Insightful Insights

Roger Montgomery thinks not – and in this interview with Radio 2GB’s Ross Greenwood he discusses why Singapore’s pervasive attractiveness for investors is likely to remain for some time. Listen here.

This interview was broadcast 18 July 2012.

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Roger Montgomery certainly thinks so, and he discusses with Ticky Fullerton how his Value.able investing strategy provides much lower valuations of the current market in this interview on ABC’s The Business broadcast 18 July 2012.  Watch here.

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

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Monday’s announcement of total ANZ job ads falling by 8.9% year on year in June 2012 indicates the slowdown in many Western world economies is gaining momentum Down Under.

The ANZ Australian job ad market series (combined newspaper and online) fell by 1.2% in June 2012 on May 2012.  In turn, May’s figure was down 2.6% from April.

The 8.9% year on year decline was driven by 8.5% and 17.5% year on year declines in online and newspaper job advertisements, respectively.

by Roger Montgomery Posted in Insightful Insights, Value.able.

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Sani Group, China’s biggest maker of construction machines has announced a cut to its workforce.

Given lay-offs did not occur in the down cycles of 2005 and 2008, this is a clear sign some pain is being experienced in China’s industrial heartland.

Sany’s 60,000 staff produces concrete machinery, excavators, cranes, pile drivers and road machinery.  Its revenue exceeds RMB80 billion or US$12.5 billion.

With the tripling in demand for machinery in China since 2001, it appears Sany has recently been selling machines on generous credit terms.  As a result the machinery maker saw its net receivables double over 2011.

The slowdown in Chinese construction activity is not a good omen for the iron-ore price, currently US$135/tonne. China’s demand accounts for 63% of iron-ore’s global seaborne trade.

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

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Fairfax Media’s restructure announcement has been welcomed by the market, but what prospects does their revised business model have for future profitability?  Roger Montgomery provides his Value.able insights to ABC1’s Ticky Fullerton in this edition of ‘The Business’ broadcast on 18 June 2012. Watch here.

by Roger Montgomery Posted in Insightful Insights, Takeovers, TV Appearances, Value.able.

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As you already know, despite the enthusiasm for mining service companies back in April, we sold our holdings substantially and in some cases completely.  We have not shared our peers’ – some of whom include themselves in the ‘value investing’ camp – enthusiasm for BHP.  Our reasoning for this is our thesis regarding iron ore prices, which is unchanged from late last year.

Back then it was simply the classic investment response to higher prices.  Iron Ore prices between 1985 and and 2004 have traded between $11 and $15  and in real terms since the 1920’s prices have traded between $30 and $45. In 2004 the price of iron ore started rallying and hit $187 in 2007.

Putting aside the fact that iron ore experts now ‘guess’ $140 is the new medium term price and $100 the long term price, the rally in price from 2004 to now has produced a huge investment boom and turned millionaires into billionaires as they revalue their reserves (or other bulls value them for them).

It follows that  the investment boom will now produce additional supply.  The impact of this additional supply cannot be anything but falling prices.

Well, that was our thesis.  And then China began slowing down.  We wrote about that too

If you have been a regular to the Insights Blog, you will be familiar with some of our recent thoughts on iron ore here:

April 3)  http://rogermontgomery.com/mining-services-a-crowded-trade/

April 18) http://rogermontgomery.com/building-heaps-piles-at-bhp/

APril 11) http://rogermontgomery.com/will-china-demand-iron-or/

And you can watch this video I published here on December 8 last year:

Since July last year BHP is down 30% and RIO down 36%.  Since April and early May they are down 15% and 20% respectively.  Many investors are now thinking they are cheap.  But there is the possibility of a classic Value Trap.

Forecast valuations may yet decline further, even if share prices bounce. Here’s our thoughts…

PORTFOLIO POINT: BHP and Rio’s review of capex programs represents a stark turnaround from comments made just two months ago, and it’s a worrying sign for the rest of the sector.

BHP is trading at three-year lows, Fortescue is down 17% from recent highs and Rio is visiting lows last seen in 2008. If you own shares in any of these companies, only Telstra would have saved your portfolio from a shellacking.

The big caps, however, are not the only stocks that have suffered. Over recent years, it is likely that you would have observed my interest in mining services. That interest was a product of the presence of value for money.

This is a sector I know well and have covered numerous times. I have discussed and brought listed businesses – including Decmil Group (DCG), Forge Group (FGE) and Matrix Composites & Engineering (MCE) – and IPOs – GR Engineering (GNG) and Maca (MLD) – to your attention.

This was mostly at a time when there was little market interest, despite their apparent growth profiles, quality aggregated balance sheets and (now with the exception of MCE) management.

Today, however, that story is very different and I find myself erring on the side of caution when it comes to ‘picks and shovels’.

Each week, a stronger case is building that a key growth engine for capex spending by our miners is slowing – that is, commodity prices are falling.

Take one commodity I have discussed recently: iron ore.

In 2010-11, world iron ore production grew 8.1% (or 227mt) to 2.80bt. Assuming similar growth levels in 2011-12, iron ore production will grow to 3.04bt, an increase of about 237mt. (In a classic supply response, BHP production is forecast to grow by 20%, Rio by 30% and FMG by 25%.)

And assuming China consumes 60% of global production again (highly optimistic), its demand would increase by 136.2mt. However, moderating growth means current estimates for China’s iron ore requirements are half this level. With few other countries growing or competing heavily with China, who will pick up that supply overhang in a low-growth environment?

By 2015, two entire Pilbara regions (700mt) in supply terms are estimated to come onto the market. It’s a far stretch to expect China to absorb 420mt (60%) of that.

The impact, I expect, is pressure on iron ore prices.

Many other commodities are looking like they are set to suffer a similar fate. Record prices over a decade have created an investment boom that is climaxing at a time when global demand is losing interest. And you need two to tango. When soaring supply meets softening demand, lower prices follow.

So what are the implications? Put simply, for those who dig stuff out of the ground and export it, margins and cash flow will be squeezed (a situation I have been monitoring closely and alerting readers to for at least six months). It’s why I haven’t bought BHP.

In previous periods, a revenue squeeze has been a precursor to capex plan deferrals or delays lasting years. Barely economical projects are shelved as miners focus instead on financing core (capital-intensive) operations, rather than aggressive growth targets.

Indeed, the 1990s was a very different period for miners, and those who serviced the mining sector barely made it onto investment radars. Companies struggled to cover their cost of capital and total annual capex was less than $20 billion for the entire mining industry.

Today, many miners are generating returns on equity in excess of 30% (‘super profits’?) and capex runs in excess of $60 billion per annum. Are such numbers maintainable forever? No. And if it can’t go on forever, it must stop.

Just a few days ago, BHP Billiton and Rio Tinto announced that they are re-evaluating their capital expenditure programs. These comments are in stark contrast to their latest financial reports and presentations made just two months ago.

In those reports, confidence was effervescent and the deployment of $40 billion in a global cash capex spree was on the cards. Today, as China’s growth rate slows and some investors lobby for a greater focus on cost control and returning funds to shareholders, tens of billions of dollars of an extensive development project pipeline is under review.

When the two leading businesses that account for about 35% of total industry investment start to make noise, it’s time to sit up and pay attention.

We are bound to see many other miners follow suit and the chorus is growing louder by the day. Citigroup conducted a survey in April and found that 50% of all miners were considering lowering their investment budgets.

That compares to less than 20% in January.

Figure 1. A picture tells a thousand words

At the start of the financial year, capital expenditure was forecast to rise 34%, with an increase of 18% in 2013.

The forecast today is for a rise of only 13% this year and a fall in 2013. This represents a material deterioration in market conditions in a very short period of time. All of this weighs on the ‘bright prospects’ that once surrounded those companies which service the miners.

This brings us back to Decmil, Forge and investing. I bought both of these businesses in the Montgomery [Private] Fund near its inception.

Forge is a business that has a significant exposure to second-tier miners, especially those expanding their iron ore operations. Decmil, on the other hand, has around 43% of its business exposed to resources and the balance to oil & gas.

While plenty of work is still forecast to be in the pipeline for mining services companies, there are also plenty of companies trying to win it.

If we are at the peak of the current capex cycle, this is as good as it gets in terms of margins for mining services businesses and also workloads.

With that in mind, and coupled with prices increasing to levels I deem attractive for what are businesses with high operating leverage, I have decided to read the writing on the wall and position our investments in a more conservative manner. I sold our Forge holding some weeks ago and also scaled back our holding of Decmil.

It is possible I am early to leave the party – the band is still playing. But the mining industry is bracing for a pullback in investment spending, as the biggest companies reassess their capital expenditure plans amid escalating costs and an uncertain growth outlook. I anticipate that analysts will revise their earnings forecasts lower for 2013 and beyond.

The valuations I look at in Skaffold will also fall, I expect, as those earnings revisions are fed through. Of course, I could also be completely wrong but I reckon the big mining companies’ historical predilections for over-paying for acquisitions (another reason I have been loath to invest) may just revisit them.

The combination of a contracting market and high operating leverage means I simply prefer the safety of cash. Better to be confident of a good return than hopeful of a great one.

This article was first published on May 16, 2012

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

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Facebook floated last week and amazingly it has been holding above its IPO price of $38 per share. I say amazingly because I reckon its value to be substantially lower. I will publish my completed calculations in the near future

Here’s a taster:  “For a purchaser of Facebook shares today and wanting 15 percent per year over the next five years (doubling your money),  Facebook’s market capitalization has to double to $200 billion without any additional shares being issued (options to be exercised will put paid to any fairy tale notions about that). Google is valued by the market today at $200 billion.  Both businesses are similar in terms of margins etc so arguably Facebook needs to increase its sales tenfold in the next five years to achieve the same valuation as Google today.  But keep in mind, Google has about $40 billion of cash in its accounts.  Facebook has nothing like that.”

For now I thought the trading in Facebook on its first day was a useful entrée to the world of High Frequency and Algorithmic trading and I also thought that comic Andy Borowitz’s tongue-in-cheek look at Facebook provided a welcome break from the doom and gloom pervading investment markets.

From: http://www.borowitzreport.com/

MENLO PARK, CA (The Borowitz Report) – On the eve of Facebook’s IPO, Founder and CEO Mark Zuckerberg published the following letter to potential investors:

Dear Potential Investor:

For years, you’ve wasted your time on Facebook. Now here’s your chance to waste your money on it, too.

Tomorrow is Facebook’s IPO, and I know what some of you are thinking. How will Facebook be any different from the dot-com bubble of the early 2000’s?

For one thing, those bad dot-com stocks were all speculation and hype, and weren’t based on real businesses. Facebook, on the other hand, is based on a solid foundation of angry birds and imaginary sheep.

Second, Facebook is the most successful social network in the world, enabling millions to share information of no interest with people they barely know.

Third, every time someone clicks on a Facebook ad, Facebook makes money. And while no one has ever done this on purpose, millions have done it by mistake while drunk. We totally stole this idea from iTunes.

Finally, if you invest in Facebook, you’ll be far from alone. As a result of using Facebook for the past few years, over 900 million people in the world have suffered mild to moderate brain damage, impairing their ability to make reasoned judgments. These will be your fellow Facebook investors.

With your help, if all goes as planned tomorrow, Facebook’s IPO will net $100 billion. To put that number in context, it would take JP Morgan four or five trades to lose that much money.

One last thing: what will, I, Mark Zuckerberg, do with the $18 billion I’m expected to earn from Facebook’s IPO? Well, I’m considering buying Greece, but that would still leave me with $18 billion. LOL.

Friend me,

Mark

Following that lighthearted distraction, if you are interested in how High Frequency Trading and [some examples] of Algorithmic (Algo) Trading looks in the real world, watch this:

As the following chart reveals (you will have to suspend reality and imagine that the future always looks exactly the same as the past) some analysts think Facebook’s growth will mimic that of other high profile social networks.  No doubt the underwriters of Facebook will hope they’re wrong.

Either way it will be more than a little interesting to watch. Did you buy shares in Facebook?  If not, why not? And if you did, what were the reasons?

Posted by Roger Montgomery, Value.ableauthor, SkaffoldChairman and Fund Manager, 21 May 2012.

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Matthew was so disappointed about the April takeover offer for a company he owned, that he wrote a letter to his rep – the CEO

More of us should be doing likewise, remembering the words of Richard Puntillo; “in theory, publicly traded corporations have shareholders as their kings, boards of directors as thesword–wielding knights who protect the shareholders and managers as the vassals who carry out orders. In practice, in the past decade, managers have become kings who lavish gold upon themselves, boards of directors have become fawning courtiers who take coin in return for an uncritical yes-man function and shareholders have become peasants whose property may be seized at management’s whim.”

Has a company you owned shares in been taken over and left you disappointed rather than elated?  Its simplistic and a sign of immaturity as an investor to celebrate a takeover when the price paid does not justify the prize.  Its far too easy for investors to do the ‘Wall Street walk’ when a bid is received.  Matthew’s actions serve as a reminder that their are issues beyond the immediate return that must also be considered.

Hi Roger and team,

I sent the following letter to the CEO of a company today that I am a shareholder in called IDEAS International. They are a small company but very successful and operate in an area that is experiencing huge growth. They are little known, very thinly traded and not appropriate for most investors. Perfect for me!

IDEAS International was formed in 1981 and listed on the ASX in 2001. The IDEAS business is essentially one of analysing computer resource usage. This is important for companies who operate servers because this information allows these companies to increase efficiency and get value for money from their IT purchases. In a commodity like business (i.e. cloud servers) companies that can assist you to squeeze out another 1% in efficiency or when buying $20m of hardware to buy the correct servers for the job, paying a small fee to a company like IDEAS is a no-brainer. They provide independent advice based on real-world scenarios. They collect this information from the other part of their business which is in providing independent monitoring and analysis services to the same companies. Cloud computing is a huge growth area at the moment and it will get bigger. IDEAS is only just making a dent in this business and the demand for their services will grow as the cloud computing business is increasingly commoditised.

On wednesday they went in to a trading halt pending the release of information regarding a control transaction. Today they released a takeover bid by a large international IT outfit called Gartner with the full support of the board. No premium to current prices has been offered, the takeover is at $1.40, the same as the trading price for the last month. The quality of this company is high, it is cheap and Gartner are getting away with robbery.

The below letter doesn’t fit the theme of the recent “Guest Posts” but I thought you might consider it anyway. I won’t be at all concerned if you don’t think it is appropriate.

Kind Regards,

Matthew Rackham

**********

IDEAS International

ASX Code: IDE

“Takeover Disappointment”

Dear Mr Bowhill,

I read with interest the takeover proposal by Gartner for IDEAS released to the ASX this morning.

I am a private investor and I will be up front and say that I am very disappointed to hear that you are recommending the proposal.

IDEAS is a fantastic business. There are very few businesses as good as IDEAS in Australia, let alone on the ASX. Not only is this a fantastic business but by what I have read it seems to be run very well by management. Overlay this on the growth in the server space which IDEAS is in and my impression is this company has many exciting years of growth ahead of it.

In comparison Gartner looks to me to be a lousy business. Significant debt, slim profit margins and poor return on assets are the lot of Gartner’s management and shareholders.

But maybe these could be forgiven if the sale price rewarded current shareholders equally to future shareholders. Sadly however, it does not. If something close to recent performance continues I expect IDEAS to be worth in excess of $3 per share and maybe up to $4.20 in four years time. If the AUD drops this figure will be higher. Looking at your financial statements IDEAS will have the capacity to pay much larger dividends in the very near future as well. Net of cash Gartner are buying our company for $13.1 million and with earnings of $1.9 million and cash flow of $2.8 million – Gartner are making a steal. I expect Gartner will get their purchase outlay back within 4 years, and much earlier when they leverage their much larger distribution network.

I have to ask the question: Why if Gartner are so keen to use the resources of IDEAS do the management of IDEAS not license Gartner as a reseller/agent/partner ? This would ensure the value of IDEAS stays with the shareholders of IDEAS, allow IDEAS management to achieve their aspirations of making IDEAS a globally significant business and Gartner can continue on as, albeit slightly less so than before, a lousy performing business. In this scenario everyone gets the value they are entitled to.

Longstanding shareholders of IDEAS may feel that the performance of IDEAS share price has not been all that great for many years and this is a chance to “cash out” at a good price. What I would say to them is that (1) this is not the time to “cash out” given IDEAS is on the cusp of a large ramp up in use of it’s services – if they have waited this long surely they can hold on a few more years to realise the benefits of their patience and (2) higher share prices in normal circumstances result in greater liquidity in the shares so if they want to cash out they will be able to in a few years anyway. New shareholders from the GFC period have nothing to lose either way (good luck to them!).

I am very frustrated by this opportunistic offer for our company,

Kind Regards,
Matthew Rackham

by Roger Montgomery Posted in Insightful Insights, Value.able.

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A broker sent us a copy of these notes taken at the 2012 Berkshire Annual general meeting.  The media has taken excerpts and they’ve gone viral but we like the completeness of the document we were sent.  Have a read and feel free to share your thoughts.

2012 Berkshire Hathaway Notes Annual Meeting Notes

Posted by Roger Montgomery, Value.able author, SkaffoldChairman and Fund Manager, 16 May 2012.

by Roger Montgomery Posted in Companies, Insightful Insights.

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PORTFOLIO POINT: Office provider Servcorp is basking in strong earnings forecasts from analysts, but a capital raising in 2010 raises some important questions about the company.

Recently (Click here), I discussed Leighton and the quality of management’s relationship with its employees. Here I look at another company with a shareholder who holds a controlling stake, and examine its relationship with minority shareholders.

You can look at anything from a number of angles and, more often than not, reach an entirely different conclusion. Two investors, for example, presented with the same set of facts can reach polar opposite conclusions. It’s the old glass half-full versus half-empty line.

I find that having a set view and unwittingly being tied to that perspective limits one’s ability to switch fast enough when the evidence is mounting that the view might be wrong. Few are completely immune, but self-awareness is the first step to conquering any weaknesses.

The investing consequence of opening one’s mind to change is that portfolio turnover goes up. I may buy something back that I recently sold, because new evidence suggests I should, and that ‘re-purchase’ may be at a higher price. This may be seen as somewhat flaky and I agree it would be, if it were not evidence-based.

Looking at things differently, however, is necessary because it does produce fresh insights. On page 20 of Warren Buffett’s 2003 annual letter to shareholders, he wrote: “…I made a big mistake in not selling several of our larger holdings during The Great Bubble.” Shining a light – or perhaps a light with a different filter – undeniably helps our investment analysis.

With that in mind, I want to present some numbers from Servcorp’s annual reports and ask you to think about what your conclusion might be.

This service and virtual office provider has not produced growing profits since 2007.

Source:  www.Skaffold.com PATENTS PENDING.

Back then, profits were $34 million, and while they grew to $39 million in 2009, they subsequently fell to $5 million in 2010 and $4 million in 2011. For the record, analysts are in aggregate forecasting profits to grow to $13 million in 2012, and $28 million and $37 million in 2013 and 2014, respectively.

So that’s one way of looking at this business and on that basis, you may be tempted to investigate the opportunity as a turnaround story. I certainly am, as any global recovery from the Euro crisis would position Servcorp well with the rollout of its floor leasing operations.

Is there another perspective?

But before I go jumping in, here’s another way to consider the information. In 2010, the full year profits plunged to $5 million, the company raised $78 million – on top of the $76 million already invested – by issuing 18 million shares. This move took shares on issue to 98 million and capital raised to $154 million. And looking at the retained earnings account for that year reveals that the balance declined by $10 million.  This is something I want to pick up on.

When a company earns a profit of $5 million, as Servcorp did in 2010, retained earnings rise by this amount. Then, if dividends are paid, retained earnings goes down by the amount of the dividend. A net decline of $10 million in retained earnings after a $5 million profit suggests $15 million was paid in dividends.

One way to look at this situation is to assume that the capital raising is for growth; I will give the company the benefit of the doubt and agree. An alternative and admittedly more cynical way to look at it is to assume the capital raising might have been designed to pay for the dividend.

One response to the latter proposition and the one I am leaning towards is that the capital raising was much larger than the amount the dividend exceeded earnings by and therefore the real intention of the capital raising was, indeed, growth. In turn, one retort from a much more jaded or cynical investor could be that the capital raising was made larger to disguise the fact that a larger dividend was desired. It’s all rather circular, as you will discover in a moment.

Perhaps we might never know the thought process of the board at the time and such postulations are only speculative at best, but there are two important questions, answers to which would provide some illumination. The first would be whether the money invested does indeed lead to the growth in earnings that the analysts seem to be expecting – albeit growth that will only produce profits in 2014 that are in line with those of 2007/08. The second might be to ask whether a majority and controlling shareholder is present. Once again, we can’t prove motives, but as investors we are certainly within our rights to enquire.

In the first instance, only time will tell us whether the money is invested profitably. The cash is certainly now available to help grow the business, revenue and profits. To the credit of management, first-half 2012 profits were over $8 million. So the numbers are indeed moving in the right direction.

Regarding the latter issue of ownership, we find the managing director and CEO also owns 51% of the company. Of course, to retain control they must have participated in the capital raising during the 2010 financial year, but keep in mind it could be argued that half the dividend helped fund it.

And I always ask the following question: If a company is in need of capital, why pay a dividend? It’s a basic question and often – but not always – the answer seems to point to maintaining support for the share price, a noble (if perhaps unsustainable and diluting) goal. Directors are arguably acting in shareholder’s best interests by doing things that support the share price but it is imperative the techniques are sustainable. Ultimately the best method is a sound business.

In 2011, the company did almost the same thing as it did in 2010. While no additional equity was raised, and thus the controlling shareholder was therefore spared the requirement of writing another cheque, profits of $4 million were reported, but dividends of $16 million (51% of which went to entities associated with the CEO/MD) ensured that retained earnings fell to $59 million. The $8 million dollars (50% of the dividend) arguably further reduced the personal contribution of the majority shareholder to the capital raising.

For our fund, a return on equity now of just 7% suggests Servcorp is currently not investment grade, and its share price also appears to be expensive compared to our estimate of its intrinsic value. That would change if upgrades to guidance are provided.

While we haven’t answered the questions we posed, we have certainly raised the one we should ask management before we decide to invest. In theory the board works for the shareholders so you are within your rights to ask questions such as these of the board. For your own investing, I can only leave it to you to decide whether the cup is half-full or half-empty.

Posted by Roger Montgomery, Value.able author, SkaffoldChairman and Fund Manager, 3 May 2012.

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