Companies

I am away for Christmas and January and will only be publishing thoughts to the blog on a spasmodic basis.

If you go to my website, www.rogermontgomery.com, and register for my book or send a message to me, I will let you know via email when I am back on deck.

I expect 2010 will be a very interesting year on the inflation, interest rate and commodity fronts so stay tuned and focus on understanding what is driving a company’s return on equity and how to arrive at its value.

Before doing anything seek always professional advice, but zip up your wallet if you hear the words “only trade with what you can lose”. I don’t like losing money at any time and neither should you.

Posted by Roger Montgomery, 23 December 2009

by rogermontgomeryinsights Posted in Companies, Energy / Resources, Insightful Insights, Market Valuation.

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Half of all shareholders in Australia own at least one major bank in their share portfolios. The economics for banks in the last two years have changed dramatically and on several fronts.

First, they are believed to have largely dodged the impact of the GFC. This was predictable, as was the second change – the substantial gain in market share the banks enjoyed as their mortgage origination peers fell like dominoes relying, as they were, on short term wholesale funding and with no deposit base.

For both reasons I mentioned at the end of 2008 and the beginning of 2009 on CNBC that bank prices represented a rare opportunity to own the best businesses you can on an island – a legislated oligopoly that charges people to get their own money in and out.  You can see the video from December 16 here.

There was also another major change that kept analysts on our toes. Dilutionary capital raisings wreaked havoc on the returns on equity and the equity per share for all four majors. Then Westpac, previously the bank with the best business performance, bought St George, and CBA bought ING. NAB has since bid for Axa (at arguably a price that is double the intrinsic value of the Axa) and ANZ…well who knows (read more here)

The effect of all this activity has not changed the fundamental attraction of owning a big four bank on an island of 22 million people who don’t care what you charge them because they cannot be bothered moving to another bank; “they’re all the same”. What has changed however is the future returns on equity for each of the banks and therefore, their intrinsic values.

Here’s my take on each banks’ forecast return on equity range for the next few years and valuation. I have ordered them by profitability in ascending order (ROE range, Intrinsic value):

NAB (11%-15%, $22.08)

ANZ (12.6%-16%, $18.10)

WBC (14.5%-18%, $19.19)

CBA (17.5% – 20.7%, $53.53)

In every case, current prices are well ahead of the current valuation however, I should add that the valuations are based on 2010 estimates and for all four banks, the valuations rise significantly in future years as ROE heads towards the top of each of the ranges given. Given the time frames that I can see, you will be waiting for values to catch up to current prices. NAB and ANZ are the cheapest, but you are buying the new 2^nd tier banks. WBC is a better performing bank than ANZ and NAB but its price reflects it and you will be waiting twice as long as the others to catch up.

Many of you have told me you want to keep this blog a little bit of a secret, but let me tell you we will all benefit if we receive contributions and insights from those closer to the coal face of various industries.  So let me encourage you to post your own thoughts and insights and invite anyone else you know (that owns bank shares for example or works in a company that is a competitor to any of those I mention) to do likewise. Do you think you know anyone that owns bank shares and would benefit from this insight? Spread the link.

http://rogermontgomeryinsights.wordpress.com/

Posted by Roger Montgomery, 23 December 2009

by rogermontgomeryinsights Posted in Companies, Financial Services, Insightful Insights.

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Commodity prices…  can anyone predict their movements? Driven by supply and demand, and exaggerated by speculation, predicting the price of oil, iron ore, coal, diamonds and titanium is an almost impossible task.  \It is however a task that is required if you are planning to buy shares in a mining company. Ruling out mining exploration companies that make no profit, and whose race to a valuation of zero is only retarded by the amount of cash remaining in the bank and measured by a ratio called the cash ‘burn’ rate, we are left with the producers.

For reasons mentioned above, no mining company is easy to value, however some lend themselves to valuations better than others. The best are those that are large, broadly diversified and relatively stable. BHP immediately comes to mind.  Born as a silver and lead mine in Broken Hill in 1885, BHP, following the 2001 merger between it and Billiton, is now the world’s largest mining company with operations from Algeria to Tobago and everywhere in between.

But even BHP cannot escape the commodity cycle and this can be seen in the swings in its valuations in the past.  BHP’s valuation can be $48 in one year (2008) and $13 the next (2009). This “valuation volatility” is vastly different to JB Hi-Fi, for example, whose value has risen from less than a dollar in 2003 to $20 to $24 today and in a steady ‘staircase’ fashion.

Many of you have asked me for a valuation for BHP. Using the earnings estimates of the rated analysts on the company, there is clearly some optimism about BHP’s prospects. Returns on equity are expected to rise from 17.5% this year to 24% next year, and circa 28% in 2011 and 2012. These numbers however are still lower than the rates of return the company generated between 2005 and 2007. The estimate I come up with for BHP using the actual estimates of the rated analysts is a value of A$36.56, and if the analysts are right, the value rises dramatically in future years.

Warren Buffett doesn’t like businesses that are price takers – commodity type businesses. The reason is that it is impossible to forecast future rates of return on equity with any confidence.  BHP reflects this historically.  BHP is big enough now that in some cases it is calling the (price) shots, but don’t forget we are talking about capital-intensive businesses.

Posted by Roger Montgomery, 23 December 2009

by rogermontgomeryinsights Posted in Companies, Energy / Resources.

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On the Sky Business Channel with Nina May recently, a caller rang in and asked for my valuation of MacMahon Holdings Limited (ASX Code: MAH).

I ran the numbers and received mixed signals. The return on equity of the company has only exceeded 21% in one year – 2008. In 2006 returns on equity were less than 1% and since 2002 ROE with these two years removed, has averaged just under 14%. This is not a return on equity to get excited about. Disappointingly, the company has also raised $216 million from shareholders, and diluted them by increasing the shares on issue by more than 300% since 2000.

The decline in borrowings between 2007 and today from $169 million to $111 is initially encouraging, as is the reduction of retained losses by $86 million since 2002, but since 2007 the company has raised $78 million through equity raisings. Arguably it is not the performance of the business that is reducing the debt burden and the retained losses simultaneously, but the performance of the company’s PR team. Finally, at a price of 59 cents, all the value investing margin of safety is gone.  Indeed the price today is about my value for this company two years out. I cannot predict what the share price will do – it may double from here, but on present performance expectations, such a move would not be justified.

Posted Roger Montgomery, 23 December 2009

by rogermontgomeryinsights Posted in Companies.

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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

by rogermontgomeryinsights Posted in Companies.

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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.

by rogermontgomeryinsights Posted in Companies, Consumer discretionary, Insightful Insights.

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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

by rogermontgomeryinsights Posted in Companies, Energy / Resources.

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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

by rogermontgomeryinsights Posted in Companies, Insightful Insights.

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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

by rogermontgomeryinsights Posted in Companies, Insightful Insights.

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