policy and maturity of a policy does not always occur at the end of the company’s financial year. For that reason, when premiums are adjusted for the period to which remaining possible (contingent) liability exists, the adjusted revenue is referred to as the gross earned premium. Some insurance companies also report this number.

From your perspective, the total amount of premium you pay represents the gross written premium, but if you paid for your insurance policy two months before the end of the company’s financial year, then the gross earned premium would be the amount you paid adjusted for two months.

By subtracting reinsurance costs from gross written premium, the net written premium is produced. If timing adjustments or accrued adjustments for contingent liabilities are made at this point, the result is net earned premium.

To recap, net earned premium is simply the revenue from writing all policies, less reinsurance costs and adjusted for timing.

Subtracting claims and expenses from the net earned premium produces the underwriting result which, you may recall, excludes investment returns. Adding investment income on the float or reserves to the underwriting result produces the insurance result.

Without trying to confuse you, the insurance result does not include investment returns on the shareholder capital part of the business. The shareholder capital part of the business raises equity capital from the owners to meet capital adequacy or prudential regulation requirements and these funds may also be invested.

With a typical industrial business, we might assess its performance using the profit and loss statement and a variety of ratios, such as gross profit margin, net profit margin or EBIT margin. We can do the same thing with insurance companies, but the ratios are given different names.

If we divide the insurance result (think of the insurance result as the EBIT of the whole company) by the net earned premium (which you should think of as the net revenue), we produce the insurance trading result (ITR). The insurance trading result is like the EBIT margin in that it is a pre-tax number – it also excludes interest on any debt.

There are rough rules of thumb about what numbers like the ITR should be. One dollar of premiums can be supported by about $0.50 of equity. If the insurance trading result is 10%, then the result is equivalent to a 20% return on equity. And if an investor is seeking a 10% required return, the right price to pay for an insurer might be double their equity.

The loss ratio is the ratio of paid claims to the net earned premium during the year. By comparing the amount paid out to the amount received, it measures the insurance companies’ effectiveness in pricing and predicting insurance policies and claims.

The expense ratio measures the proportion of sales the company expended on overheads. It measures operating expenses by comparing them to premium income. It is an efficiency measure, much like the cost to income ratio used by banks.

Finally, the combined ratio: this is a measure of profitability of daily operations. A ratio below 100% indicates that the company is making underwriting profit, while a ratio above 100% means that it is paying out more money in claims that it is receiving from premiums.

The combined ratio is reported in the context of the underwriting and insurance profit. It combines the claims ratio and the expense ratio. Remember, the claims ratio is claims owed as a percentage of revenue earned from premiums. And the expense ratio is operating costs as a percentage of revenue earned from premiums. The combined ratio is calculated by taking the sum of both types of incurred losses and expenses (underwriting expenses, including commissions, as well as claims) and then dividing them by earned premium. In short, combined ratio is the amount that revenue was eroded by to leave the profit margin, and doesn’t include investment income.

QBE reported its combined ratio had risen from 89.7% in 2010 to 96.8% and attributed the increase to higher costs (reinsurance and claims) associated with more frequent catastrophes and a higher net present value of claims due to a lowered discount rate (thanks to historically low interest rates overseas).

Even if the combined ratio is above 100%, a company can potentially still make a profit, because the ratio does not include income received from investments.

At the risk of completely losing you, the profit reported by the insurance company is in many ways like the profit reported by an airline – it is an accounting construct. You see, the item labelled ‘claims’ doesn’t correspond to actual cash claims made. Instead, it is invented by the accountants and actuaries and infected by an adjustment to the reserves. If you think of the reserves or float – the aggregated premiums received – as a liability or an amount set aside to cover future claims, then the claims item is an estimate based on current rates and the costs of those claims. As reported by QBE in its 2011 results this week, it is also impacted by changes to discount rates.

Table (E) on page 129 of QBE’s just-released annual report displays the adjustments made to the company’s flood or reserves as a result of a change in these estimates. The change to the reserve (you can see this by running your eye down a column) has an impact on the reported profit through the claims item in the profit and loss statement. For example, in 2004 the reserve changed from $3.4 billion at the end of the year of accident to $2.8 billion seven years later. This is a net benefit of $600 million to profits over that period. In the 2011 QBE result, an amount of $US64 million has been reported as “saving on prior year central estimate”.

Armed with this information, you are now a few steps closer to appreciating QBE’s results.

In 2011, QBE produced an underwriting profit of $US494 million compared to $US1.2 billion in 2010. QBE’s gross written premium (the total amount of money the company received in the form of payment for insurance policies for that year) rose 34% to $US18.3 billion, thanks in no small part to acquisitions. Net earned premium income (the gross profit after reinsurance and adjusted for timing) rose 35% to $US15.4 billion. Large individual risk and catastrophe claims amounted to 15.3% of net earned premium versus 9.5% in 2010 (see table).

The large number of painful hits to the company from these events have made it somewhat gun shy and it has pulled back some of its business lines in regions where reinsurance is too expensive. This may or may not be the right move. Only time will tell.

The insurance profit margin (contribution to profit from underwriting and investment income as a percentage of net earned premium) fell to 7.1%, compared with 15% in 2010.

The inefficiency of the stockmarket, however, was revealed when the company said its results were in line with the guidance it gave in January. In that trading update, the company gave guidance for all the above ratios, but analysts were left to translate the ratios into a net profit after tax figure. As at Monday this week, that translated consensus profit figure was $A936 million and 84 cents per share.

Yesterday, with its shares in a trading halt, QBE’s net profit came in at $US704 million ($A657 million) and EPS of $US0.61 cents per share ($A0.57 cps). The company also announced a capital raising through a bookbuild with a $10.50 floor, to raise $500 million, replacing Tier 2 convertible debt that under new APRA guidelines cannot be regarded as regulatory capital. This will dilute next year’s earnings.

You can see from the graph below that the reason for QBE’s terrible share price performance since 2007 is the fact that returns (the blue line) on ever increasing equity (the growing grey columns) have fallen from 26% in 2007 to less than 8% in 2011.

If, with your newfound understanding of the insurance business, you are interested in buying QBE at the lowest prices since 2007, then you need to be confident that the return on equity will begin to rise to levels that are materially above those available in a relatively risk-free bank account. And for this to happen, premiums will need to seriously pick up while claims remain low and nature stays quiet for a while.

Posted by Roger Montgomery, Value.able author, Skaffold Chairman and Fund Manager, 15 March 2012.

by Roger Montgomery Posted in Companies, Financial Services, Insurance.

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At the outset, let me say I am not going forecast anything.  I don’t know whether the market will rise or fall next.  Andy Xie however, in his column entitled; A world flying blind wrote:  “Playing with expectations works temporarily. The risk-on trade is in a mini bubble, as today’s, buyers want to be ahead of the slower ones. The buying trend is sustainable only if the global economy strengthens, which is unlikely. The stocks aren’t cheap. Desirable consumer stocks are selling for 20 times earnings. Banks are cheap for a reason. Internet stocks suggest another bubble in the making. The Fed is trying to inflate an expensive asset. The rally, hence, is quite fragile. As soon as a shock like Greece defaulting or bad economic news unfolds, the market will quickly head south.”

In the great de-leveraging we are witnessing, cutting interest rates (monetary policy) doesn’t spur economic activity because businesses and individuals are simply trying to get out from under a mountain of debt first.  The next option is to simply hand over money (quantitative easing) and then if that doesn’t work expand budget deficits through government spending (fiscal policy).  A positive by-product of the money printing is that lower long-term bond rates guarantee a negative real yield – How can bonds be seen as ‘safe’ if they are 100% guaranteed to result in less purchasing power? – and investors are forced to buy other assets like stocks and pile into the “risk on” trade referred to above.  Sadly, just as the money being printed isn’t finding its way into the economy – its being hoarded by the zombie banks who should have been allowed to collapse and/or write off their bad loans – the rally in the stock market isn’t helping the masses and indeed may itself be fading.

Chart 1 suggests to some investors that the latest attempt to encourage participation in the stock market hasn’t worked.

Chart 1 reveals that not only have retail investors continued to pull out cash from US equity mutual funds (about $66 billion since October), but the market peak of the week of February 29 coincided with the biggest weekly outflow for 2012 – $3 billion.

Chart 2.  Ratio of accumulators to dissavers plotted against P/E ratios

Back to more recent observations and the 20% stock market rally over the last four months has been described as a completely artificial “ramp” by some and has been driven entirely by the global liquidity injections of the US, UK, European and Japanese central banks.  The conclusions for some investors is that the smart money – those that have bought in anticipation of retail ‘follow-through’ will soon scramble for the exits.  What do you think?

Skaffold’s ASX200 Value Indicator is a live and automatically-updated valuation estimate of the ASX200.  It updates and changes every day.  The future valuation estimates are based on the the constantly updated forecasts for earnings and dividends of the biggest 200 companies.  You can’t beat it as a guide to the overall market level and whether you should be enthusiastic or not about looking more deeply for value.

Chart 3.  ASX200 Value Indicator

Source: Skaffold.com

Based on current forecasts for 2012 you can see that the market looks about fair value.  It isn’t overly expensive but neither is it, in aggregate, cheap.  Based on 2013 forecasts however the market appears to be reasonable value.  So the question is whether those 2013 forecasts are reasonable.  Typically, forecasts are optimistic.  We have previously written here of the persistence of optimism in forecasts by analysts.  If that is again the case for 2013, then you wouldn’t be getting overly enthusaistic about our market unless there was a pull back.  And according to those referenced above, a pull back is on the cards.  What do you think?

I believe there are individual companies that have produced amazing results this reporting season and in an upcoming post we will list the very best.  I also think that there is still some value among these companies.  The challenge for those new to long term value investing is to be able to stick to your guns, accumulate positions in extraordinary companies at deep discounts to rational estimates of intrinsic value and stand apart from the daily gyrations of fear and rumour about default, money printing and recession.

Looking forward to your comments.

Posted by Roger Montgomery, Value.able author, Skaffold Chairman and Fund Manager, 8 March 2012.

by Roger Montgomery Posted in Companies, Insightful Insights, Market Valuation.

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Roger Montgomery discusses why ‘watching the Directors’ is a “Value.able” strategy when assessing future business performance in his March 2012 Money Magazine article.  Read here.

by Roger Montgomery Posted in Companies, Intrinsic Value, Investing Education, On the Internet.

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Do BHP Billiton (BHP), Fortescue Metals (FMG), Seek (SEK), Bluescope Steel (BSL), GR Engineering (GNG), CSL (CSL), Peak Resources (PEK), Harvey Norman, (HNN), Buru Energy (BRU), The Reject Shop (TRS), ASG Group (ASZ), Tatts Group (TTS) and  Webject (WEB) make Roger’s coveted A1 grade?  Watch this edition of  Sky Business’ Your Money Your Call broadcast 29 February 2012 to find out.  Watch here.

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

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We have been delighted with the reports coming out from the smaller industrial companies and note again the growing divergence in the performance of the XJO versus the XNJ (ASX 200 versus All Industrials). We attribute this to a declining enthusiasm for the ‘resource story’ and the fact that many of the industrial companies we like (and own, including MTU) are producing such fantastic results despite evidence of a terrible domestic economic backdrop.

Headline revenue was down 14% as a result of the reduction of unprofitable EDirect business activity.  Thats good.  Underlying revenue (excluding the zero margin Edirect business) rose 8% and the dividend was up 29%. Business cash flow was $17.5mln compared to reported profit of $16.7mln.   The impact on valuations should be positive again but ultimately will be determined by the returns generated on the $21.8mln paid for the two acquisitions made in the current half.

Since 2003 (the year before MTU listed) the company has increased profits by more than 91% per annum and is forecast to grow profits again to $36 mln in 2012.  To generate the increase in profits (of $27mln to 2011) $60 million has been raised and $30 million borrowed.  The return on incremental equity is about 50% suggesting the acquisitions made thus far have reflected an astute allocation of capital.  We’ll be keeping an eye on the debt but reckon a recovery in the local economy (as interest rates are lowered and hopefully passed on by the banks) will give MTU another boost.

According to one of our brokers who has a buy recommendation on the stock, the following stocks are at risk of reducing their dividends:  Examining for factors…”forecast earnings revisions, payout ratios, stock price stability and free operating cashflows, the companies that are most at risk of further dividend cuts are SWM, GWA, TTS, HVN, QBE and MYR. Those that have reduced dividends but continue to pose a risk include BBG, CSR, DJS, GFF, HIL, MQG, OST, PPT, PBG, PTM, TAH, and TEN.”

Not a recommendation of course. Seek and take personal professional advice before engaging in ANY securities transactions.

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

by Roger Montgomery Posted in Companies, Insightful Insights, Investing Education, Skaffold.

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We all know retail businesses are swimming against the tide. We have written about that subject here at the blog on many occasions and below is a brief list of more recent posts:

We are not investors in momentum or sentiment however this blog allows me to share our thoughts with you and we are noticing a shift in investor sentiment now. The stock market indices with exposure to resources are underperforming the indices without. The industrial indices are rising at a faster rate and falling at a slower rate than their resource-rich bretheren.  Today is a classic example, This tells us that a shift is afoot. If you have been reading this blog regularly, you will know that we are also not enthusiastic about Iron Ore prices and believe prices of $100 per tonne or less are possible in coming years.  On air, I have explained that is our reason for not purchasing BHP despite optimistic earnings forecasts by analysts.

I think the lower-iron-ore price story is catching on and quietly but surely investors are reducing their relative weighting to resource heavyweights.

With that in mind, it could be that most down-in-the-dumps retail sector that now holds a few gems. Next week we’ll explore the results of the reporting season but for today I thought we should revisit The Reject SHop following its half year results.

Here’s the list of recent posts covering retail stocks and the retail sector.

http://rogermontgomery.com/invest-in-kfc-or-just-eat-it/
http://rogermontgomery.com/is-it-just-harvey-norman-or-bricks-mortar-retailing-generally/
http://rogermontgomery.com/are-bargains-available-at-woolworths/
http://rogermontgomery.com/now-waving-drowning/
http://rogermontgomery.com/not-so-high-at-jb-hi-fi/
http://rogermontgomery.com/dumped-by-the-wave-of-fashion/

Way back in September 2009, I published my reason for selling The Reject Shop:

“I can’t stop thinking that the value of the business just cannot rise at a fast enough clip to justify the current price. I really don’t like trading things that I have bought but I don’t think the value of the business can continue to rise indefinitely. With a share price of $13.45 (intraday today) and a valuation of $11.27, the shares are 24% above their intrinsic value. This combination of factors tells me we are safer in cash.”

Like many value investors, I was a little premature and the price first rallied to more than $17.00.  Since then the price has steadily declined to $11.80 after hitting a low of $9.12.

More recently – in December – I wrote:

“The Reject Shop still enjoys its high brand awareness but, as is typical in many store roll out stories, as the offer matures the later sites are less profitable than the early sites.

This doesn’t fully explain the fact that during a period in the economy where one would expect a bargain offering to shine, it hasn’t. Eighty percent of Australians still know the brand but I believe consumer experience and mismanagement has done it some damage.

According to one report, 20% of the population believe the company offers rubbish – cheap Chinese junk that quickly breaks after use and fills our tips. It’s the very reputation China itself is trying, but frequently failing, to shake off.

The other reason for damage to the brand is confusion brought on by mismanagement. Several years ago the average unit price was about $9 and basket size was $11, but over the years one cannot help but have noticed many higher-priced items creeping into the stores.”

Value investors are often early to buy and early to sell but over the long run, being certain of a good return is safer than being hopeful of an exceptional one and so, when it comes to buying decisions a demonstrated record is often essential.

In TRS’s FY12 earnings guidance, the company noted “Significant expenditure on increasing brand awareness”.  This is a real shame because at the time the company float The Reject Shop enjoyed 90% brand recognition and thats why its store roll out was working so well – shoppers knew the company, the store and the offer even though they had never been into a store in their area.

The company has provided earnings guidance for the full year 2012 of $20.5 to $22 million and while some smart analysts will note this is a 53 week year – we don’t care about such arbitrary lines in the sand.  Our approach to investing is involves treating any purchase and ownership as if we owned the whole company.  In that light and over the long term it doesn’t matter whether there are 52 weeks in a year or 52.5 or 53.

Thirteen analysts cover the stock and this week, eight have upgraded (only one downgraded) their forecasts for 2012 (remember the downgrade could be an error on the part of teh analyst rather than the company disappointing) .  I still believe the business will mature but there could be some value in the turnaround and a stabilisation of strong cash flows, and returns on equity over the next few years around 35%.  This is the rate of return on equity the company generated on $21 million of equity in 2005 (its intrinsic value then was around $4.00).  Today the company is expected to return to 35% returns on equity but on 3 times the equity.  You should be able to estimate the intrinsic value from those metrics.

There have been terrific results amongst our fund holdings such as Credit Corp, Seek, Breville Group, ARB, Decmil and Maca.  Have you been encouraged by any of the results?  Start a discussion by clicking on the Comments button below.

Posted by Roger Montgomery, Value.able author, Skaffold Chairman and Fund Manager, 24 February 2012.

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

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Click on the image at left to see a close up of the stocks we like.

I reckon 2012 will be the year to get set and fill your portfolio with high quality businesses, demonstrating bright prospects for intrinsic value growth and a margin of safety. That will be the topic of my talk today as I kick off the ASX’s 2012 Investor Hour series. Here are the details:

Topic: Buying opportunity

When: Tuesday 21 February
Where: Wesley Conference Centre, 220 Pitt Street, Sydney (venue location)
Time: 12 noon – 1pm. Please arrive by 12.00 noon for start
Details:

The time to get interested in share investing and make good returns is precisely when everyone else isn’t. But know that the key to slowly and successfully building wealth in the sharemarket is to avoid losing money permanently.

At this event Roger will set out his principles for stock selection.

Roger Montgomery is a highly-regarded value investor, analyst and author and a regular contributor and commentator across the media. Roger is an analyst at Montgomery Investment Management Pty Ltd.

Presenter(s): Roger Montgomery, www.Skaffold.com, www.Montinvest.com

Posted by Roger Montgomery, Value.able and Skaffoldauthor and Fund Manager, 21 February 2012.

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

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On one side of the investing coin is the idea that you lay out money today to get more back later. The flipside is that buy purchasing today you forego consumption today for the ability to consume more later.

They aren’t quite the same thing of course, because the latter idea introduces inflation and suggests the purpose of investing is to at least maintain purchasing power (generate returns in line with inflation) or increase purchasing power (generate real returns in excess of inflation).  In a useful reminder Buffett observes:

“Even in the U.S., where the wish for a stable currency is strong, the dollar has fallen a staggering 86% in value since 1965, when I took over management of Berkshire. It takes no less than $7 today to buy what $1 did at that time. Consequently, a tax-free institution would have needed 4.3% interest annually from bond investments over that period to simply maintain its purchasing power. Its managers would have been kidding themselves if they thought of any portion of that interest as “income.””

Therefore an investment that is price stable but loses purchasing power is very risky (think US T-Bonds) while an asset that is volatile in price but almost certain to increase purchasing power over time is less risky than the conventional measures of risk would dictate.

This is how Buffett begins an excerpt of his forthcoming letter to Berkshire Hathaway shareholders HERE. One scenario his introduction does not contemplate of course is deflation. Japanese real estate and equity prices are fractions of their previous levels and a bond offering even a miniscule return would produce an increase in purchasing power. Like many readers, you might reach the conclusion that the absence of this scenario in his letter along with the knowledge of aggressive equity purchases in recent months, indicates he does not believe deflation is a possibility.

The other subject of his letter is Gold. Melted down all the gold in the world would amount to one 68 cubed foot of uselessness. Somewhat ironically he reflects on its purchasing power today – all the agricultural land in the United States, sixteen companies as valuable as Exxon and a trillion dollars in walking-around money.

But he points out that the companies will have thrown off dividends and the land would have produced food. And so the article leads to the defence of buying businesses as a superior strategy (to owning gold ‘that just sits there’) – as we believe at Montgomery Investment Management, and you might as Value.able graduates (after seeking and taking personal professional advice).

I believe Buffett’s take on the investing landscape is ultimately correct (bubbles are always followed by a bust and nothing goes up forever);

“What motivates most gold purchasers is their belief that the ranks of the fearful will grow. During the past decade that belief has proved correct. Beyond that, the rising price has on its own generated additional buying enthusiasm, attracting purchasers who see the rise as validating an investment thesis. As “bandwagon” investors join any party, they create their own truth — for a while.”

But I trust you can see the irony in claiming gold is useless and yet it can buy 16 Exxons and so on. As the chart shows, it has underperformed stocks over the long term and without boasting about it Buffett uses the S&P500 index to demonstrate the superiority of stocks. In a thinly veiled warning to gold bugs he likens the current enthusiasm for gold to the internet bubble and US housing speculation pre-2007.

In his enthusiasm for stocks being best able to retain purchasing power or increase it, I can’t but help remembering that Buffett was a more circumspect proponent of stocks in the seventies – a period of very high inflation. While in 1974, when Forbes asked Buffett how he felt about the stock market at the time, Buffett replied, “Like an oversexed guy in a whorehouse”, his 1979 letter to investors serves as a useful reminder of the limits of any asset to retain purchasing power during bouts of high inflation.

“Just as the original 3% savings bond, a 5% passbook savings account or an 8% U.S. Treasury Note have, in turn, been transformed by inflation into financial instruments that chew up, rather than enhance, purchasing power over their investment lives, a business earning 20% on capital can produce a negative

real return for its owners under inflationary conditions not much more severe than presently prevail.

If we should continue to achieve a 20% compounded gain – not an easy or certain result by any means – and this gain is translated into a corresponding increase in the market value of Berkshire Hathaway stock as it has been over the last fifteen years, your after-tax purchasing power gain is likely to be very close to zero at a 14% inflation rate. Most of the remaining six percentage points will go for income tax any time you wish to convert your twenty percentage points of nominal annual gain into cash.

That combination – the inflation rate plus the percentage of capital that must be paid by the owner to transfer into his own pocket the annual earnings achieved by the business (i.e., ordinary income tax on dividends and capital gains tax on retained earnings) – can be thought of as an “investor’s misery index”. When this index exceeds the rate of return earned on equity by the business, the investor’s purchasing power (real capital) shrinks even though he consumes nothing at all. We have no corporate solution to this problem; high inflation rates will not help us earn higher rates of return on equity.”

Another warning to stick to high ROE businesses…

Finally remember that if you are buying stocks, unlike commodities, there exists management risk, execution risk, result risk, competitor risk, economic risk, currency risk etc. Anything can go wrong in a business and frequently does. And while Chalrie Munger has pointed out that “Almost all good businesses engage in ‘pain today, gain tomorrow’ activities”, you must know what you are doing.

I think stocks are indeed the best opportunity to retain and increase purchasing power but only the good quality ones.  Knowing what you are doing and sticking to high rates of return on equity, little or no debt and A1 or A2 businesses increases your chances of doing even better than the both the stock market index of which they are constituents and inflation.

Posted by Roger Montgomery, Value.able and Skaffoldauthor and Fund Manager, 14 February 2012.

by Roger Montgomery Posted in Companies, Insightful Insights, Skaffold.

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