Energy / Resources

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

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

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Their is something prescient in the name John Deason and Richard Oates gave to their 1869 gold nugget the ‘Welcome Stranger’ and the one Kevin Hillier gave to his 875 troy ounce find ‘The Hand of Faith’.  Today’s gold price is indeed very welcome to gold bugs and there is plenty of faith needed that prices will rise even further.  But gold bugs have received a terse warning from none other than Warren Buffett who has just released Berkshire’s 2011 letter.  For those of you who believe gold (A.K.A. the barbarous relic) is the best investment you won’t find any more support from Warren this year than any other (with the exception of his 1999 dalliance into silver) . You can find his complete letter here: Berkshire 2011 Annual Report.

Here’s the section on gold:

“The second major category of investments involves assets that will never produce anything, but that are purchased in the buyer’s hope that someone else – who also knows that the assets will be forever unproductive – will pay more for them in the future. Tulips, of all things, briefly became a favorite of such buyers in the 17th century.

This type of investment requires an expanding pool of buyers, who, in turn, are enticed because they believe the buying pool will expand still further. Owners are not inspired by what the asset itself can produce – it will remain lifeless forever – but rather by the belief that others will desire it even more avidly in the future.

The major asset in this category is gold, currently a huge favorite of investors who fear almost all other assets, especially paper money (of whose value, as noted, they are right to be fearful). Gold, however, has two significant shortcomings, being neither of much use nor procreative. True, gold has some industrial and decorative utility, but the demand for these purposes is both limited and incapable of soaking up new production. Meanwhile, if you own one ounce of gold for an eternity, you will still own one ounce at its end.

What motivates most gold purchasers is their belief that the ranks of the fearful will grow. During the past decade that belief has proved correct. Beyond that, the rising price has on its own generated additional buying enthusiasm, attracting purchasers who see the rise as validating an investment thesis.

As “bandwagon” investors join any party, they create their own truth – for a while. Over the past 15 years, both Internet stocks and houses have demonstrated the extraordinary excesses that can be created by combining an initially sensible thesis with well-publicized rising prices. In these bubbles, an army of originally skeptical investors succumbed to the “proof” delivered by the market, and the pool of buyers – for a time – expanded sufficiently to keep the bandwagon rolling. But bubbles blown large enough inevitably pop. And then the old proverb is confirmed once again: “What the wise man does in the beginning, the fool does in the end.”

Today the world’s gold stock is about 170,000 metric tons. If all of this gold were melded together, it would form a cube of about 68 feet per side. (Picture it fitting comfortably within a baseball infield.) At $1,750 per ounce – gold’s price as I write this – its value would be $9.6 trillion. Call this cube pile A. Let’s now create a pile B costing an equal amount. For that, we could buy all U.S. cropland (400 million acres with output of about $200 billion annually), plus 16 Exxon Mobils (the world’s most profitable company, one earning more than $40 billion annually). After these purchases, we would have about $1 trillion left over for walking-around money (no sense feeling strapped after this buying binge).

Can you imagine an investor with $9.6 trillion selecting pile A over pile B? Beyond the staggering valuation given the existing stock of gold, current prices make today’s annual production of gold command about $160 billion. Buyers – whether jewelry and industrial users, frightened individuals, or speculators – must continually absorb this additional supply to merely maintain an equilibrium at present prices.

A century from now the 400 million acres of farmland will have produced staggering amounts of corn, wheat, cotton, and other crops – and will continue to produce that valuable bounty, whatever the currency may be. Exxon Mobil will probably have delivered trillions of dollars in dividends to its owners and will also hold assets worth many more trillions (and, remember, you get 16 Exxons). The 170,000 tons of gold will be unchanged in size and still incapable of producing anything. You can fondle the cube, but it will not respond.

Admittedly, when people a century from now are fearful, it’s likely many will still rush to gold. I’m confident, however, that the $9.6 trillion current valuation of pile A will compound over the century at a rate far inferior to that achieved by pile B.”

Before simply believing Warren WILL be right…There’s this in the annual report as well: “Last year, I told you that “a housing recovery will probably begin within a year or so.” I was dead wrong”

A much older quote that summarizes Buffett’s long-held view is this one “It gets dug out in Africa or some place. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head.”

In my earlier post on this subject HERE, I note; “But I trust you can see the irony in claiming gold is ‘useless’ and yet it can buy [all the agricultural land in the United States, sixteen companies as valuable as Exxon and a trillion dollars in walking-around money].

For those of you who are interested in two alternative perspectives, (assuming the debasing of fiat money across the globe is not enough to encourage you), I thought you might find some of what you need in the following points, and also Warren Buffett’s father’s views. (Note: we only own three or four gold stocks all of which have rising production profiles and do not require ever increasing gold prices to support the returns on equity that justify much higher valuations.  So we aren’t quite in the ‘carried-away’ camp even though some have doubled in price.  This latter development delights us in this market).

And now a short commercial break…

Here are two Skaffold screenshots, each gold stocks we currently own.  If you are a member of Skaffold, you should be able to pick them right away.  If you aren’t a member, what are you waiting for?  Head over to www.skaffold.com and become a member today.

And now back to our regular programming…

From gold’s mouth itself;

Let’s start with the basics of my enduring characteristics. I have some characteristics that no other matter on Earth has…

I cannot be:

Printed (ask a miner how long it takes to find me and dig me up)
Counterfeited (you can try, but a scale will catch it every time)
Inflated (I can’t be reproduced)

I cannot be destroyed by;

Fire (it takes heat at least 1945.4° F. to melt me)
Water (I don’t rust or tarnish)
Time (my coins remain recognizable after a thousand years)

I don’t need:

Feeding (like cattle)
Fertilizer (like corn)
Maintenance (like printing presses)

I have no:

Time limit (most metal is still in existence)
Counterparty risk (remember MF Global?)
Shelf life (I never expire)

As a metal, I am uniquely:

Malleable (I spread without cracking)
Ductile (I stretch without breaking)
Beautiful (just ask an Indian bride)

As money, I am:

Liquid (easily convertible to cash)
Portable (you can conveniently hold $50,000 in one hand)
Divisible (you can use me in tiny fractions)
Consistent (I am the same in any quantity, at any place)
Private (no one has to know you own me)

From an entirely different perspective on gold it may be worth reading the Hon. Howard Buffett.  Congressman Buffett argues that without a redeemable currency, an individual’s freedoms both financial and more broadly is dependent on politicians. He goes on to observe that fiat (paper) money systems tend to collapse eventually, producing economic chaos. His argument that the US should return to the gold standard was not adopted.

Human Freedom Rests of Gold Redeemable Money
Posted Thursday, May 6, 1948

By HON. HOWARD BUFFETT

U. S. Congressman from Nebraska
Reprinted from The Commercial and Financial Chronicle 5/6/48

Is there a connection between Human Freedom and A Gold Redeemable Money? At first glance it would seem that money belongs to the world of economics and human freedom to the political sphere.

But when you recall that one of the first moves by Lenin, Mussolini and Hitler was to outlaw individual ownership of gold, you begin to sense that there may be some connection between money, redeemable in gold, and the rare prize known as human liberty.

Also, when you find that Lenin declared and demonstrated that a sure way to overturn the existing social order and bring about communism was by printing press paper money, then again you are impressed with the possibility of a relationship between a gold-backed money and human freedom.

In that case then certainly you and I as Americans should know the connection. We must find it even if money is a difficult and tricky subject. I suppose that if most people were asked for their views on money the almost universal answer would be that they didn’t have enough of it.

In a free country the monetary unit rests upon a fixed foundation of gold or gold and silver independent of the ruling politicians. Our dollar was that kind of money before 1933. Under that system paper currency is redeemable for a certain weight of gold, at the free option and choice of the holder of paper money.

Redemption Right Insures Stability
That redemption right gives money a large degree of stability. The owner of such gold redeemable currency has economic independence. He can move around either within or without his country because his money holdings have accepted value anywhere.

For example, I hold here what is called a $20 gold piece. Before 1933, if you possessed paper money you could exchange it at your option for gold coin. This gold coin had a recognizable and definite value all over the world. It does so today. In most countries of the world this gold piece, if you have enough of them, will give you much independence. But today the ownership of such gold pieces as money in this country, Russia, and all divers other places is outlawed.

The subject of a Hitler or a Stalin is a serf by the mere fact that his money can be called in and depreciated at the whim of his rulers. That actually happened in Russia a few months ago, when the Russian people, holding cash, had to turn it in — 10 old rubles and receive back one new ruble.

I hold here a small packet of this second kind of money – printing press paper money — technically known as fiat money because its value is arbitrarily fixed by rulers or statute. The amount of this money in numerals is very large. This little packet amounts to CNC $680,000. It cost me $5 at regular exchange rates. I understand I got clipped on the deal. I could have gotten $2½ million if I had purchased in the black market. But you can readily see that this Chinese money, which is a fine grade of paper money, gives the individual who owns it no independence, because it has no redemptive value.

Under such conditions the individual citizen is deprived of freedom of movement. He is prevented from laying away purchasing power for the future. He becomes dependent upon the goodwill of the politicians for his daily bread. Unless he lives on land that will sustain him, freedom for him does not exist.
You have heard a lot of oratory on inflation from politicians in both parties. Actually that oratory and the inflation maneuvering around here are mostly sly efforts designed to lay the blame on the other party’s doorstep. All our politicians regularly announce their intention to stop inflation. I believe I can show that until they move to restore your right to own gold that talk is hogwash.

Paper Systems End in Collapse
But first let me clear away a bit of underbrush. I will not take time to review the history of paper money experiments. So far as I can discover, paper money systems have always wound up with collapse and economic chaos.
Here somebody might like to interrupt and ask if we are not now on the gold standard. That is true, internationally, but not domestically. Even though there is a lot of gold buried down at Fort Knox, that gold is not subject to demand by American citizens. It could all be shipped out of this country without the people having any chance to prevent it. That is not probable in the near future, for a small trickle of gold is still coming in. But it can happen in the future. This gold is temporarily and theoretically partial security for our paper currency. But in reality it is not.

Also, currently, we are enjoying a large surplus in tax revenues, but this happy condition is only a phenomenon of postwar inflation and our global WPA. It cannot be relied upon as an accurate gauge of our financial condition. So we should disregard the current flush treasury in considering this problem.

From 1930-1946 your government went into the red every year and the debt steadily mounted. Various plans have been proposed to reverse this spiral of debt. One is that a fixed amount of tax revenue each year would go for debt reduction. Another is that Congress be prohibited by statute from appropriating more than anticipated revenues in peacetime. Still another is that 10% of the taxes be set aside each year for debt reduction.
All of these proposals look good. But they are unrealistic under our paper money system. They will not stand against postwar spending pressures. The accuracy of this conclusion has already been demonstrated.

The Budget and Paper Money
Under the streamlining Act passed by Congress in 1946, the Senate and the House were required to fix a maximum budget each year. In 1947 the Senate and the House could not reach an agreement on this maximum budget so that the law was ignored.

On March 4 this year the House and Senate agreed on a budget of $37½ billion. Appropriations already passed or on the docket will most certainly take expenditures past the $40 billion mark. The statute providing for a maximum budget has fallen by the wayside even in the first two years it has been operating and in a period of prosperity.

There is only one way that these spending pressures can be halted, and that is to restore the final decision on public spending to the producers of the nation. The producers of wealth — taxpayers — must regain their right to obtain gold in exchange for the fruits of their labor. This restoration would give the people the final say-so on governmental spending, and would enable wealth producers to control the issuance of paper money and bonds.

I do not ask you to accept this contention outright. But if you look at the political facts of life, I think you will agree that this action is the only genuine cure. There is a parallel between business and politics which quickly illustrates the weakness in political control of money.

Each of you is in business to make profits. If your firm does not make profits, it goes out of business. If I were to bring a product to you and say, this item is splendid for your customers, but you would have to sell it without profit, or even at a loss that would put you out of business. — well, I would get thrown out of your office, perhaps politely, but certainly quickly. Your business must have profits.

In politics votes have a similar vital importance to an elected official. That situation is not ideal, but it exists, probably because generally no one gives up power willingly.

Perhaps you are right now saying to yourself: “That’s just what I have always thought. The politicians are thinking of votes when they ought to think about the future of the country. What we need is a Congress with some ‘guts.’ If we elected a Congress with intestinal fortitude, it would stop the spending all right!”

I went to Washington with exactly that hope and belief. But I have had to discard it as unrealistic. Why? Because an economy Congressman under our printingpress money system is in the position of a fireman running into a burning building with a hose that is not connected with the water plug. His courage may be commendable, but he is not hooked up right at the other end of the line. So it is now with a Congressman working for economy. There is no sustained hookup with the taxpayers to give him strength.

When the people’s right to restrain public spending by demanding gold coin was taken from them, the automatic flow of strength from the grass-roots to enforce economy in Washington was disconnected. I’ll come back to this later.

In January you heard the President’s message to Congress or at least you heard about it. It made Harry Hopkins, in memory, look like Old Scrooge himself.
Truman’s State of the Union message was “pie-in-the-sky” for everybody except business. These promises were to be expected under our paper currency system. Why? Because his continuance in office depends upon pleasing a majority of the pressure groups.

Before you judge him too harshly for that performance, let us speculate on his thinking. Certainly he can persuade himself that the Republicans would do the same thing if they were In power. Already he has characterized our talk of economy as “just conversation.” To date we have been proving him right. Neither the President nor the Republican Congress is under real compulsion to cut Federal spending. And so neither one does so, and the people are largely helpless.

But it was not always this way.
Before 1933 the people themselves had an effective way to demand economy. Before 1933, whenever the people became disturbed over Federal spending, they could go to the banks, redeem their paper currency in gold, and wait for common sense to return to Washington.

Raids on Treasury
That happened on various occasions and conditions sometimes became strained, but nothing occurred like the ultimate consequences of paper money inflation.
Today Congress is constantly besieged by minority groups seeking benefits from the public treasury. Often these groups. control enough votes in many Congressional districts to change the outcome of elections. And so Congressmen find it difficult to persuade themselves not to give in to pressure groups. With no bad immediate consequence it becomes expedient to accede to a spending demand. The Treasury is seemingly inexhaustible. Besides the unorganized taxpayers back home may not notice this particular expenditure — and so it goes.

Let’s take a quick look at just the payroll pressure elements. On June 30, 1932, there were 2,196,151 people receiving regular monthly checks from the Federal Treasury. On June 30, 1947, this number had risen to the fantastic total of 14,416,393 persons.

This 14½ million figure does not include about 2 million receiving either unemployment benefits of soil conservation checks. However, it includes about 2 million GI’s getting schooling or on-the-job-training. Excluding them, the total is about 12½ million or 500% more than in 1932. If each beneficiary accounted for four votes (and only half exhibited this payroll allegiance response) this group would account for 25 million votes, almost by itself enough votes to win any national election.

Besides these direct payroll voters, there are a large number of State, county and local employees whose compensation in part comes from Federal subsidies and grants-in-aid.

Then there are many other kinds of pressure groups. There are businesses that are being enriched by national defense spending and foreign handouts. These firms, because of the money they can spend on propaganda, may be the most dangerous of all.

If the Marshall Plan meant $100 million worth of profitable business for your firm, wouldn’t you Invest a few thousands or so to successfully propagandize for the Marshall Plan? And if you were a foreign government, getting billions, perhaps you could persuade your prospective suppliers here to lend a hand in putting that deal through Congress.

Taxpayer the Forgotten Man
Far away from Congress is the real forgotten man, the taxpayer who foots the bill. He is in a different spot from the tax-eater or the business that makes millions from spending schemes. He cannot afford to spend his time trying to oppose Federal expenditures. He has to earn his own living and carry the burden of taxes as well.

But for most beneficiaries a Federal paycheck soon becomes vital in his life. He usually will spend his full energies if necessary to hang onto this income.
The taxpayer is completely outmatched in such an unequal contest. Always heretofore he possessed an equalizer. If government finances weren’t run according to his idea of soundness he had an individual right to protect himself by obtaining gold.

With a restoration of the gold standard, Congress would have to again resist handouts. That would work this way. If Congress seemed receptive to reckless spending schemes, depositors’ demands over the country for gold would soon become serious. That alarm in turn would quickly be reflected in the halls of Congress. The legislators would learn from the banks back home and from the Treasury officials that confidence in the Treasury was endangered.

Congress would be forced to confront spending demands with firmness. The gold standard acted as a silent watchdog to prevent unlimited public spending.

I have only briefly outlined the inability of Congress to resist spending pressures during periods of prosperity. What Congress would do when a depression comes is a question I leave to your imagination. I have not time to portray the end of the road of all paper money experiments.

It is worse than just the high prices that you have heard about. Monetary chaos was followed in Germany by a Hitler; in Russia by all-out Bolshevism; and in other nations by more or less tyranny. It can take a nation to communism without external influences. Suppose the frugal savings of the humble people of America continue to deteriorate in the next 10 years as they have in the past 10 years? Some day the people will almost certainly flock to “a man on horseback” who says he will stop inflation by price-fixing, wage-fixing, and rationing. When currency loses its exchange value the processes of production and distribution are demoralized.

For example, we still have rent-fixing and rental housing remains a desperate situation.

For a long time shrewd people have been quietly hoarding tangibles in one way or another. Eventually, this individual movement into tangibles will become a general stampede unless corrective action comes soon.

Is Time Propitious
Most opponents of free coinage of gold admit that that restoration is essential, but claim the time is not propitious. Some argue that there would be a scramble for gold and our enormous gold reserves would soon be exhausted.

Actually this argument simply points up the case. If there is so little confidence in our currency that restoration of gold coin would cause our gold stocks to disappear, then we must act promptly.

The danger was recently highlighted by Mr. Allan Sproul, President of the Federal Reserve Bank of New York, who said:
“Without our support (the Federal Reserve System), under present conditions, almost any sale of government bonds, undertaken for whatever purpose, laudable or otherwise, would be likely to find an almost bottomless market on the first day support was withdrawn.”

Our finances will never be brought into order until Congress is compelled to do so. Making our money redeemable in gold will create this compulsion.
The paper money disease has been a pleasant habit thus far and will not he dropped voluntarily any more than a dope user will without a struggle give up narcotics. But in each case the end of the road is not a desirable prospect.

I can find no evidence to support a hope that our fiat paper money venture will fare better ultimately than such experiments in other lands. Because of our economic strength the paper money disease here may take many years to run its course.

But we can be approaching the critical stage. When that day arrives, our political rulers will probably find that foreign war and ruthless regimentation is the cunning alternative to domestic strife. That was the way out for the paper-money economy of Hitler and others.

In these remarks I have only touched the high points of this problem. I hope that I have given you enough information to challenge you to make a serious study of it.

I warn you that politicians of both parties will oppose the restoration of gold, although they may outwardly seemingly favor it. Also those elements here and abroad who are getting rich from the continued American inflation will oppose a return to sound money. You must be prepared to meet their opposition intelligently and vigorously. They have had 15 years of unbroken victory.
But, unless you are willing to surrender your children and your country to galloping inflation, war and slavery, then this cause demands your support. For if human liberty is to survive in America, we must win the battle to restore honest money.

There is no more important challenge facing us than this issue — the restoration of your freedom to secure gold in exchange for the fruits of your labors.
I am internationally accepted, last for thousands of years, and probably most important, you can’t make any more of me.”

Posted by Roger Montgomery, Value.able author, Skaffold Chairman and Fund Manager, 26 February 2012.

by Roger Montgomery Posted in Energy / Resources, Insightful Insights, Skaffold, Value.able.

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Following on from our comment yesterday about BHP and comments in the media explaining why we weren’t buyers of BHP or RIO (falling Iron Ore prices and a contracted customer (28% of RIO’s revenue last year) who won’t honor contracts), we are interested in the flow of information through the week.

First the RBA held off cutting rates.  Did they know that China would soon be exporting inflation (cost pressures there)?  Then the next day China reported…guess what….the biggest jump in inflation…so forget about rate cuts there to help out US and Euro exports?

And now we are hearing that over at RIO a freeze has been placed on contractors and recruitment. Read; “massive overspend / cost inflation”.

Today Bloomberg quoted an analyst on China:  “Domestic demand was genuinely weak in January, while exports remained on a gradual downward trend,” said Yao Wei, a Hong Kong-based economist for Societe Generale SA.  And “Tom Albanese, chief executive officer of Rio Tinto Group, said yesterday he remains confident of a so-called soft landing in China…  Inflation (CNCPIYOY) accelerated last month for the first time since July as food prices climbed before the holiday that started Jan. 22, a statistics bureau report showed yesterday. An index of export orders in the agency’s survey of manufacturing purchasing managers released last week showed a contraction for the fourth straight month.  The IMF said in a Feb. 6 report that China’s economic expansion may be cut almost in half from its 8.2 percent estimate this year if Europe’s debt crisis worsens, a scenario that would warrant “significant” fiscal stimulus from the government.(See my postscript).

17/2/2012 PostScript:  An analyst we regard highly wrote this to us today:

“On this recent visit, our wise counselor forecast China’s growth rate will be in therange of 8 to 9% in 2012—assuming no major external shocks. Inflationary pressurewill be lower this year than last, especially in the first half of the year. The inflation ratein China for the entire year will be lower than 4%. Low inflation will allow thegovernment to deregulate prices—water, natural gas, and power.Our trusted counselor believes that export markets cannot be counted on to deliver thegrowth that China needs in 2012. Likewise, domestic consumption, while on the rise as apercentage of GDP, is hard to stimulate quickly. Therefore, the only remaining option to preventChinese economic growth from slowing is for the government to use investment as a stimulus.”

Here’s a quick view from Skaffold of RIO.  To become a Skaffold member and enjoy having every stock in the Australian market quality rated and valued and all valuations and data automatically updated for every company every day CLICK HERE

Posted by Roger Montgomery, Value.able and Skaffoldauthor and Fund Manager, 10 February 2012.

by Roger Montgomery Posted in Energy / Resources, Insightful Insights, Manufacturing.

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The ability to pick stocks that never go down, is NOT one of our skills.  Plenty of you can attest to that.  Value investing using the method we advocate in Value.able and using Skaffold.com cannot prevent losses, it is about minimising the cases of permanent impariment.

Asked by BRW’s Tony Featherstone which small caps we liked we nominated a few. Here’s the list and if you cannot read it properly or would like to also read about the TOP 10 Start Ups of 2011, grab this week’s copy of the BRW.

Remember to seek and take personal professional advice before engaging in any security transactions.

Posted by Roger Montgomery, Value.able and Skaffold author and Fund Manager, 9 February 2012.

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Roger Montgomery thinks not, and discusses why in this article published in The Sydney Morning Herald on 7th February 2012.  Read here.

by Roger Montgomery Posted in Energy / Resources, In the Press, Intrinsic Value, Investing Education.

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In 2010 here at the Insights Blog I wrote:

“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.”

I now wonder whether we are seeing the bubble slip over the precipice?  Falling property prices (10 per cent of the Chinese economy) leads to lower construction activity, leads to declining demand for Australian commodities, leads to falling commodity prices, leads to bigs drops in margins for a sizeable portion of the market index…

Watch this video and decide for yourself.

Posted by Roger Montgomery, Value.able author and Fund Manager, 8 December 2011.

by Roger Montgomery Posted in Energy / Resources, Insightful Insights, Market Valuation, Property, Value.able.

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What is the value of a company that wakes up to find it has sold very little or even nothing in the last six months? My very long-term outlook for the price of oil hasn’t changed, but I can make the argument that the shares of Matrix C&E cannot currently be valued as a going concern any more confidently than I can a speculative exploration company.

While its a very harsh interpretation and its not the only interpretation, there are things to be concerned about.

Before I go into what disappointed me about the result, let me make an observation about the short term share price action.  It appears that many short term investors could be overreacting to the report.  Management are very confident that they will win new business and if they do, the share price represents and opportunity.

First, cash flow. Its something I have mentioned here at the blog previously – as have others.

Submitted on 2011/07/05 at 1:08am: “The short and mid term outlook for Matrix will be dependent on them securing some contracts and their cash flow will be dependent on them getting a few deposits paid. We have put a call into the company to see if we can get an answer but they may soon be in blackout so we’ll have to wait and see.”

Submitted on 2011/06/24 at 1:46pm: “Great stuff Ash. Good to challenge and shake things up. Any opposing views, go right ahead and put them up. I know that lots of you are concerned about Matrix. Watch their cash flows…”

There were many useful insights provided here at the blog about Matrix and their cash flow.

Prior to those comments, in April in fact, I noted we had participated in the capital raising at $8.50. But our holdings were small and hadn’t exceeded 1% of our portfolio because of our concerns about cash flow.  You may also remember I demonstrated declining intrinsic values for Matrix in the future, which triggered some concerned responses.  You really do need to understand the business, and the benefits of diversification.

Many might throw their hands up and give up on the intrinsic value approach, and while I would be delighted to see fewer value investors, this is as much an overreaction as the plunging share price may be today. There are critics who suggest there’s a problem with the intrinsic value approach.  Gloating is predictable, but they do fail to understand that any shortcoming is not the approach but its application; You need to understand cash flow (heck, there’s a whole chapter in Value.able!) and you need to understand the business (it’s what Value.able is all about).

So here are some of the facts, thoughts and reasons I think the market is reacting the way it is.  Don’t forget, in the short run, the market is a voting machine.

First:

MCE missed analysts’ expectations. Thats the first reason for a negative reaction by the market.  I should point out that the share price has been declining significantly for two trading sessions prior to this blog post and has fallen 50% from its highs in April.

Second:

Profit grew 85 per cent (but not by as much on a per share basis). While the question should be if an analyst’s forecast is missed, is it the company’s fault or the analyst’s, in this case those forecasts are a function of company guidance. Guidance was $40 million at the start of the year, then $36 million. This week profit came in at $33.6 million. Earnings per share grew 56 per cent (less than the 85% growth in total NPAT) thanks to a capital raising that was used to construct a facility that hasn’t yet generated returns.

Third:

Fifty six percent growth in earnings is stunning.  Make no mistake about that.  Again, all things being equal, if such growth were to continue it would almost certainly cause intrinsic values to rise and materially.

Fourth:

The company is forecasting revenue growth of 20 per cent. This is “company guidance”. If NPAT margins can be maintained – duplication costs could be removed next year, which would be positive for margins – profit will equate to 52 cps. But in the face of few or no new contract wins in the last 12 months, are management being optimistic?  Thats probably the key to working out if the current price is an overreaction and therefore an opportunity.

To grow revenue by 20 per cent to $224m, they need $114m of new work, on top of the current order book of $110m, which declined 70m in the last six months. Note the zero balance under Deposits in the Balance Sheet too.  There’s $500 million of work in the tender pipeline.  If they win 30% of that (a figure the company suggests is reasonable) that is $150 million and if won this year, will help the company achieve its target.

Fifth:

Analysts were forecasting 2012 EPS of 66 cents in July. Using these numbers, MCE’s valuation is over $10.00. But your valuation is only as good as your inputs. Those analysts are now forecasting earnings of 61 cents per share for 2012 and my own number is now closer to 51 cents (see above). In the absence of any announcements of contract wins, expect further downgrades from analysts.

Sixth:

Significant contract wins would have the opposite impact on intrinsic value and it could rise again.

Seventh:

If they achieve 52 cents of earnings per share, my intrinsic value becomes $6.80 – still significantly higher than the current share price but well down on the previous estimates of intrinsic value. The fact that $6.80 is above the current share price is one of the reasons I am keen to talk to the company!

But don’t forget, they have to win some contracts, because at the moment the [declining] order book is just 58 per cent of last year’s revenue. More importantly, in the absence of any contract wins, that intrinsic value could fall precipitously.  As I say above; “There’s $500 million of work in the tender pipeline.  If they win 30% of that (a figure the company suggests is reasonable) that is $150 million and if won this year, will help the company achieve its target.”  Its important the company make clear (at the AGM for example) details about the length of the tendering and commissioning cycle for all shareholders.

Eighth:

Aaron Begley is confident that they will convert about 30% of the work they tender for.  With $500 million in tender work thats will satisfy their revenue growth targets.

Ninth:

In the first half of last year cash declined, despite the fact the company borrowed more money and raised more capital. In the second half, the business generated just $900,000 of cash. There is no way to dress this up though and its not impressive for a company with a market cap earlier in the year of over $700 million and $350 million now.  As mentioned in some of the posts, it could merely be a function of the long lead cycles of commissioning oil rigs, in which case there may be an opportunity worth investigating.

Tenth:

In conclusion, the results revealed this:  Order book fell from $180m in the first half to $110m now. The $70 m decline is matched by the cash receipts in the second half. Given the fact that deposits in liabilities on the balance sheet fell to zero, we can assume the company made little or no new sales in the second half. Its with this in mind that you need to consider whether the companies forecasts are bullish or not.  They need to win some business to justify the estimate of intrinsic value

As at June 30, 2011, MCE’s quality rating is A2. There is virtually zero chance of a liquidity event. But non manufacturing overheads are running at $750k a month, so the cash will be diminishing if there are no contract wins. That is what is driving the share price lower.

THEY NEED TO WIN SOME CONTRACTS OR SHAREHOLDERS NEED TO BETTER UNDERSTAND THE TENDERING CYCLE LENGTH.

Finally:

It is quite fair for critics to point out the one-eyed focus many investors have on the Value.able intrinsic value formula. The formula is a good one, but it is only as good as the inputs you feed it and they must come from an understanding of the business. I took a call from an share market investor who didn’t understand why the share price for Matrix was falling after reporting such strong profit growth. If that sounds like you, take a break and get back to the books to understand the business and its prospects. At the very least, it will help to either, 1) temper your enthusiasm for a company that is at a discount to your intrinsic value estimate, 2) change your estimate of intrinsic value or, 3) give you a better understanding of whether that intrinsic value is rising or declining.

On a separate note, there is a very real chance of a downside overreaction too, something we are always on the lookout for!

General and Educational Information only.  Not a solicitation to act or trade in any security in any way.  Always seek and take personal professional advice.

BigAir Group?

Digging in a little deeper to BigAir’s financials and you may notice a few things to be cautious about too – always important to read past what management tell you about revenue numbers climbing to the moon and do your own thinking.

These are all symptoms of a fast growing business, and a business which has grown by acquisition.

Firstly, a little cash strapped? Current Liabilities > Current Assets by 400k. This is mainly due to the $3.6m they owe on their acquisitions in the next 12 months. They have announced the acquisitions but hadn’t paid for them at June 30. Don’t forget that they also owe $1.375m, which is in non-current liabilities – a total of $5m in payments are still to be made for past acquisitions already announced. See note 18 to the accounts for more.

The next 12 months are important, and with Current Liabilities > Current Assets, its not an not an ideal position to be in, although they may be able to cover this by working their working capital. What you now need to work out is if future cash flow and of course CAPEX, which seems to run @ $2.5-$3.2m, will provide enough free cash for them to self fund their operations and liabilities. It is of course is hard to work out because maintenance CAPEX and growth CAPEX is harder to separate when a company grows quickly through acquisitions.

The university business may prove distracting, but some serious players in the industry really like fixed wireless broadband.

General and Educational Information only.  Not a solicitation to act or trade in any security in any way.  Always seek and take personal professional advice.

Posted by Roger Montgomery and his A1 team, fund managers and creators of the next-generation A1 service for stock market investors, 24 August 2011.

by Roger Montgomery Posted in Energy / Resources.

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For those interested in Shale Gas stocks, an interesting article was published in the New York Times at the weekend.

Here’s an excerpt or two from the article…

“Money is pouring in” from investors even though shale gas is “inherently unprofitable,” an analyst from PNC Wealth Management, an investment company, wrote to a contractor in a February e-mail. “Reminds you of dot-coms.”

“And now these corporate giants are having an Enron moment,” a retired geologist from a major oil and gas company wrote in a February e-mail about other companies invested in shale gas. “They want to bend light to hide the truth.”

…and here is the link to the story: http://www.nytimes.com/2011 and a link to more than 480 pages of leaked insider emails and reports: http://www.nytimes.com/interactive

And more recently, in this e-mail chain from April 2011, United States Energy Information Administration officials express concerns about the economic realities of shale gas production.

I am not allowing any comments on this subject. Do your own research and seek personal professional advice.

Please continue contributing to the two prior posts, listing the companies you think we should be watching this reporting season (Scroll Down).

Posted by Roger Montgomery, author and fund manager , 27 June 2011.

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

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In August 2010 Matrix Composites & Engineering, when we first began commenting on the company, was trading around $2.90. Thirty days later the share price was at $4.48. Today MCE is trading at just over $9.00 and has a market capitalisation of more than half a billion dollars. It’s no longer just a little engineering business. Like the Perth industrial precinct of Malaga in which its headquarters are based, MCE is growing rapidly (according to Wikipedia there are currently 2409 businesses with a workforce of over 12,000 people in Malaga. The 2006 census listed only 28 people living in the suburb).

But has MCE’s share price risen beyond what the business is actually worth?

Stock market participants are very good at telling us what we should buy and when. When it comes to selling, it seems silence is the golden rule.

If you receive broker research, take out a report and turn to the very back page – the one beyond the analyst’s financial model. You will often find a table that lists every company covered by that broker’s research department. Now look to the right of each stock listed. What do you notice?

Buy… Buy… Hold… Buy… Buy… Accumulate… Hold…

What about sell?

There aren’t many companies in Australia worthy of a buy-and-hold-forever approach. And if you have invested in a company with a previous BUY recommendation, the luxury of a subsequent Ceasing Coverage announcement by the analyst is not helpful.

So then, when should you sell? It is a question I have been asked, to be honest, I can’t remember how many times. Because I have been asked so many times, it’s a question I answered in Chapter 13 of Value.able – a chapter entitled Getting Out.

Value.able Graduates will recognise a sell opportunity. Yes, it is an opportunity. Fail to sell shares and you could eventually lose money.

Of course, any selling must be conducted with a certain amount of trepidation, particularly when capital gains tax consequences are considered. But not selling simply because of tax consequences is unwise.

We pay tax on our capital gains because we make a gain. Yes, its difficult handing over part of our investment success to the Tax Man for seemingly no contribution, but without success our bank balance would remain stagnant forever.

When then should you sell? In Value.able I advocate five reasons. For now I would like to share with you a possible reason.  Based on any of the other reasons I may be selling Matrix so make sure you understand this is a review based on one of five reasons.

Eventually share prices catch up to value. In some cases it can take ten years, but in the case of Matrix, it has taken far less time for the share price to approach intrinsic value.

One signal to sell any share is when the share prices rise well above intrinsic value.

There are no hard and fast rules around this. And don’t believe you can come up with a winning approach with a simple ‘sell when 20% above intrinsic value’ approach either.

What you MUST do is look at the future prospects. In particular, is the intrinsic value rising? I believe it is for Matrix (and I am not the only fund manager who does – you could ask my mate Chris too).

Here’s some of his observations:  Risks associated with the timing of getting Matrix’s facility at Henderson up and running are mitigated by keeping Malaga open. And Malaga is producing more units now than it was only a few months ago. Matrix could also produce more units from Henderson than they have suggested (the plant is commissioned to produce 60 units per day) and I believe the cost savings will flow through much sooner than they say. Recall the company has indicated Henderson could save circa $13 million in labour, rent and transport costs (see below analyst comment). Excess build costs are now largely spent and if the company can ramp up to 70 units a day, HY12 revenue could double.

Why do I believe this? Because a recent site visit for analysts suggested it. As one analyst told me: “Production of macrospheres has started from Henderson with 7 of the 22 tumblers in operation. This is a good example of the labour savings to come as it’s now a largely automated process – there were only 3 people working v >20 on this process at Malaga.”

(Post Script:  My own visit to WA at the weekend revealed a company capable of producing just over 100 units per day – Henderson + Malaga)  Moreover, the sad events unfolding in Japan will force a rethink on Nuclear.  If nuclear energy – recently hailed as a green solution to global warming – reverts to being a relic of an old world order, demand for oil will increase.  Oil prices will rise.  Deep sea drilling will be on everyone’s radar even more so.

And the risks?  Well, one is pricing pressure from competitors. This is something that needs to be discussed with management, but preferably with customers!

Some Value.able Graduates may be reluctant to place too much emphasis on future valuations. Indeed I insist on a discount to current valuations. If it is your view that future valuations should be ignored, then you should sell.

Personally I believe one of my most important contributions to the principles of value investing is the idea of future valuations. Nobody was talking about them at the time I started mentioning 2011 and 2012 Value.able valuations and rates of growth. They are important because we want to buy businesses with bright prospects. And a company whose intrinsic value is rising “at a good clip” demonstrates those bright prospects.

If you have more faith and conviction that the business will be more valuable in one, two and three years time, you may be willing to hold on. On the basis of this ONE reason I am currently not rushing to sell Matrix (of course I may sell based on any of the other four reasons), however notwithstanding a change to our view (or one of the other four criteria for selling being met) I do hope for much lower prices (buy shares like you buy groceries…)

I cannot, and will not, tell you to sell or buy Matrix and I might ‘cease coverage’ at any time. As I have said many times here, do not use my comments to buy or sell shares. Do your own research and seek and take personal professional advice.

What I do want to encourage you to do is delve deeply into the company’s history, its management, their capabilities, recent announcements and any other valuable information you can acquire.

And in the spirit demonstrated by so many Value.able Graduates, feel free to share your findings here and build the value for all investors.

When the market values a company much more highly than its performance would warrant, it is time to reconsider your investment. Looking into the prospects for a business and its intrinsic value can help making premature decisions. Premature selling can have a very costly impact on portfolio performance not only because the share price may continue rising for a long time, but also because finding another cheap A1 to replace the one you have sold, is so difficult. At all times remember that my view could change tomorrow and I may not have time to report back here so do your own research and form your own opinions. Also keep in mind that we do not bet the farm on any one stock so even if MCE were to lose money for us (and we will get a few wrong) we won’t lose a lot.

Posted by Roger Montgomery, author and fund manager, 18 March 2011.

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

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Last month on Your Money Your Call John asked for my insights on Universal Coal (ASX:UNV)l.

UNV is not currently investment grade. It is a business that would not receive an adequate MQR.

Section 3.13 of the Prospectus reads: “The directors… believe that they do not have a reasonable basis to forecast future earnings on the basis that the operations of the company are inherently uncertain”.

Given this statement by management, any investment in Universal Coal appears to be speculative.

Without confidence in the future of the business, estimating its Value.able valuation is nearly impossible and investing is risky.

Turn the stock market off, focus on extraordinary businesses (re-read Chapters 5 – 9 of Value.able), calculate what the business is truly worth and buy them for less than they’re worth. And if you haven’t already done so, pick up your copy of Value.able at my website, www.rogermontgomery.com (there aren’t many Second Edition copies left).

Sky Business Channel have been invited to appear on Your Money Your Call this Thursday, 10 March. Tune in from 8pm Sydney time.

Posted by Roger Montgomery, author and fund manager, 8 March 2011.

by Roger Montgomery Posted in Companies, Energy / Resources.

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