Companies

“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.

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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.

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.

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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 2^nd, 3^rd and 7^th 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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I took an Anzac-weekend break from analysing companies and valuations.

It’s the 20^th 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.

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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.

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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.

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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.

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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.

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The requests for valuations and insights have been coming in thick and fast, and I have to confess to being a little surprised. The vast majority of requests have been for great quality businesses, some of them even the ‘A1’ companies that I alluded to on the Sky Business Channel a few weeks ago (the highlights will be on my YouTube channel in the next week or so).

If you have sent me an email requesting my insights and valuation for a particular business, thank you. You have uncovered some really interesting stories.

Lloyd, who was kind enough to drive me to the airport following my ASX Investor Hour presentation in Perth last November, suggested one such company to me, Forge Group Limited (FGE). At the time, FGE was trading at a bit more than a dollar.

If my memory serves me correctly, Lloyd bought the stock around 30 cents. I looked at it, ran it through my models and liked it a lot. For a tiny little company it was a true A1 – very high quality on all counts. It had also doubled its profits a few times.

Today it trades at $2.82 and has received a bid for 50% from Clough Limited. They have a hide! This company is potentially worth a great deal more, but don’t take my word for it – remember that you should see my view as just one more opinion, should always conduct your own valuations and research, and if necessary, seek independent advice from someone familiar with your financial circumstances and needs.

If you asked me to value a particular business, and there have been a few requests, I would have explained that I will do my best to post a valuation up as soon as possible but those companies that received the most requests would be posted first.

So here are my insights, and valuations, for the most popular businesses, as requested by you over recent weeks and even months.

Electrical contractor, Southern Cross Electrical Engineering Ltd (SXE)

Prior to its capital raising and downgrade, SXE was expected to generate Returns on Equity in excess of 37% in 2010 and 30% in 2012. Recent events however are likely to see these numbers fall to 22% and 27% respectively. The value today is 96 cents and lower than the current price, however the value next year, if it can earn the new forecast numbers, will be higher than the current price. You need to satisfy yourself that the revised expectations are indeed achievable.

Pawn shop chain (and commercial microfinance operator), Cash Converters International (CCV)

There has been a lot of interest in Cash Converters. I have seen these stores and while I cannot see them becoming a retailing powerhouse like a JB Hi-Fi or even The Reject Shop, that may not be the company’s intention. More than 2/3rds of reported profits are generated from secured and unsecured small personal loans that are distributed by a network of 509 second hand goods stores.  CCV has the metrics of an attractive business indeed its an “A” class stock, but scale is the issue.  Just how big can they ever be?  If we remember that we want a) Big Equity and b) Big Returns on Equity, then I can see the big returns on equity but Big Equity may be someway off.

The value of CCV today however is 74 cents – about ten cents higher than the current price, and based on current estimates is worth 93 cents in a couple of years. Those valuations compare favourably to the current price and very favourably to the 32 cents the shares traded at in March 2009.  Always keep in mind that you want to buy these sorts of stories at very big discounts to intrinsic value.

Figure 1.  CCV’s historical and forecast earnings and dividends per share

On the surface here’s a company that has the quality characteristics I like and is at a discount to intrinsic value.  The only question mark is about how big they can get.  If you intend to trade shares of CCV seek independent financial advice from a qualified professional who is familiar with your needs and circumstances and do not rely on the general nature of comments posted here.

Investors must also be aware of the impact of the intention of the Consumer Credit Code Amendment Bill 2007 and the subsequent Fee, Credit and Transition Bills as they relate to the nationalisation of regulation of operators such as Cash Converters and its perceived competitors, such as City Finance.

(Postscript:  ‘Reg’s’ comment below and my response are worth reading and considering and investors should pay attention to the growth of the company’s loan book and the relationship with its new largest shareholder and try to get answers to the questions I pose about continued growth and the ongoing relationship of loan book growth to retail stores)

Online job lister, Seek Limited (SEK)

Seek is a great business. Like all of the world’s most successful internet stories, it’s a plain old list. And it has developed that competitive advantage some companies achieve when scale and popularity leads to ‘essentialness’. People search for jobs at seek.com.au because there are lots of jobs, and there are lots of jobs because lots of people look for jobs there. I haven’t worked out if reaching this point is a function of strategy or dumb luck, but by definition someone has to make it to this point and he who gets there generates a lot of money and a high Return on Equity that is protected from imitation.

Seek is no exception, and its Return on Equity is expected to exceed 30% over the next two and half years. But while ROE is good and its earnings and intrinsic value growth is heading in a smooth north easterly direction, the fact remains that its popularity, as reflected in the current price of $7.90, is well in excess of the value, which is closer to $5.00 and rising to $6.30 in a couple of years. Sorry guys! Of course it was available to buy below $5.00 as recently as August last year, but that is of little use to you now. Patience is required.

Cranes for hire company, Boom Logistics Limited (BOL)

Boom Logistics is a business I remember reviewing when it floated. I was there at the IPO briefing and even then I didn’t like it. And didn’t I look foolish not taking any stock – it shot up from its listing price of 99 cents to almost $4.00 in less than 28 months.

I can sometimes get very frustrated knowing what a business is really worth and since 2005, the value of this business has been declining, along with its Returns on Equity. In 2004 ROE was 30% and today it is expected to approach 4.5%. Because you can do better in a bank account with no risk, you should think very carefully about investing in BOL. It is trading at 33 cents, but its value is less than 10 cents.

Hospital operator, Ramsay Health Care Limited (RHC)

Ramsay Healthcare is a business whose ‘theme’ I like. The population of Australia is ageing – the number of people over 75 will double in the next decade and a half, and while that will bring much sadness, the reality is that hospitals are there to provide the care that an ageing population needs. Despite a great story, hospitals aren’t that easy to run well.

You see, unlike most other businesses, hospitals can’t simply place a price on a service based on its cost and add a mark-up. Instead, they have to deal with insurance pay scales, meaning hospitals will make more money taking care of some patients and not others, and this is often not within their control.

Generally, hospitals make more money when more things happen to patients, such as pathology tests, diagnostic and therapeutic procedures, and operations. Operations are usually reimbursed at a higher rate than a medical patient, and while length of stay counts, its usually the hospital that has more surgical patients is the one that makes more money.

Conversely, a patient who lingers in a hospital is costing them money as their ongoing care may not be justified and they are blocking that bed from receiving another, better paying patient. Ever had a baby in hospital and felt like you were being booted out before your were ready? Anyone?

This is just the tip of the iceberg, but explains why running a hospital is so much more challenging than selling DVD’s to teenagers.

Having said that, Ramsay is doing a good job, as Figure 1 testifies.

Figure 2.  RHC’s historical and forecast earnings and dividends per share

Of course, there is a bit of hockey-stick optimism in the forecasts, and you can thank my peers in the analyst community for that. More importantly however, the hospital is generating Returns on Equity of about 14% over the next three years, up from circa 10% in the last few years.

The value of the business is rising, along with the returns. In 2000 Ramsay’s intrinsic value was just 58 cents. In 2012 its forecast intrinsic value is $8.13. – that’s an increase of 25 percent per year! Exceptional, but the price has never allowed investors to buy at a discount to intrinsic value.

In April 2000 RHC shares traded as low as 74 cents, but never below the 2001 valuation of 91 cents. Since then you have had to buy the shares above intrinsic value in order to participate in the growth in intrinsic value.  But whereas in 2000 you only needed to wait a year for intrinsic value to catch up, you would be waiting much longer today. With the shares currently priced at $13.50, even a 2 -year wait won’t see the value catch up.  It looks a little pricey now.

Keep in mind that I cannot predict share prices. I can tell you what things are really worth and tell you that over time price and value catch up with each other one way or another, but that is all I can tell you. I guess I can also vouch, having managed a couple of hundred million dollars, that if you buy good businesses below intrinsic value, things tend to work out ok.

Mining laboratory operator and cleaning solution seller, Campbell Brothers Limited (CPB)

Second last on the list is Campbell Brothers. Its been generating a decent Return on Equity for a decade, and its intrinsic value has been rising every year in that time. But like Ramsay, CPB’s intrinsic value will still not have reached the current price, even in 2012. I reckon it is worth $20 in 2011, and today its trading at $29.

Finally, one that needs no introduction, ASX Limited (ASX)

I have written about the ASX in my forthcoming book, Value.able. The ASX is worth less than $21 today and intrinsic value should rise to $26 in 2012. But Returns on Equity are not a patch on other companies, averaging 13.5% over the next few years. And despite the monopoly characteristics the company evidently has, it has not been able to charge what it wants for fear of emigration to rivals applying to set up. As a result, there is some correlation to the direction of the stock market, and predicting it is like predicting the price of a commodity – difficult.

Is your hand still up?

I have deliberately left out any discussion about debt, so be sure the companies you are investing in have little or none.  There is much more on this in Value.able, including a chapter devoted to when to sell.

I hope you are getting a great deal of use from these valuations and I look forward to your comments and input.

Posted by Roger Montgomery, 19 March 2009

by Roger Montgomery Posted in Companies, Health Care, Insightful Insights.

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Woolworths reported its first half 2010 results in recent weeks and the 17 per cent decline in the share price ahead of the result suggested investors may have been betting that the company was giving up ground to a revitalised Coles story. The price of Wesfarmers shares – being almost double their intrinsic value – certainly suggests enthusiasm for the latter company’s story.

Studying the results and the company however suggests any pessimism is unfounded and premature.

When I study JBH’s results there’s evidence of a classic profit loop. Cut prices to the customer, generate more sales, invest in systems and take advantage of greater buying power, invest savings in lower prices and do it again. Entrench the competitive advantage.

It would be obvious to expect Woolworths, with its history of management ties to Wal-Mart (who also engages the profit-loop) to be producing the same story, however WOW is flagging an arguably stronger position.

Where JBH’s gross profit margin keeps declining and net profit margin rising, Woolworths’ gross margin has increased every year since 2005. Revenues were 4.2% higher and gross profits rose by 6.5% in the latest half year result. Like JBH, WOW’s EBIT growth was stronger at 11%. As analysts we are mystified as to what is driving the increase in gross profit margins but standing back, you realise its a really good thing; if analysts cannot work it out then perhaps neither can the competitors and that’s good for maintaining a competitive advantage.  Competitors cannot replicate something if they don’t know how its produced.

Woolworths competitive advantage – an important driver of sustainably high rates of return on equity (I expect them to average 27% for the next three years – subject to change of course at any time and without warning or notification afterwards) – is its scale and its total dominance, ownership of and class leadership in supply-chain management.  The result is that a small increase in revenue even if due to inflation, results in a leveraged impact on profits.

From a cash flow perspective the other fascinating thing is the negative working capital. To those new to investing, working capital is typically an investment for a company; a business orders its products from a supplier, pays on 30 days terms and then spends the next few months selling the product it sells. If its takes a long time to sell the product and the customer takes time to pay, then there is an adverse impact on cash flow because the business is forking out cash today and not getting paid for some weeks or months.

In Woolworths case, as you might expect, the company is so strong and its buying power so dominant that it can dictate terms to its suppliers, making sure they deliver the right quantities at the right time. It can pay them when it likes and perhaps even pay them AFTER it sells the goods to consumers who buy with a debit, cash or credit card, which means Woolworths gets its money from its sales activity immediately. The difference of course can be invested.This virtuous cycle is highlighted by a negative number for working capital (WC = Inventory – Trade Payables + receivables – other creditors) which in Woolworth’s case, got even more negative! Don’t go rushing out and buying the shares because of this fact – its well known to the market and suppliers (who no doubt resent the company’s powerful market position). In the latest result, it was also attributable to timing differences in creditor payments.

The steep decline in the share price ahead of the company’s first half results suggests that many investors and analysts may have considered the company “ex-growth” and favoured Wesfarmers. Given the relative performances and valuations, this is likely to prove to be a mistake (more about that in a moment).

The company still has a lot of room to substantially increase sales and profits and the disbelief in this regard reminds me of the decade after decade in which analysts said Coca-Cola couldn’t grow anymore.

It would take a very almost illegally-informed and dedicated analyst to reach the conclusion that the company cannot continue to enlarge its coffers from further improvements to its overseas buying capability, its private label sales (both admittedly to the detriment of many smaller local owners of branded products) or its supply chain management. There’s also growth from acquisitions (speculative and don’t ever base a purchase on it), the Everyday Rewards loyalty card program and the hardware rollout (it will interesting to find out what they think their USP is).

While it will be interesting to find out what has been driving the competitor Wesfarmers sales numbers (basket size of more customers), the fact remains that it is premature to write off Woolworths. Many analysts will also be concerned about retailers cycling (comparing sales and profits to previous results) the fiscal stimulus, this is simply a short-term distraction and does not have anything to do with the long-term value of the company.

On that front, my calculated intrinsic value for Woolworths has risen every year for the last decade. When Buffett says he’s looking for companies with a “demonstrated track record of earnings power”, its because it translates to rising valuations. Woolworths was worth $2.39 in 2000. Intrinsic value rose to $14.84 in 2005 and $25.70 in 2009. Today’s value of $25.80 is expected to rise to $28.00 in 2011 and almost $30 in 2012.

The current price of $28.05 is therefore now equivalent to the valuation 15 months out and the February low prices are perhaps a better reflection of the current valuation that I have.

I have rarely been able to buy Woolworths at any significant discount to intrinsic value in the last decade and while I don’t know what the price will do next, I do know that irrespective of whether Woolworths offers lower prices in the supermarket or the share market, you would be ill advised to ignore them.

Please be reminded that my valuations for the future are based on analyst expectations, which can change at any time.

Posted by Roger Montgomery, 8 March 2010.

by Roger Montgomery Posted in Companies, Consumer discretionary, Insightful Insights.

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