Companies

On Wednesday this week I wrote in Alan’s Eureka Report:

“Postscript: I note that McMillan Shakespeare, a salary packaging specialist many readers know I have followed for some time, saw its founder sell a significant number of shares. You should know that it is not the quantum of the sale that should pique your curiosity or set off alarm bells, but the timing, coming as it does ahead of the findings of Dr Ken Henry’s first major overhaul of Australia’s tax system in 50 years, which could include potentially adverse changes to fringe benefits tax and thus salary packaging demand.”

“My experience as a fund manager is that when major owners or founders are selling it has sometimes been the start of a negative period for the company and its shares (CCP). At other times, founders and major stakeholders have sold and the shares have gone on to do great things (TRS). In this case I have been leaning to the cautious side – as it seems Anthony Podesta, MMS’ founder has.”

Addendum 16 Dec. 2009:  The facts remain that MMS is a wonderful company with huge cash generation, high rates of return on equity and net fixed assets and a company that up until recently was trading well below its intrinsic value. That intrinsic value value has also been rising significantly in recent years but some caution is warranted ahead of the release of Ken Henry’s tax review and the government’s determination about what recommendations it will adopt.

By Roger Montgomery, 11 December 2009

First published 9 December  2009, www.EurekaReport.com.au

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I had a call yesterday from one of my brokers (who also happens to have become a friend). He informed me that the restrictions have come off all the broker’s so that they are now able to write research about Myer. As you would expect so soon after its widely supported float (A float that lost money for the thousands of investors who sold out in the first weeks), the research has been predictably bullish. It is not however the views of the analysts that is interesting. What is interesting is the reference in several of the reports to a relative P/E. The argument goes that because Harvey Norman and David Jones have a higher P/E than Myer, that the gap should narrow and Myer’s P/E should rise, pulling the price up with it. See any weaknesses in the logic?

Its like saying that there’s a Ferrari and there’s a VW Combi and the VW combi will get faster because the Ferrari is too fast compared to it.  Clearly such conclusions are flawed.

The performance of management, the economics of businesses and their prospects all affect their values and the sentiment towards them, which in turn, affects prices in the short term.

Buffett has frequently said that academics where correct in observing the market was frequently efficient.  In other words, a lot of the time, the price is right and perhaps in the case of Myer it should be on a lower P/E than David Jones.  This post should be read in conjunction with my previous posts on Myer that discuss its intrinsic value.

Roger Montgomery, 10 December 2009.

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For some reason over the last few weeks I have received an influx of requests for a valuation on Caltex. I guess it must have something to do with the share price declines.

Let me start by saying, you are on a hiding to nothing, trying to value this company. Like any business, the true value of Caltex has nothing to do with its share price and is instead determined by its equity and the profitability of that equity. As you are probably already aware profitability (return on equity) is going to be heavily impacted by input costs and revenues which for Caltex are fast changing. To better understand Caltex profits, have a look at what goes into the price of a litre of petrol that it sells.

To determine an Australian refiners’ profits you must start with the Singapore refiners’ price for petrol. This is because Australia’s local oil refineries compete with imported petroleum products from refineries in Asia, regardless of the cost of importing and refining crude oil. Consequently, the price of petrol at Australian refineries is based on international petrol prices. If local prices were higher than international prices, imports of petrol would displace local production. The result is “import parity pricing” – in other words, what it would cost to land fuel from Singapore refineries into Australian terminals. In turn, this price includes the Singapore benchmark price for refined petrol or diesel, the addition of an Australian “quality premium” (dubious but said to take into account Australia’s “high fuel standards”), plus shipping costs and cargo insurance. The result is then converted from US dollars per barrel into Australian cents per litre (1 Barrel = 159 litres).

So, starting with the Singapore petrol price (which is itself prone to wild swings),we have to add shipping (variable), quality premium, shipping insurance (variable), covert to Aud (variable), then add port costs (relatively stable), then add wholesale and retail margins (variable) and freight (variable) and then after GST and the Governments fuel excise we have a retail price for petrol.

You can see that there are many factors that are out of Caltex’s control and will determine its profitability and I haven’t addressed the factors that will influence the Singapore refiner’s margin, although the cost of crude oil has the most impact in the long term.

Feel like a break yet?

The result is that Caltex’s profitability is volatile and this is evident in the numbers. In 2001 Caltex’s return on equity was -20%, while it was 40% in 2004. Based on some of the research I have seen, return on equity is expected to be around 10% for the next three years. Really? Who knows? How could you know? It will depend on the price of oil. In the 2007 year (Caltex has a December year end) oil prices traded between US$49.90 and US$99.29 and Caltex’s return on equity was 24%.  n 2008 the oil price began at US$96, rallied to US$147 and fell to US$32.40. Caltex’s return on equity that year was 1.3%.

If we assume that the analysts are right with their forecasts of a 10 percent return on equity, then the value of Caltex is somewhere between $8 and $9. My valuation actually comes in at $8.74 but for the reasons I described above, I would not even consider a purchase unless the shares were at a very substantial discount to this valuation.

You should be aware that if you are trying to value Caltex, you are punting and making a plain old bet. Its a bet you might get right, but it is speculating not investing. Perhaps if you can buy Caltex at a 50% discount to a conservative estimate of intrinsic value it would be a safer bet but even then it is still a bet.

Posted by Roger Montgomery, 10 December 2009

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Another viewer question I would like to share…

Roger,

A few questions (assume for all questions below that I am referring to stocks with low debt and high return on equity):

1) If you see the market as overvalued and most stocks you look at above their intrinsic value, do you just stay in cash until they become cheaper, even if you could be waiting years (like the 2003-2007 period)?

RM – I look at individual companies rather than the market. If there are no individual companies that are cheap, the answer is yes.

2) I know you like stocks that pay no dividends, but what happens if management does something stupid and the stock price plummets? At least you have got something from your investment if you have received dividends.

RM – You have misunderstood my stance on dividends, which is quite a common misunderstanding. My position is that all things being equal, a company with a high ROE that can retain its profits and compound them at a high rate is worth more than a company with the same ROE but paying some proportion of its earnings out as a dividend.

I am quite happy to buy companies that pay dividends – I bought Fleetwood earlier this year on a dividend yield of more than 20% – but the price I must pay for them is lower.

On the second part of your question, you are right. The assumption is that if management is going to retain profits they must generate high returns on those retained earnings. The track record of management doing stupid things however is long so I can understand shareholder reticence towards management hanging onto the cash.

3) Do you have any concerns about buying a stock that has low liquidity (as it could be difficult to sell if something goes wrong)

RM – Even when managing more than $100 million I bought shares with low liquidity, but I was right in those cases and their superior performance eventually attracted increased liquidity. Had I been wrong then yes, the illiquidity would have been a problem. They key is to worry more about being right, then you don’t have to worry about the liquidity.

Posted by Roger Montgomery, 3 December 2009

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A long-term value investing friend, Pauline, recently asked me: Do you value CSL at all?

The short answer is yes – I wrote an article on November 4 for Alan [Kohler] about CSL.

Click here to read my thoughts.

Posted by Roger Montgomery, 3 December 2009

by rogermontgomeryinsights Posted in Companies, Health Care.

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I find investing intellectually and financially stimulating, and being able to share the process equally rewarding.

A large number of investors, financial planners, stockbrokers, and a very observant plumber have emailed me requesting the various insights that I mentioned on Market Moves with Richard Gonclaves and Nina May’s Your Money Your Call on the Sky Business Channel.

Many of you have also asked for individual stock recommendations or how I might be able to advise you. Here is the official response…

As you can imagine, I have received innumerable requests to manage funds, provide share market advice, review and establish share portfolios and the like. Having recently resigned (June 30) from the financial services and funds management businesses I founded, listed on the ASX and sold, I am not currently able to assist with these requests, however, with your permission, I will keep your details and let you know when I am in a position to assist.

In the meantime you can follow my thoughts by tuning in to Ross Greenwood’s Money News program on 2GB (NSW), ABC Statewide Drive (NSW) with John Morrison, watching the Sky Business Channel, reading my weekly Value Line column in Alan Kohler’s Eureka Report and visiting my blog, Roger Montgomery Insights.

If you have registered your details at my website, www.Rogermontgomery.com, I will contact you when my guide book to showing you how to identify great businesses and value them is available for purchase in late February or early March.

Until then, I have written an eight-page note on how to construct a share portfolio using my approach to identifying great businesses and valuing them.

I have also uploaded an article I recently wrote for Alan Kohler’s Eureka Report about airlines and why their accounting will make you sit up and take notice.

Enjoy your reading and investing and keep in touch.

Roger

Posted by Roger Montgomery, 30 November 2009

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While chatting with Nina May on her Sky News program Your Money Your Call, a viewer called in to ask about Crane Group (ASX: CRG).

My curiosity was piqued because somewhere back in 2006 I owned the shares, but shortly after I changed my mind and never looked at them again. When my valuation model spat out the numbers I could immediately see why it hadn’t come up on my radar again.

Ten years ago the business was generating 10.4% returns on its equity – nothing to write home about. In 2012 it is forecast to earn the same, up from about 7.5% today.

For anyone reading my Roger Montgomery Insights blog for the first time, an ROE of 7.5% is not much better than you can get in the bank, and given the risks associated with owning a business and the fact that there are businesses we can invest in that are generating 20%, 30% even 40% and trading at small multiples of their equity (and without vast amounts of debt or accounting goodwill), it makes no sense to sell something in my portfolio that is first grade for something that is not.

CRG was worth about $6.00 ten years ago and today its worth about $5.00. If the analysts are right with their earnings forecasts, my value of the business will not rise much more than 7.5% in 30 months time to just under $5.40.

With the price today at almost $9.00, there is no incentive to buy the shares.

For new visitors to my blog, a caveat and a little background: My valuation is not a price prediction. I do not know what the price is going to do. Whilst I can tell you the value of a share with a high degree of confidence, I cannot accurately predict the future price. The price could rise or fall substantially and I simply cannot know.

My objective instead is to buy high quality businesses – those with little or no debt, high returns on equity and sustainable competitive advantages – at prices well below their intrinsic values. If, after buying the price falls and I still have confidence in my valuation, then the fall represents an opportunity rather than a reason to be fearful and sell.

For the year to June 30, the funds I founded and ran (I have since sold and resigned from these businesses) returned 3% to 11% in a year that the market fell about 21%. Since June 30, my portfolios (you can track them in Alan Kohler’s Eureka Report and Money Magazine) have risen 26% and 31% respectively, whilst the market is up 19%.

Posted by Roger Montgomery, 30 November 2009

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Some time ago Peter Switzer invited me on to his program to discuss five stocks for the long term that met my criteria for quality at least, and value if possible.

We didn’t end up with enough time to cover them so I was asked back on October 28. By that time the market had rallied hard so the three I could find were MMS ($3.99 back then) now $4.44, JBH (then $21.50) now at $22.96 and WOW (then $28.82) now $28.42.

The other two I mentioned, to satisfy the more speculative viewers, were ERA (then $24.70) now $24.46 and SXE ($1.62) now $1.63.

The 2009 valuations for MMS, JBH, and WOW are $4.69, $25.76 and $27 respectively. For ERA and SXE the 2009 valuations are $33 and $1.97 respectively.

At all times I have deliberately based these valuations on consensus analyst’s estimates so that there is no favouritism. But keep in mind analysts estimates are prone to change and therefore so are the valuations.  Further, it is worth remembering that when I run my aggregate valuations over the market, it tells me that the market as a whole is about 15 percent above its valuation.  In other words the market in aggregate is no bargain and may be a little expensive.

Also keep in mind that if you go and transact in any security in any way based on these opinions, you do so at your own risk. I really do mean it when I recommend that you seek advice from a professional adviser, broker or planner that knows your financial circumstances.

By Roger Montgomery, 19 November 2009

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Believing completely in my valuation model and approach, I now rarely read about “the world’s greatest living investor” Warren Buffett and his legendary investment company Berkshire Hathaway.

But perhaps I should pay more attention? Because it seems that each deal or media appearance is worthy of further scrutiny and the well-reported $US26 billion buyout of railway company Burlington Northern Santa Fe is no exception.

This largest-ever Buffett investment, combined with a strong Australian dollar and a controversial 50-for-1 split of the Berkshire B class shares (which lowers their share price from $US3325 per share to about $US67) makes a back-of-the-envelope valuation of Berkshire Hathaway an interesting exercise.

So, with enthusiasm, I offer my value of Berkshire Hathaway.

The average annual compounded rate of growth in Berkshire’s book value – its equity – is equal to its return on equity. We can thus approximate the true rate of return on equity for Berkshire by examining the actual rate of change in book value.

Post acquisition, intrinsic value will not increase by the attractive rate it has in the past, unless returns on equity of the past can be maintained as the book value of the company continues to expand. The law of large numbers applies here. It is relatively easy to achieve 20% on $1 million – I can think of two stocks right now that will do that for you over the next two years (and I’ll be writing about these companies in the coming weeks for Alan Kohler’s Eureka Report), but achieving 20% on the $US118 billion of book value Berkshire has today will be a lot more difficult. That is why Buffett needs elephants, and elephants at the right price.

In the four or five decades since 1964, book value has grown by a compounded rate of 20.1 percent – a startling effort – and because of the high rate of return on equity that it reflects, each dollar retained has created more than a dollar of long-term market value. That is why the share price of Class A shares now stands at over $US100,000 per share.

But Buffett has always warned that, in the future, the massive amounts of capital at his disposal means that while you and I have a universe of thousands of companies that can have a material positive impact on our wealth, his investment universe is a few hundred at best. He needs elephants, and if he doesn’t get them his return on equity must inevitably fall. Recently return on equity has averaged 7.5%.

In valuing the shares, there is the A-class, which trade at over $US100,000 each, and the B-class, to which I referred earlier. The simplest way for me to convey the value is to estimate an A-Class equivalent valuation. And to cut to the chase, the value – based on an assumed 12% return on equity (optimistic perhaps) – is approximately $US108,000.

Given that the B-class shares, as an investment, are 1/30th the value and are about to be split 50-for-1, the value of them based on the optimistic return on equity is $US72. If, however, you assume that Berkshire Hathaway continues to achieve the average 7.5% returns on equity it has recently, the valuation falls dramatically because Buffett is retaining profits and generating a rate of return on them that is less than I can achieve elsewhere.

In such circumstances, the only price to pay is a discount to the forecast $US82,000 per-share book value of the company – about $35 per post-split B-class share.

By Roger Montgomery, 13 November 2009

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On Richard Goncalve’s Market Moves show on the Sky Business Channel last week I mentioned I would estimate a value for Fortescue Metals Group (ASX:FMG). Let me be the first to say that, like IT businesses, companies in the resources sector are notoriously difficult to value. This is not because they are in a fast changing industry whose long term economics are difficult to predict, but because the economics are based on commodity prices that change daily and whose prediction is almost impossible.

Having said that I should offer a caveat; Buffett’s announcement that he is buying the railroad operator Burlington/Santa Fe in a $44 billion deal – his biggest ever – suggests he truly believes that fuel prices are going up a lot. Indeed while higher diesel prices will raise the costs of running trains, it will raise the cost of operating trucks over trains by a factor of four.

But I digress, FMG – based entirely on 2010 consensus analyst forecasts – is worth $1.90 to $2.00. Another caveat – consensus analysts predictions could be wrong.

By Roger Montgomery, 4 November 2009

by rogermontgomeryinsights Posted in Companies, Energy / Resources.

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