Insightful Insights

By Praveen J on 9th January 2012 and updated Feb 20 2012

This year I have been given an opportunity to write about my experiences in applying what I have learnt as a Value.able graduate and Skaffold member. At the moment I am looking to invest in stocks with a market capitalisation under $2 billion (small to micro caps). Key MINIMUM criteria for me include: Return on Equity > 15%, Net Debt/Equity < 50%, and forecast change in Intrinsic Value > 5%. I will also be focussing on investment grade companies across ALL Industry Sectors/Groups that have Skaffold Quality Scores between A1 to A3, and B1 to B3. This will encompass my “investment universe” of stocks on the ASX. I will of course require a decent margin of safety, but I will be watching stocks that are trading close to their Intrinsic Value or at a small premium, in the event of a decline in price over the next 3 to 6 months. Initial screening using Skaffold reveals over 100 stocks, a more aggressive filter would reduce this number even further. Amongst the results are 10 stocks in the Basic Materials Sector and Gold & Silver Group, 6 of which are predominantly involved in gold exploration, development and production:

• Ramelius Resources (ASX:RMS)
• Medusa Mining Limited (ASX:MML)
• Silver Lake Resources (ASX:SLR)
• Dragon Mining (ASX:DRA)
• CGA Mining (ASX:CGX)
• Regis Resources Limited (ASX:RRL)

Table 1. Stocks listed by safety margin (highest to lowest, 9th January 2012) (Source: Skaffold):

Although Ramelius Resources (RMS) meets my initial screening criteria and is an A1 company, it has a NEGATIVE forecast EPS growth. So in this blog post I will be discussing and comparing Medusa Mining Limited (MML) and Silver Lake Resources (SLR). Here we have two companies that have commenced production of gold (they are making money), they are fundamentally healthy, they have good prospects for Intrinsic Value appreciation, AND are both trading at a discount to their Intrinsic Value. Being commodity businesses, the question I have to ask is whether either really have any competitive advantage. I will discuss this later.

Now in the context of the European sovereign debt crisis, anaemic growth in the US, and concerns of a slowdown in the Chinese economy, I am wary about investing directly in a small cap Australian mining company. However, in this case we are dealing with a commodity that may benefit in this time of uncertainty, with gold long being regarded as a “safe-haven”. Having said that, the future price of gold is still a significant element of risk. At the time of writing the price had dropped down to around US$1600/ounce, after a peak of close to US$1900/ounce in September 2011. Below are some charts of historical gold prices, I’m not going to try and analyse them, but they may serve as a point of discussion. Certainly investing in gold equities requires a bullish stance on the future price of gold in the medium to long term.

Figure 1. Spot gold price chart last 1 year:

Figure 2. Spot gold price chart long-term:

GOLD PRIMER:

Annual reports and AGM presentations for gold and other mining companies assume a level of pre-existing knowledge. Without this, they really make no sense at all. So let me start with some bare basics before I discuss each stock in detail:

What is an Element? An element is a pure chemical substance. You may have heard of something called the periodic table (maybe in your high school science class), this is actually a list of all chemical elements. Examples of elements include carbon, oxygen, aluminum, iron, copper, lead, and of course gold.

What is a Mineral? A mineral is a naturally occurring solid chemical substance that is a combination of elements.

What is an Ore? An Ore is a type of rock that contains minerals. Most individual elements are found in the form of a mineral, though there are some elements that can be found in their elemental state, gold is one of them. Gold is also found in combination with silver and occasionally copper.

What is an Ore Deposit? This is an accumulation of Ore.

JORC? This is the Joint Ore Reserves Committee. The Code for Reporting of Mineral Resources and Ore Reserves (the JORC Code) is widely accepted as a standard for professional reporting purposes.

What is a Mineral “Resource” and what is an Ore “Reserve”? These terms are often incorrectly used interchangeably, the exact JORC definitions are below:

Figure 3. Resources versus Reserves (Source: JORC):

RESOURCE; “A CONCENTRATION OR OCCURRENCE OF MATERIAL OF INTRINSIC ECONOMIC INTEREST IN OR ON THE EARTH’S CRUST IN SUCH FORM, QUALITY AND QUANTITY THAT THERE ARE REASONABLE PROSPECTS FOR EVENTUAL ECONOMIC EXTRACTION. THE LOCATION, QUANTITY, GRADE, GEOLOGICAL CHARACTERISTICS AND CONTINUITY OF A MINERAL RESOURCE ARE KNOWN, ESTIMATED OR INTERPRETED FROM SPECIFIC GEOLOGICAL EVIDENCE AND KNOWLEDGE. MINERAL RESOURCES ARE SUB-DIVIDED, IN ORDER OF INCREASING GEOLOGICAL CONFIDENCE, INTO INFERRED, INDICATED AND MEASURED CATEGORIES.”
RESERVE; “THE ECONOMICALLY MINEABLE PART OF A MEASURED AND/OR INDICATED MINERAL RESOURCE. IT INCLUDES DILUTING MATERIALS AND ALLOWANCES FOR LOSSES, WHICH MAY OCCUR WHEN THE MATERIAL IS MINED. APPROPRIATE ASSESSMENTS AND STUDIES HAVE BEEN CARRIED OUT, AND INCLUDE CONSIDERATION OF AND MODIFICATION BY REALISTICALLY ASSUMED MINING, METALLURGICAL, ECONOMIC, MARKETING, LEGAL, ENVIRONMENTAL, SOCIAL AND GOVERNMENTAL FACTORS. THESE ASSESSMENTS DEMONSTRATE AT THE TIME OF REPORTING THAT EXTRACTION COULD REASONABLY BE JUSTIFIED. ORE RESERVES ARE SUB-DIVIDED IN ORDER OF INCREASING CONFIDENCE INTO PROBABLE ORE RESERVES AND PROVED ORE RESERVES.”

What is the difference between high and low-grade gold Resource? There aren’t any fixed definitions that I could find, but generally < 4.0 grams/tonne is low-grade, >8.0 grams/tonne is high-grade, and everything in between is about average. A large amount of low-grade gold could be just as profitable as having high-grade gold, as it could be cheaper and easier to mine the low-grade gold (for example low-grades in “open pit” or near surface mines, versus high-grades in “narrow vein” or deep underground mines).

Stages of mining: exploration, development, or production? Exploration involves primarily drilling activity in order to discover ore deposits and then define the Resource and Reserve levels, as well as feasibility studies, development involves primarily engineering / construction work, and production involves the mining, processing at the mill, and selling of the commodity.

Junior, mid-tier, or senior gold producers? Junior gold producers are generally considered as those producing under 200,000 ounces per annum of gold, seniors over 1,000,000 ounces, and the mid-tier producers in between.

What is a mining tenement? This is basically a license/permit granted by the Government to undertake exploration, development, and/or mining activities in a specific area.

What are royalties? Royalties are an expense that needs to be paid to the State Government in Australia for any minerals that are mined. In Western Australia for example, royalties are 2.5% of the value of gold produced.

What are cash costs? This is the operating cost required to produce one ounce of gold. Average worldwide cash costs are around US$620/ounce. Cash costs do not include capital expenditure. TOTAL cash costs include royalties.

What is hedging? Agreeing on the sale price of a certain volume of gold ahead of producing it, it is done to protect the company from the short-term volatility of the market gold price, but will reduce return when the price is rising.

Quick comparison of gold producing companies… First of all, make sure you compare similar companies, i.e. a junior producer with another junior producer, not a junior with a senior. Look at the total amount of resources they have, quoted in ounces, look at the cash costs, and look at how much ounces they have produced per year, and what level is expected in the future. Look for companies that are actively drilling to expand their resource base and find new ore deposits. A company may have one site producing gold, another being developed, and several others under exploration. This ensures that when Resources deplete at one site, there are other potential mines in the wings.

ANALYSIS: MEDUSA MINING LIMITED (ASX:MML)

MML is an un-hedged gold producer listed on the ASX and LSX and is currently operating in the Philippines.

Figure 4. MML’s Skaffold Line (Source: Skaffold 6th January 2012):

Looking at the figure above we can see that the share price has been on the climb since early 2009. The ACTUAL Intrinsic Value (which is based on analyst forecasts) has also followed suit since then, and has generally remained above market price. Market price reached a peak of $8.35 in September 2011 but has since been on a downward slope. More importantly though, the ACTUAL Intrinsic Value is expected to continue rising. In this instance however, the AVERAGE Intrinsic Value (a more conservative estimate), which is based on past performance with an emphasis on the last 3 years, is not expected to rise as strongly. As this value does not necessarily take into account all possible future events, what I need to find out is what future prospects the company has that could have contributed to the analyst’s forecasts. Another important thing to consider is why has the market price dropped almost 50% in just a few months? I’ll come back to this last point later…

Currently MML’s production is focussed on the Co-O mine in the Mindanoa Island area. A second potential gold production centre is under exploration at the Bananghilig deposit. MML currently have JORC code compliant mineral Resource of 21.3 million tonnes, at a grade of 9.6 grams/tonne (g/t) at Co-O and 1.3 g/t at Bananghilig, for a total of 2.6 million ounces (mOz). The company aims to keep Resource and Reserve levels at the Co-O mine stable year to year (by replacing whatever is used up each year), and in doing so avoid spending too much money on expanding this base to levels that will not get mined for several years. Exploration budget for 2012FY is US$27 million. Gold production for 2011FY was 101,474 ounces. Total cash costs for 2011FY were an extraordinarily low US$189/ounce (includes royalties). This could be due to the fact that mining is done predominantly via hand-held equipment, and labour costs are low. The site is also adjacent to a highway with close access to the port, and has grid power via hydropower.

Production for 2012FY was expected to be around 90,000 to 100,000 ounces. This will be ramped up to 200,000 ounces per annum by 2014FY after completion of the Co-O mine expansion. Exploration continues at Bananghilig, MML are targeting production of 200,000 per annum at this site by 2016FY. Near future expansion related capital expenditure will be funded from existing cash rather than through capital raisings and debt facilities, which is great and not surprising given their huge operating margins. Having said that, with regards to Bananghilig, no announcement has been made yet regarding whether feasibility studies are to take place, and whether this deposit will go into production phase at all. Further to this, based on current Reserves at Co-O, its mine life is only about 5 years. The risk here is if they are unable to continue replenishing the Resource and Reserve base over the coming years to extend the mine life further. However published analyst research reports are suggesting a possible mine life of over 25 years, indeed a similar mine south of Co-O (Diwalwal) has been mining for 20 years. There is also the risk of political/social instability in this country. MML is targeting 400,000 ounces per annum of production of gold by 2016FY.

Figure 5. Production timetable in ounces (Source: MML AGM Presentation November 2011):

ANALYSIS: SILVER LAKE RESOURCES (ASX:SLR)

SLR is also an un-hedged gold producer that currently operates in 2 key regions of Mount Monger and Murchison in Western Australia, approximately 50km south east of Kalgoorlie.

Figure 6. SLR’s Skaffold Line (Source: Skaffold 6th January 2012):

From the figure above what I can see is that the market price has generally been above the ACTUAL Intrinsic Value, although it appears that a great opportunity to buy would have been at the start of 2011. The ACTUAL Intrinsic Value has increased significantly since then, and looks like rising quite rapidly over the coming few years. Market price reached a peak of $3.87 in December 2011, and in fact SLR was one of the best performing stocks on the ASX for the year, significantly outperforming the S&P ASX 200 Index. However, the market price has since dipped down, and a buying opportunity has once again presented itself! The AVERAGE Intrinsic Value is also rising, but as with MML, the growth here is more conservative. Note that as these two lines become closer together, our confidence in the Intrinsic Value estimate is increased.

SLR currently has 24.1 million tonnes of JORC Resource at grades of 8.9 (g/t) at Mount Monger and 2.8 g/t at Murchison for a total of 3.3 mOz as at June 2011. The company is aiming to build the Resource base for 2012FY to 5 mOz. In the last 2 financial years, they have increased this Resource base by 1 mOz each year. This has been via an extensive drilling programme each year that is part of their long-term exploration budget ($18 million per annum). Total production of gold for 2011FY was 63,425 ounces. Total cash costs for 2011FY were US$674/ounce (includes royalties). The Mount Monger operations are targeting production of 100,000 to 110,000 ounces for 2012FY. The company expects to ramp up production here to 200,000 ounces per annum by 2014, with an expected mine life > 10 years. The Murchison operations will start production in Q3 2013FY, and is expected to produce 100,000 ounces per annum (from 2014FY) with an 8-10 year mine life. Mining at these locations is predominantly underground. Open pit productions have recently commenced at their Wombola Dam site. SLR has also recently reported high-grade copper discoveries at their Hollandaire site within the Eelya Complex that could provide added value. SLR is targeting 300,000 ounces per annum of production of gold by 2014FY.

Figure 7. Production timetable in ounces (Source: SLR AGM Presentation November 2011):

REVENUE, NET PROFIT, CASH FLOW, RETURN ON EQUITY:

Figures 8 & 9. Comparison of Annual Revenue & Reported Net Profit:

Revenue levels for both companies look excellent, but we can clearly see that MML’s net profit figures are significantly larger than SLR’s, and is a reflection of their low operating costs. But as with any business, we need to delve deeper and look at their overall cash flow. With an impending “credit crunch” in 2012, and a degree of caution in the market with equity investing, a healthy cash flow could be essential in order for junior companies to be able to confidently fund their exploration and development activities.

Figure 10. MML Skaffold Cash Flow (Source: Skaffold 30th December 2011):

Figure 11. SLR Skaffold Cash Flow (Source: Skaffold 30th December 2011):

Both companies have rising levels of cash flow from operations (blue line). MML has an overall funding surplus (green line) that is increasing, and has also managed to pay dividends for 2011FY. Whilst at SLR the overall funding surplus is decreasing, to the point that there is now a funding GAP. This suggests that they have used up more cash in investments and financing than they have received directly from their operations. According to Skaffold, money to account for this spending has come from shareholder equity raisings and increased debt or a reduction in the cash at bank (if there is any). Looking at the Skaffold Data Table sheds more light on recent cash movements for each company…

MML generated a net cash flow of $90 million from its operating activities for 2011FY. However, it also spent a net cash flow of $49 million on investment activities, as well as $18 million for dividend payments (un-franked, low payout ratio). Investment activities were predominantly capital expenditure related to exploration, evaluation, and development activities. Despite the large amount of cash flow invested outside operating activities, after taking into account foreign exchange effects and equity capital movements (add ~ $5 million total), the company was able to increase it’s Bank Account balance by $28 million dollars. This left a 2011FY balance of $58 million (UP from $30 million 2010FY). SLR generated a net cash flow of $33 million from its operating activities for 2011FY. It also spent a net cash flow of $46 million on investment activities, clearly more than it’s operating cash flow. This is once again predominantly capital expenditure related to exploration, evaluation, and development activities. Consequently, despite a rise in revenue, net profit, and operating cash flow, the company actually had a net decrease in its Bank Account balance of $13 million, which left the 2011FY balance at $16million (DOWN from $29 million 2010FY).

MML’s last capital raising was in February 2009 for $20 million, about 3 years ago now. SLR’s last capital raising was as recently as November 2011 for $70 million, this was to help develop their Murchison project and accelerate copper exploration activities. Prior to this it had conducted capital raisings of $19 million during 2010FY and $30 million during 2008FY. Although neither company has significant debt, I think this reiterates that MML is in a better cash flow position at this stage. It appears that continued capital raisings have been required by SLR to help meet ongoing investment demands, unfortunately this could dilute shareholder ownership. Even if capital raisings were issued at a price above equity per share, I would prefer if they were able to fund their investments predominantly from existing cash flow.

A LITTLE ABOUT CAPITAL EXPENDITURE:

As I learnt with these examples, gold mining companies spend a great deal of their retained earnings and cash flow on exploring for gold and developing new mines. These expenses do not go immediately into the Income Statement, instead you will see the total expenditure in the Balance Sheet, as an Asset! These companies may have exploration happening at multiple different sites at any one time, if drilling results prove unsatisfactory, or mining is deemed not technically or financially feasible, part of these expenses will be written-down, and will affect future reported Net Profit. Similarly, cumulative exploration and development expenses will become incurred or amortised only once the mine goes into production. All this capital expenditure is not yet generating any profit, yet it adds to the equity. So unless the company is generating sufficiently higher profits each year from the mines that are in production (e.g. by producing more ounces of gold, at a higher average price, or doing it more efficiently), the Return on Equity will decline. From looking at the annual reports, I noted that MML had listed capital expenditure of US$116 million for 2011FY, and SLR A$76 million. Cleary these are highly capital-intensive businesses, though at the very least it gives their competition a high barrier to entry.

RETURN ON EQUITY:

Figure 12. MML Skaffold Capital History (Source: Skaffold 6th January 2012):

Figure 13. SLR Skaffold Capital History (Source: Skaffold 6th January 2012):

The Skaffold Capital History for MML tells me that although its Net Profits (green line) are forecast to rise over from the next few years, the shareholder equity is expected to rise even more, and thus Return on Equity (blue line) is forecast to decline from 45% 2011FY to 33% in 2014FY. Although a Return on Equity of 33% is still excellent. On the other hand, SLR’s Return on Equity is forecast to rise from 19% 2011FY, and remain stable at around 36% until 2014FY. I suspect that a stable Return on Equity is difficult to achieve in this industry given that there are often several projects on the go at different stages, some generating profits and others not, but at the very least the overall returns must always be high.

FINAL COMMENTS:

What attracts me to MML are its high margins and excellent cash flow that should insulate it against any significant changes in the gold price. A number of things may have contributed to the fall in market price, macroeconomic factors aside. Certainly the market price plunge happened not long after a mining fatality in October 2011. This, along with increased development to prepare the Co-O mine for higher production has resulted in lower production guidance for 2012FY. There was also some weather damage from a tropical storm to parts of their mill in December 2011, the scope of the effect on production will be available in the December 2011 Quarterly. Regardless, these are abnormal once-off events that should not impact on the long-term prospects of the company. For me the key is whether the Bananghalig deposit has a large enough Resource base, and whether it will be mined, as this will determine whether MML can grow from a junior to a mid-tier producer.

The advantage that SLR offers is that it already has a second mine that has progressed further in the development phase, and will commence production earlier. Though there are two things that concern me at this stage. The first being the relatively high operating costs that make SLR far more sensitive to gold price volatility. And the second is the company’s cash flow, and in particular its requirement for capital raisings to fund exploration and development activities. Having said that, forecast EPS Growth is 217%, and I expect that this should improve cash flow over the coming few years. Further to this, as with MML, the management team appears to have significant experience behind it, and in SLR’s case I noted that all the Directors hold significant shareholdings in the company, each owning over 4 million fully paid ordinary shares each.

But is either of these companies truly extraordinary? What does this mean? Well Chapter 5 in Value.able tells me that in an extraordinary business I must find the following factors; Bright long-term prospects, high Return on Equity driven by sustainable competitive advantage, solid cash flow, little or no debt, and first-class management. I think that MML comes closest to meeting all these factors, but others might disagree. The key factor for me is having a sustainable competitive advantage. In the Co-O mine they are sitting on a Resource that could last over 25 years, is extraordinarily low in operating cost, and could generate an enormous amount of cash that could easily fund future expansions, and perhaps even acquisitions. In a business that can be highly capital-intensive, the ability to fund exploration and development with cash flow rather than capital raisings and debt is a great advantage. The question mark of course is how sustainable this will be. And of course, I am no Geologist! What I do know is that this is a fundamentally healthy and profitable business, and despite this, the market is significantly undervaluing it. If I were to invest in this business, I would need to accept that there is level of risk involved, but by buying it at a significant margin of safety, and allocating such an investment in a reasonable manner within my portfolio, I think this risk could be significantly reduced.

POD’s (points of discussion):

1. Has gold’s bull run come to an end, or will it rise to new highs?
2. In your opinion, do MML or SLR have any sustainable competitive advantage?
3. What are the benefits/risks of mining in the Philippines versus Australia?

Since writing this post there have been a number of key announcements made by each company. Their share price’s and safety margins have also changed. Most notably, MML has now downgraded its 2012FY production guidance to 75,000 ounces, citing delays due to effects of tropical storms and torrential rain in December 2011 and January 2012. Also, SLR has announced a the acquisition of Phillips River Mining.

LINKS:

Skaffold
www.skaffold.com

World Gold Council
www.gold.org

JORC
www.jorc.org

DISCLOSURE:

I do not hold any shares in any of the companies mentioned in this blog post.

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

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We have been delighted with the reports coming out from the smaller industrial companies and note again the growing divergence in the performance of the XJO versus the XNJ (ASX 200 versus All Industrials). We attribute this to a declining enthusiasm for the ‘resource story’ and the fact that many of the industrial companies we like (and own, including MTU) are producing such fantastic results despite evidence of a terrible domestic economic backdrop.

Headline revenue was down 14% as a result of the reduction of unprofitable EDirect business activity.  Thats good.  Underlying revenue (excluding the zero margin Edirect business) rose 8% and the dividend was up 29%. Business cash flow was $17.5mln compared to reported profit of $16.7mln.   The impact on valuations should be positive again but ultimately will be determined by the returns generated on the $21.8mln paid for the two acquisitions made in the current half.

Since 2003 (the year before MTU listed) the company has increased profits by more than 91% per annum and is forecast to grow profits again to $36 mln in 2012.  To generate the increase in profits (of $27mln to 2011) $60 million has been raised and $30 million borrowed.  The return on incremental equity is about 50% suggesting the acquisitions made thus far have reflected an astute allocation of capital.  We’ll be keeping an eye on the debt but reckon a recovery in the local economy (as interest rates are lowered and hopefully passed on by the banks) will give MTU another boost.

According to one of our brokers who has a buy recommendation on the stock, the following stocks are at risk of reducing their dividends:  Examining for factors…”forecast earnings revisions, payout ratios, stock price stability and free operating cashflows, the companies that are most at risk of further dividend cuts are SWM, GWA, TTS, HVN, QBE and MYR. Those that have reduced dividends but continue to pose a risk include BBG, CSR, DJS, GFF, HIL, MQG, OST, PPT, PBG, PTM, TAH, and TEN.”

Not a recommendation of course. Seek and take personal professional advice before engaging in ANY securities transactions.

Posted by Roger Montgomery, Value.able author, Skaffold Chairman and Fund Manager, 27 February 2012.

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

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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.

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In his ASX Investor Hour presentation of 21 February 2012, Roger argues that whether you invest on the basis of fundamentals or technical analysis, your buying and selling decisions should always be made in the light of your valuation of the company. Roger explains the factors he takes into account in assessing the value of companies, the systems he uses to do those valuations and talks about some of the companies that he currently regards as good value.  Watch video here and view the slides here.

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On one side of the investing coin is the idea that you lay out money today to get more back later. The flipside is that buy purchasing today you forego consumption today for the ability to consume more later.

They aren’t quite the same thing of course, because the latter idea introduces inflation and suggests the purpose of investing is to at least maintain purchasing power (generate returns in line with inflation) or increase purchasing power (generate real returns in excess of inflation).  In a useful reminder Buffett observes:

“Even in the U.S., where the wish for a stable currency is strong, the dollar has fallen a staggering 86% in value since 1965, when I took over management of Berkshire. It takes no less than $7 today to buy what $1 did at that time. Consequently, a tax-free institution would have needed 4.3% interest annually from bond investments over that period to simply maintain its purchasing power. Its managers would have been kidding themselves if they thought of any portion of that interest as “income.””

Therefore an investment that is price stable but loses purchasing power is very risky (think US T-Bonds) while an asset that is volatile in price but almost certain to increase purchasing power over time is less risky than the conventional measures of risk would dictate.

This is how Buffett begins an excerpt of his forthcoming letter to Berkshire Hathaway shareholders HERE. One scenario his introduction does not contemplate of course is deflation. Japanese real estate and equity prices are fractions of their previous levels and a bond offering even a miniscule return would produce an increase in purchasing power. Like many readers, you might reach the conclusion that the absence of this scenario in his letter along with the knowledge of aggressive equity purchases in recent months, indicates he does not believe deflation is a possibility.

The other subject of his letter is Gold. Melted down all the gold in the world would amount to one 68 cubed foot of uselessness. Somewhat ironically he reflects on its purchasing power today – all the agricultural land in the United States, sixteen companies as valuable as Exxon and a trillion dollars in walking-around money.

But he points out that the companies will have thrown off dividends and the land would have produced food. And so the article leads to the defence of buying businesses as a superior strategy (to owning gold ‘that just sits there’) – as we believe at Montgomery Investment Management, and you might as Value.able graduates (after seeking and taking personal professional advice).

I believe Buffett’s take on the investing landscape is ultimately correct (bubbles are always followed by a bust and nothing goes up forever);

“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.”

But I trust you can see the irony in claiming gold is useless and yet it can buy 16 Exxons and so on. As the chart shows, it has underperformed stocks over the long term and without boasting about it Buffett uses the S&P500 index to demonstrate the superiority of stocks. In a thinly veiled warning to gold bugs he likens the current enthusiasm for gold to the internet bubble and US housing speculation pre-2007.

In his enthusiasm for stocks being best able to retain purchasing power or increase it, I can’t but help remembering that Buffett was a more circumspect proponent of stocks in the seventies – a period of very high inflation. While in 1974, when Forbes asked Buffett how he felt about the stock market at the time, Buffett replied, “Like an oversexed guy in a whorehouse”, his 1979 letter to investors serves as a useful reminder of the limits of any asset to retain purchasing power during bouts of high inflation.

“Just as the original 3% savings bond, a 5% passbook savings account or an 8% U.S. Treasury Note have, in turn, been transformed by inflation into financial instruments that chew up, rather than enhance, purchasing power over their investment lives, a business earning 20% on capital can produce a negative

real return for its owners under inflationary conditions not much more severe than presently prevail.

If we should continue to achieve a 20% compounded gain – not an easy or certain result by any means – and this gain is translated into a corresponding increase in the market value of Berkshire Hathaway stock as it has been over the last fifteen years, your after-tax purchasing power gain is likely to be very close to zero at a 14% inflation rate. Most of the remaining six percentage points will go for income tax any time you wish to convert your twenty percentage points of nominal annual gain into cash.

That combination – the inflation rate plus the percentage of capital that must be paid by the owner to transfer into his own pocket the annual earnings achieved by the business (i.e., ordinary income tax on dividends and capital gains tax on retained earnings) – can be thought of as an “investor’s misery index”. When this index exceeds the rate of return earned on equity by the business, the investor’s purchasing power (real capital) shrinks even though he consumes nothing at all. We have no corporate solution to this problem; high inflation rates will not help us earn higher rates of return on equity.”

Another warning to stick to high ROE businesses…

Finally remember that if you are buying stocks, unlike commodities, there exists management risk, execution risk, result risk, competitor risk, economic risk, currency risk etc. Anything can go wrong in a business and frequently does. And while Chalrie Munger has pointed out that “Almost all good businesses engage in ‘pain today, gain tomorrow’ activities”, you must know what you are doing.

I think stocks are indeed the best opportunity to retain and increase purchasing power but only the good quality ones.  Knowing what you are doing and sticking to high rates of return on equity, little or no debt and A1 or A2 businesses increases your chances of doing even better than the both the stock market index of which they are constituents and inflation.

Posted by Roger Montgomery, Value.able and Skaffoldauthor and Fund Manager, 14 February 2012.

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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.

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It’s been a lackluster start to this year’s company confession session. Only a few companies have so far bucked the stable / downward trend in revenues and profits.

At the top of this list, reporting what I would consider to be quality results are CCP (SQR A2) – so far the clear standout and a business we own in the Montgomery Private Fund. This is followed by WEB (SQR A2) a business whose Total Transaction Value (TTV) is growing at rates 4x the industry average but is a little expensive in terms of its future prospects for now.

And that’s about it at the quality end of the investment spectrum (with the exception of Breville, Forge and Decmil’s updates). Remember that we rate every single listed company from A1 (the best) to C5 (the worst) so we follow them all. If you want to find opportunities such as CCP before everyone else, take a look at Skaffold.com

There have been a number of other businesses which have reported so far and on face value, while LGD (SQR B2) experienced strong revenue and profit growth; a large proportion of its growth was driven by several recent acquisitions. Organic growth is less than 50% of that being reported currently; something to watch in future reporting seasons.

Now to our friends long Telstra:

(SQR B3) the half year was a little sobering for those who have bought the stock for its dividend yield. Whilst reported Free Cash Flow was $1,795b and dividends paid amounted to $1,738b, one would assume the yield was fully covered. Not so. The free Cash number reported did not include $559m in interest repayments on almost $15b debt. $500m additional debt was borrowed to fund dividends and CAPEX – debt to equity thus increased and is currently 104%. While dividends are being paid, and will probably continue being paid, its just worth noting how they are being funded…

Over at the Big Australian – BHP:

Staying at the big end of town and global diversified mineral and petroleum producer BHP (SQR B1) reported a HY NPAT $9.9b NPAT down on last year’s. The lower results was despite very attractive Iron Ore, Bulks and Petroleum margins – prices which declined in the latter part of 2012 and which may impact profits further in the 2nd half.  The acquisition of Petrohawk for $13b (which pushed gearing to 34%) contributed to earnings but couldnt arrest the decline. Industry-wide cost pressures with consumable, labour and contractor costs added $400m to cost inflation! On a more positive note, the project pipeline of $27b and $5b in actual committed projects. In the half total CAPEX (investment) projects + exploration spend was $9b – this continues to support EPC / EPCM engineers, drillers, mud suppliers (Decmil, Forge, Maca, Fleetwood et. al.) which are all operating at full capacity and expanding like there is no tomorrow. However for BHP investors, because the company continuously has to invest in greenfield projects to offset natural production decline, this results in a capital intensive investment program – something investors in BHP 20 years ago might be acutely aware of. Although they have long-life, world class assets and significant cash flows that are able to meet the demands currently, over the past three months profits have been downgraded from circa $25b to circa $19b. Indicative of an economic slowdown and slowing demand for resources. So something to be watchful of is the fact that declining profits = declining cashflows = declining future investment. Albeit the investment future and plans looks like its all boom time right now.

Posted by Russell Muldoon per Montgomery Investment Management, Value.able and Skaffoldauthor and Fund Manager, 9 February 2012.

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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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US jobs data was stronger than expected and resulted in global equity markets following the US reaction higher.  But is all as it seems?

The increase in jobs was 243,000 but 490,000 were said to be temporary jobs.  The employment number is now the same as a decade ago but a decade ago there were 30 million fewer people living in the US!

Charles Biderman notes that “Either there is something massively changed in the income tax collection world, or there is something very, very suspicious about today’s BLS hugely positive number,” adding, “Actual jobs, not seasonally adjusted, are down 2.9 million over the past two months. It is only after seasonal adjustments – made at the sole discretion of the Bureau of Labor Statistics economists – that 2.9 million fewer jobs gets translated into 446,000 new seasonally adjusted jobs.” A 3.3 million “adjustment” solely at the discretion of the BLS? And this from the agency that just admitted it was underestimating the so very critical labor participation rate over the past year? Perhaps with a hint of conspiracy theorist (all hints of which we run from as fast as possible) Biderman wonders whether the BLS is being pressured by the Obama administration during an election year to paint an overly optimistic picture. Hmmmmm…

For those of you who have seen the amazing Abbott and Costello skit ‘Who’s on first’, here’s another take on it:

COSTELLO: I want to talk about the unemployment rate in America.

ABBOTT: Good Subject. Terrible Times. It’s 8.3%.
COSTELLO: That many people are out of work?
ABBOTT: No, that’s 16%.
COSTELLO: You just said 8.3%.
ABBOTT: 8.3% Unemployed.
COSTELLO: Right 8.3% out of work.
ABBOTT: No, that’s 16%.
COSTELLO: Okay, so it’s 16% unemployed.
ABBOTT: No, that’s 8.3%…
COSTELLO: WAIT A MINUTE. Is it 8.3% or 16%?
ABBOTT: 8.3% are unemployed. 16% are out of work.
COSTELLO: IF you are out of work you are unemployed.
ABBOTT: No, you can’t count the “Out of Work” as the unemployed. You have to look for work to be unemployed.
COSTELLO: BUT THEY ARE OUT OF WORK!!!
ABBOTT: No, you miss my point.
COSTELLO: What point?
ABBOTT: Someone who doesn’t look for work, can’t be counted with those who look for work. It wouldn’t be fair.
COSTELLO: To who?
ABBOTT: The unemployed.
COSTELLO: But they are ALL out of work.
ABBOTT: No, the unemployed are actively looking for work… Those who are out of work stopped looking.
They gave up and if you give up, you are no longer in the ranks of the unemployed.
COSTELLO: So if you’re off the unemployment rolls, that would count as less unemployment?
ABBOTT: Unemployment would go down. Absolutely!
COSTELLO: The unemployment just goes down because you don’t look for work?
ABBOTT: Absolutely it goes down. That’s how you get to 8.3%. Otherwise it would be 16%. You don’t want to read about 16% unemployment do ya?
COSTELLO: That would be frightening.
ABBOTT: Absolutely.
COSTELLO: Wait, I got a question for you. That means there are two ways to bring down the unemployment number?
ABBOTT: Two ways is correct.
COSTELLO: Unemployment can go down if someone gets a job?
ABBOTT: Correct.
COSTELLO: And unemployment can also go down if you stop looking for a job?
ABBOTT: Bingo.
COSTELLO: So there are two ways to bring unemployment down, and the easier of the two is to just stop looking for work.
ABBOTT: Now you’re thinking like an economist.
COSTELLO: I don’t even know what the I just said!

While we are not waiting around for the swallows to sing – then spring will be over – we are buying stocks in a slow and measured way.  We haven’t added any new stocks to our portfolio so we are adding to existing holdings.

In Australia, the situation may not be much better.  Last year here at the blog we discussed the impending job losses at banks, manufacturers and retailers and all of that appears to be rolling along as predicted.  But as my friend Bob Gottliebsen noted today; “At the weekend, Roy Morgan Research reported a big jump in unemployment during January.  Almost certainly that will be reflected in the official figures when they are released later this month. Morgan uses a different method to calculate unemployment to the statisticians and Morgan’s December unemployment was 8.6 per cent, compared with the statisticians’ 5.2 per cent. But now Morgan estimates that January unemployment has skyrocketed from 8.6 to 10.3 per cent – the highest level since Morgan began calculating unemployment.”

“There is no doubt there are seasonal issues as those leaving tertiary education try to join the labour force. They are usually not employed until February or later months. A rise of the proportion shown by Morgan reflects much greater forces than seasonal influences and in 2012 it will be much harder for students to gain employment than in 2011.”

What does it all mean for value investors – remember, we are not economists and macro economics is not part of the value.able bottom-up approach to investing?   The implications are that we should be seeking deeper discounts to intrinsic value estimates and those estimates could decline further.

Given Skaffold (click here to Join) is currently suggesting the ASX200 is not cheap, we tend to be cautious even though my learned peers are betting with the world’s central banks that their printing of money and associated reduction in interest rates will force the world out of being defensively cash weighted and into equities and commodities.

We reckon gold makes sense in these times of destabilised fiat money.  As you know we own a number of gold stocks (some of which have returned nearly 100%) and I bought more gold (physical) before Christmas.

Here is the latest chart of the ASX200 plotted against Skaffold’s estimates of intrinsic value.  You can see that the market is trading a little higher than the estimated intrinsic value for the index.  That doesn’t mean it can’t go a lot higher, just that if you are a genuine bargain hunter, you may need to be patient.  In light of the unemployment situation noted above and the painfully strong Australian dollar, that makes sense.

In addition to the powerful benefit of such a chart as the ASX 200 Skaffold line, which by the way, is automatically keeping you up-to-date daily for changes in analysts estimates of earnings and dividends for each of the 200 indices’ constituents, Skaffold members will enjoy an unprecedented level of interactivity in upcoming updates.  By the way, I trust you are enjoying the enhanced search functionality the team delivered last week.

My team noted a few wanna-be competitors trying to plagiarise little aspects of Skaffold recently and I explained that they and you should “be flattered” and I told the team; “if you can see the competition, you aren’t at the front of the race”.  Concentrate on staying in front by looking ahead and not at those trying to catch up.  They respect Skaffold members too much to insult them by delivering second-hand ideas or technology. Skaffold keeps you in front with world beating ideas – remember the team that works on Skaffold works for Nike, Porsche, EA Games and Google.  What possible hope do the competitors have?  We’ve retained one of the world’s decorated design and development teams so Skaffold is.

Posted by Roger Montgomery, Value.able and Skaffold author and Fund Manager, 6 February 2012.

by Roger Montgomery Posted in Insightful Insights, Market Valuation, Skaffold.

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Unless you live under a waterfall in the rainforests of South America, you will have heard that Facebook has lodged its S-1 (Prospectus) for a probably May 2012 IPO.  Skaffold members can look forward to Facebook being available to view in Skaffold when the team loads up all the international stocks.

To become a Skaffold member today and discover how we have been investing click here

Back to our regular programming…

Hyped by the media around the world as the biggest internet IPO in history and asked whether we would ‘invest’ in Facebook, we note the following:

The company already has 500 shareholders and would have been required by the SEC to lodge financials in April.

Facebook Stock Code: FB

Maximum aggregate offering price: $5Bn

as yet, there is not sufficient valuation information listed in the S-1 filing with the SEC nor how many shares are being offered.

According to the S-1 cover:

845 million monthly active users (MAU)

483 million daily active users (DAU)

Users generated on average 2.7 billion Likes and Comments per day in Q4 2011.

100 billion friendships

250 million photos uploaded per day

Our observation:  Not a mention of any dollars yet! “likes”, “friends” and ‘uploaded photos’ are today what ‘page impressions’ and ‘visitors’ where in the tech boom of 1999/2000.

FB generated $3.7 billion in Revenue in 2011, up from $2 billion in 2010.  12 percent of Facebook’s revenue in 2011 was linked to its relationship with online gaming giant Zynga.

FB generated $1 billion in net income in 2011, up from $606 billion in 2010, a 40% growth rate, compared to the 165% growth rate from 2009’s $229m.

EBIT margin peaked at 52.3% in 2010 ($1m in EBIT on $2 billion in revenue), has since declined to 47.3% or $1.756Bn on $3.711Bn in Revenue, still incredible.

$3.9 billion in cash and marketable securities

Western world user growth is slowing but thats the law of large numbers.  Facebook says: “We believe that our rates of user and revenue growth will decline over time. For example, our annual revenue grew 154% from 2009 to 2010 and 88% from 2010 to 2011.  Historically, our user growth has been a primary driver of growth in our revenue. Our user growth and revenue growth rates will inevitably slow as we achieve higher market penetration rates, as our revenue increases to higher levels, and as we experience increased competition.”

The company still reported +60% earnings growth rates in 2011.  The key is whether users stay and whether they can be ‘monetized’ further. MAU additions peaked in 2010 when FB added 248m to a total of 608m; in 2011 it added 237MM to 845m.

On the subject of dividends FB says:  “We do not intend to pay dividends for the foreseeable future. We have never declared or paid cash dividends on our capital stock. We currently intend to retain any future earnings to finance the operation and expansion of our business, and we do not expect to declare or pay any dividends in the foreseeable future. As a result, you may only receive a return on your investment in our Class A common stock if the market price of our Class A common stock increases. In addition, our credit facility contains restrictions on our ability to pay dividends.”

Here’s access to the S-1: http://www.sec.gov/Archives/edgar/data/1326801/000119312512034517/d287954ds1.htm

The map of the world connected by facebook users is intriguing.  What are those pirates on the west coats of Africa doing on Facebook?

I have previously written about the forthcoming floats of internet and social media sites here: http://rogermontgomery.com/which-ipos-are-you-watching/

‘Paradigm changers’ (remember Yahoo?) have come and gone so it is essential you don’t get caught up in the hype and instead stick to the valuation approach that is the bedrock of our approach.  If you don’t know it, buy a copy of Value.able today for just $49.95.  Or to save yourself reading the last ten annual reports for every listed company, try Skaffold.

There were eight large and highly media-promoted IPOs in the last year or two (GRPN, ZNGA, LNKD, P, YOKU, DANG, AWAY, and FFN).  One analyst reported that if you could get stock in the IPO (forget it if you weren’t a major client of the lead broker or a ‘friend’ of the company) there was an average gain of 50%.  If you bought each IPO in the market on Day 1 you now have an average loss of 54% with incredibly only 1 of the 8 names (ZNGA) still holding on to gains (+11%) thanks to a rally of 15% in the last week.

We would like to go through the numbers for Facebook today and try to come up with a valuation for you.  You can do it yourself if you have a copy of Value.able.

There’s about $5.2 billion in equity, including $1bln of retained earnings.  There’s 4.1bln Class A shares and the same number of class B’s.  The preferred’s will be converted and only Class A’s sold.  We cannot calculate equity per share because the S-1 does not disclose how many shares will be issued.  ROE is about 26 per cent.  No dividends will be paid. The company states in its S-1 that it will continue to grow by acquisition as well as organically.  But the company will takeover Earth if it continues to retain profits and generates 26% returns on the incremental equity.  Assuming earnings grow at 40% and faster than the rate of return on equity, then you can expect ROE to rise.  Using these favourable metrics we reckon Facebook is worth $26-$28bln in 2012 rising to $57-$63bln in 2014.  If the IPO ‘values’ the company at $100bln as many media outlets suggest, watch out.

This paragraph from the S-1 is important:

“If you purchase shares of our Class A common stock in our initial public offering, you will experience substantial and immediate dilution.

If you purchase shares of our Class A common stock in our initial public offering, you will experience substantial and immediate dilution in the pro forma net tangible book value per share of $         per share as of December 31, 2011, based on an assumed initial public offering price of our Class A common stock of $         per share, the midpoint of the price range on the cover page of this prospectus, because the price that you pay will be substantially greater than the pro forma net tangible book value per share of the Class A common stock that you acquire. This dilution is due in large part to the fact that our earlier investors paid substantially less than the initial public offering price when they purchased their shares of our capital stock. You will experience additional dilution upon exercise of options to purchase common stock under our equity incentive plans, upon vesting of RSUs, if we issue restricted stock to our employees under our equity incentive plans, or if we otherwise issue additional shares of our common stock. For more information, see “Dilution”.

Note the blanks, which makes FB impossible to value on a per share basis, yet.

We’ll have to wait until the final days of the capital raising before we can come up with a firm valuation on a per share basis but for now, the circa $27bln valuation stands.

Posted by Roger Montgomery, Value.able and Skaffold author and Fund Manager, 2 February 2012.

by Roger Montgomery Posted in Companies, Insightful Insights, Investing Education, Value.able.

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