Insightful Insights

Did you receive my email update earlier this month about the complexity of the gold coin on Value.able’s dust jacket?

Take a look to the left. See the One Dollar coin on the cover? I never imagined a little gold coin could cause so many headaches.

Some of you have told me to ‘forget the gold – its what is inside that counts’. I agree with you. However I went to a lot of trouble to get permission from the Royal Australian Mint to use the coin, so I don’t want to give it away.

I have also agreed to a production process with the printer that, at this late stage, I cannot change.

Whilst we are adept at digging gold out of the ground, refining it, looking at it and sticking it back underground again, replicating Australia’s One Dollar coin on the cover of my book has proved to be a far more difficult challenge.

Here is what my printer emailed to me last week…

“The foil on the green case won’t have the black printing over the foil. The coins have been made black and the image will be suitable for foiling. This method is the quickest way of producing the books. [however] Given the complex nature of the gold coin on the jackets and case cover with several runs through the press, we have to allow drying time to achieve the desired result.

If you have a hard back book in your collection take a look and you will see what I am alluding to.”

So I did. I looked at every hard back in my collection and wasn’t able to find one with a picture printed on it. When I briefed the designers I asked for something unconventional. I didn’t realise what they created for me had never been done before!

Your book will arrive in the week commencing 2 August.

Thank you for your patience and understanding. I am confident Value.able will become a valuable addition to your investment education and am looking forward to hearing what you think of it after you have read it.

Posted by Roger Montgomery, 13 July 2010.

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

• 39 Comments
• save this article
• POSTED IN Companies, Insightful Insights, Investing Education

Peter Switzer invites me every Thursday fortnight to join him on the Sky Business Channel. 4 June was like any other show. Except once Peter and I had finished discussing investing and stocks and the market, he invited me to stay on for his interview with OrotonGroup CEO Sally Macdonald.

For readers of my blog, you will know that Oroton is one of my A1 businesses. And I have often said that Sally Macdonald is a first-class manager.

Below are the highlights from that interview.

Each time a new video is uploaded to my YouTube channel I post a note at my Facebook page. On Facebook will also find my upcoming talks, editorial features, TV interviews, radio spots and the latest news about Value.able.

If you are yet to pick up the latest issue of Money magazine find it at the newsstand now, there are a bunch of terrific columns. Click here to read my monthly column. This month I write about ‘Great Retail Stocks’.

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

• 23 Comments
• save this article
• POSTED IN Companies, Consumer discretionary, Insightful Insights, Investing Education

I am keen to explore this topic with you. You may need a little patience. Its about charting and technical analysis, so read on.

I am reading a book that was recently gifted to me by a very well-known and highly-regarded private equity investor. If you know him, chances are he has given you a copy of it too. To say he became animated when he gave it to me is to understate just how profound he believes the contents of this book is.

I haven’t been able to put it down (partly because its worthy of careful study, but mostly because when I do, its bright yellow cover has become a magnet for a child’s curious but sauce-soaked hands and every other manner of foreign contaminant). The book is called The (mis)behaviour of markets and its by Benoit Mandelbroit.

To some this name will be familiar, but to many, if not most, his name will be new. He is the Sterling Professor Emeritus of Mathematical Sciences at Yale University and a Fellow Emeritus at IBM’s Thomson J. Watson Laboratory. He has received the Wolf Prize in Physics, the Japan Prize in Science and Technology, awards from the National Academy of Sciences in the US and the IEEE (look it up). But he is best known for being the inventor of fractal geometry and is arguably the 20th century’s most celebrated mathematician.

Don’t be afraid. The book is the Popular Science or Popular Mechanic version of his work. Its easy to read, if you have an interest.

Having a passion for and grasp of valuation theory, and of course no shortage of views of my own, I was keenly interested in Medelbroit’s dissection of the history of modern finance and its foundations having been set in the work of Pascal & Fermet’s work for aristocratic gamblers in the 1600s; then (Henri Poincare’s doctoral student) Bachelier’s application of probability theory to the frowned-upon business of trading in French Bonds in 1900 and his research Theorie de la Speculation. Then on through Benoit Medelbrot’s own PHD student Eugene Fama’s translation and expansion of the theoretical framework in what would become known as the Efficient Market Theory. Bechalier’s work has also been the basis of work by Markowitz (Modern Portfolio Theory) and Sharpe (CAPM).

I am interested in this dissection because Bechalier’s main assumptions that 1) price changes are independent (thinking tossing a coin) and 2) are normally distrubuted (the convenient but incorrect observation that there are lots of small positive and negative changes in price and very few big positive or negative changes in price) dominates Wall Street (read global stock markets) and are the basis of measuring the riskiness of stocks and of modern techniques for portfolio construction. These things are still taught at graduate school, and as a friend who is sitting them tells me, the CFA exam is replete with the stuff.

But that is my interest.

I suspect your interest may be found very early in the book on pages 8 and 9. Here is an excerpt from Mandelbrot’s own pen:

“…”Because” is the key word here: The price of a stock, bond, derivative or currency moves “because” of some event or fact that more often than not comes from outside the market. World wheat prices rise because a heat wave desiccates Kansas or Ukraine. The dollar sinks because talk of war raises oil prices. This is all common sense. Financial newspapers thrive on it; they sell newspapers and rank all the “becauses.” Financial firms make an industry of it; they employ thousands of fundamental analysts, classified by genus into macroeconomic and sectoral, “top-down” and “bottom up.”  … The implicit assumption in all this: If one knows the cause, one can forecast the event and manage the risk.

Would it were so simple. In the real wold, causes are usually obscure…unknown or unknowable…it can be concealed or misrepresented…And it can be misunderstood. The precise market mechanism that links news to price, cause to effect, is mysterious and seems inconsistent. Threat of war: Dollar falls.  Threat of war: Dollar rises. Which of the two will actually happen? After the fact, it seems obvious; in hindsight fundamental analysis can be reconstituted and is always brilliant. But before the fact, both outcomes may seem equally likely…

In response, the financial industry has developed other tools. The second-oldest form of analysis, after fundamental, is “technical.” This is a craft of recognising patterns, real or spurious – of studying reams of price, volume and indicator charts in search of clues to buy or sell. The language of the “chartist” is rich: head and shoulders, flags and pennants, triangles (symmetrical, ascending, or descending). The discipline, in disfavour during the 1980s, expanded in the 1990s as thousands of neophytes took to the Internet to trade stocks and insights. It truly thrives, however, in currency markets… And in the fun-house mirror logic of markets, the chartists can at times be correct. Sterling/dollar quotes really can approach a level advertised by the technical analyst, and then pull back as if hitting a wall – or accelerate as if bursting through a barrier. But this is a confidence trick: Everybody knows that everybody else knows about the support points, so they place their bets accordingly. It beggars belief that vast sums can change hands on the basis of such financial astrology…”

So what is your opinion or experience? Has charting worked for you or do you agree with Mandelbroit? As you know, I don’t personally use charts and while it might be challenging to argue with the  Sterling Professor Emeritus of Mathematical Sciences at Yale University, I am interested in hearing from you if you have found charting singularly responsible for substantial profits. It will also be valuable to hear any stories from those whose experiences have agreed with Mandelbroit’s conclusions.Feel free to be as detailed as you like, but if you have read books or attended courses I would prefer you refrain from naming the authors or presenters.

So what are your thoughts?  If you have never written before, this could be the topic that has you posting a reply to a blog for the first time. Click Leave a Comment below and start sharing your thoughts.

Posted by Roger Montgomery, 1 July 2010

by Roger Montgomery Posted in Insightful Insights.

• 169 Comments
• save this article
• POSTED IN Insightful Insights

Value.able can now be pre-purchased online at my website, www.rogermontgomery.com. My book is on the printing press and will be delivered in about 21 days.

There will only be one print run.

In Value.able I share my stock investing rules for long-term value investing and online trading that you can follow to reproduce my excellent stock market returns (have a look at the June issue of Money magazine).

Click here to pre-purchase your copy today.

Posted by Roger Montgomery, 30 June 2010.

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

• 3 Comments
• save this article
• POSTED IN Companies, Insightful Insights, Investing Education

Keep an eye out for my email to you tomorrow.

If you have pre-registered for a copy(s) of Value.able, I will be sending you a special link to purchase your reserved copy(s) before it is released to the general public next week.

The price of $49.95 includes GST and postage anywhere in Australia (allow 21 days) and you can probably claim a tax deduction, although you may want to check.

I have enjoyed writing Value.able for you immensely. I trust you will find it just as enjoyable and easy to read and I look forward to hearing your thoughts after you have read it.

Posted by Roger Montgomery, 21 June 2010.

by Roger Montgomery Posted in Insightful Insights, Investing Education.

• 20 Comments
• save this article
• POSTED IN Insightful Insights, Investing Education

In March this year I shared my insights about QBE with readers of Alan’s Eureka Report. Since that time QBE’s share price has fallen from over $22.00 to $19.00 – a decline of around 15%. That may explain why I have received a few requests asking for an updated estimate for QBE’s value?

If you take your cues from price action, you would probably conclude something might be wrong with the company.

Open up a newspaper, flick on the TV, or do both on your new iPad and you will be overwhelmed with the events in the US, the debacle that is the Euro zone, and BP’s oil spill – one of man’s greatest catastrophes.

With 40% of gross written premiums being derived in the US and a further 40% from London and Europe, it is likely QBE is exposed, somewhere.

Even at home the company appears to be right in the firing line of the Lennox Head twister, Victoria’s bushfires and recent floods.

It’s not all bad news though – the declining Australian Dollar ensures QBE’s overseas earnings are now worth more.

So is there something wrong at QBE? Or is the market just reacting to bad news? Buffett says you pay a high price for a cheery consensus, so maybe bad news is just what’s needed to make QBE attractively priced…

You have to remember that QBE is in the business of forecasting and betting against bad news – it exists to manage risk and spread it around when there is too much for it to shoulder alone. And given its successful decade-long track record of doing so, I can strongly argue that it performs this activity significantly better than many, if not most, of the other insurers listed on the ASX.

Things that you and I perceive as negatives are usually positives for insurance companies. Think of the last time you had to make an insurance claim. Did your premium rise the next time you chased around for a better price?

In March this year a sensible price to pay for QBE was $19.83. Now a sensible price is $19.92. So even with all the negative news and natural disasters, the only thing that appears to have changed is the market price.

The truth is that the business operations that make up QBE’s brand have been moving much slower than its share price would suggest, and the rising valuation suggests things are believed to be improving.

While the price was well above the estimated valuation three months ago, I couldn’t have predicted the share price would fall below it.

I did say that “With a gun to my head and forced to make a decision, I would bet with Frank O’Halloran at QBE every time”. That remains the case today.

I do get excited when the market, in its wisdom, decides that it temporarily dislikes great businesses. The result is a fall in the share price. Who doesn’t like to buy more of a good thing for less? The price however may not have declined far enough to provide the sort of Margin of Safety Ben Graham said should be required in Chapter 20 of his Intelligent Investor – arguably one of the two most important teachings in investment history.

There are a bunch of insurance businesses listed on the ASX. Some are pure insurers and some have insurance divisions within the business. I am interested to hear what you think of any of them. Have you had to deal with them and have you had a good or not so good experience? Do you work in the industry? Can you shed some light on who you think is the best and why? Share your thoughts by clicking Leave a Comment below.  AND REMEMBER – YOU MUST OBTAIN PERSONAL PROFESSIONAL ADVICE BEFORE CONDUCTING ANY TRANSACTION OF ANY KIND IN ANY SECURITY IN THE MARKET.

Posted by Roger Montgomery, 11 June 2010.

by Roger Montgomery Posted in Companies, Insightful Insights, Insurance.

• 36 Comments
• save this article
• POSTED IN Companies, Insightful Insights, Insurance

I have discovered through the book publishing process that being a perfectionist is costly. I have also discovered that being reasonably adept at investing does not make one even remotely adept at being the foreman of a book publishing project.

I pulled the book out of the jaws of the printer when a few typos were spotted. Correcting the text of course threw the alignment out so it was back to the typesetters. The typesetters are an impressive group of designers and proofreaders and from them I learned that hyphenated sentences aren’t acceptable, and the top of a page can’t begin with the last word of the last sentence from the previous page. Who would have known?

The changes impacted the index so the book couldn’t go to the indexer until every word was in its final resting place. I didn’t even know there were “indexers”, let alone final resting places and even ‘widows and orphans’. Investing it seems is not the sole domain of jargon and lingo.

Happily my work is done and Value.able will be with the printer next week.

Patience is the hallmark of the world’s best investors. It appears patience is also the hallmark of every investor who has visited my blog or written me an email. Thank you.

Good things come to those who wait, and provided you have pre-registered with me you will soon receive an email announcing the opening of the ordering window and inviting you to claim your reserved copy of Value.able for $49.95, including GST and shipping anywhere in Australia.

If you are ordering from overseas, that’s no problem; country-specific delivery rates will be available. Finally, for those who have reserved multiple copies, as gifts for family and friends, don’t worry, your additional copies have been registered along with your copy.

I am only printing First Editions for those who have pre-registered at www.rogermontgomery.com so be sure to register. I look forward to your thoughts after you have read Value.able.

Posted by Roger Montgomery, 4 May 2010

by Roger Montgomery Posted in Insightful Insights, Investing Education.

• 17 Comments
• save this article
• POSTED IN Insightful Insights, Investing Education

Whilst many use Ben Graham’s models for intrinsic value to evaluate the attractiveness of companies, I don’t. Let me explain why.

Just before I begin though, I want you to know that I am a little nervous about publishing a post advocating against a strict Graham-approach, as it may put a few noses out of joint. So, unlike many of my other posts, I have referenced what I believe to be the pertinent quotes that I have read and that brought me to or reinforced my conclusion that value investors should move on from many parts of Graham’s framework.

In the 1940’s Benjamin Graham (who passed away in 1976) was regarded “as a sort of intellectual dean of Wall Street, [and] was one of the most successful and best known money managers in the country.”[1] In 1949, an eager Warren Buffett read Graham’s book The Intelligent Investor and the rest, as they say, is history.

Warren Buffett regards Graham’s book Security Analysis as the best text on investing, regularly referring investors to that piece and his other seminal The Intelligent Investor. Many of you will also know one of my favourite Graham publications, The Interpretation of Financial Statements.

Yet whilst Buffett remains an adherent and advocate of Graham’s Mr. Market allegory and the Margin of Safety, thanks to his long time partner at Berkshire Hathaway, Charlie Munger, he has moved far from the original techniques taught and applied by the man described as the ‘father of value investing’.

Ben Graham advocated a mostly, if not purely, quantitative approach to finding bargains. He sought to buy businesses trading at a discount to net current asset values – what has been subsequently referred to as ‘net-nets’. That is, he sought companies whose shares could be purchased for less than the current assets – the cash, inventory and receivables – of the company, minus all the liabilities. Graham felt that talking to management was sort of cheating because smaller investors didn’t have the same opportunity.

Whilst the method had been very successful for Graham and the students who continued in his tradition, people like Warren Buffet, Walter Schloss, and Tom Knapp, Graham’s ignorance of the quality of the business and its future prospects did not impress Charlie Munger. Munger thought a lot of Graham’s precepts “where just madness”, as “they ignored relevant facts”.[2]

So while Munger agreed with Graham’s basic premise – that when buying and selling one should be motivated by reference to intrinsic value rather than price momentum, he also noted “Ben Graham had blind spots; he had too low of an appreciation of the fact that some businesses were worth paying big premiums for” and “the trick is to get more quality than you pay for in price.”[3] When Munger referred to quality, he was likely referring to the now common belief held by many sophisticated investors that an assessment of the strategic position of a company is essential to a proper estimation of its value.

In 1972, with Munger’s help, Buffett left behind the strict adherence to buying businesses at prices below net current assets, when, through a company called Blue Chip Stamps, they paid three times book value for See’s Candies.

See’s is a US chocolate manufacturer and retailer – whose product I have purchased and eaten more than my fair share of, whose factory I have toured and whose peanut brittle ranks with the best I have ever tasted.

Buffett noted; “Charlie shoved me in the direction of not just buying bargains, as Ben Graham had taught me. This was the real impact he had on me. It took a powerful force to move me on from Graham’s limiting view. It was the power of Charlie’s mind. He expanded my horizons”[4] and, “… My guess is the last big time to do it Ben’s way was in ’73 or ’74, when you could have done it quite easily.”[5]

So Buffett eventually came around, and the final confirmation, for those still advocating the Graham approach to investing, that a superior method of value investing exists was this from Buffett; “boy, if I had listened only to Ben, would I ever be a lot poorer.”[6]

Times in the US were of course changing as well, and it is vital for investors to realise that the world’s best, those who have been in the business of investing for many decades, do indeed need to evolve. In the first part of the twentieth century industrial manufacturing companies, for example, in steel and textiles, dominated the United States. These businesses were loaded with property, plant and equipment – hard assets. An investor could value these businesses based on what a trade buyer might pay for the entire business or just the assets, and from there, determine if the stock market was doing anything foolish.

But somewhere between the 1960’s and the 1980’s many retail and service businesses emerged that had fewer hard or tangible assets. Their value was in their brands and mastheads, their reach, distribution networks or systems. They leased property rather than bought it. And so it became much more difficult to find businesses whose market capitalisation was lower than the book value of the business, let alone the liquidating value or net current assets. The profits of these companies were being generated by intangible assets and the hard assets were less relevant.

To stay world-beating, the investor had to evolve. Buffet again:  “I evolved…I didn’t go from ape to human or human to ape in a nice, even manner.”[7]

Many investors cling to the Graham approach to investing even though some, if not many of his brightest and most successful students, moved on decades ago.

If you are reading this and want to adopt a value investing approach, there is no doubt in my mind that your search for solutions will take you into an examination of the traditional Graham application of value investing. It is my hope, however, that these words will serve as a guide towards something more modern, more relevant and, whilst can’t be guaranteed, more profitable.

If you have tried to adopt the Graham approach and had some successes (or failures) and are keen to share, I would be delighted if you post your own experiences here at my blog. Alternatively, if you have reached your own conclusions about the best approach to value investing, feel free to post a comment by clicking the Leave a Comment link just below and to the right.

Posted by Roger Montgomery, 30 April 2010.

[2] Damn Right.  Janet Low.  John Wiley & Sons 2000.  Pg 77

[3] Damn Right.  Janet Low.  John Wiley & Sons 2000.  Pg 78

[4] Ibid

[5] Robert Lezner, “Warren Buffett’s Idea of Heaven” Forbes 400, October 18, 1993 p.40

[6] Carol J. Loomis, “The Inside Story of Warren Buffett,” Fortune, April 11, 1988 p.26

[7] L.J.Davis, Buffett Takes Stock,” New York Times Magazine, April 1, 1990, pg.61.

by Roger Montgomery Posted in Insightful Insights, Investing Education.

• 37 Comments
• save this article
• POSTED IN Insightful Insights, Investing Education

I took an Anzac-weekend break from analysing companies and valuations.

It’s the 20^th anniversary of the launch of the Hubble Telescope, which provided the world with new insights into life, the universe and everything. Insights are what this blog is all about, and many of you have insights that are extraordinarily valuable and worth sharing.

Around October last year I received a tip to look at Decmil and Forge. That’s all that was said; “Roger, you should have a look at Forge and Decmil”

So I did. And the rest, as they say, is history. It turned out Forge qualified as an ‘A1’ company and Decmil was right up there too. Both were trading at large discounts to their intrinsic values. That’s two from two.

Another contributor has insights into healthcare stocks, benefiting everyone who visits this blog. And a CEO or two have provided clarity about their business models and their competitive positions.

A frequent question I am asked is: “Roger, thank you for providing these insights for free…but why do you do it?”

Well, first, I want you to see that valuing companies works better. If I can demonstrate that to you, you will have some confidence in doing it yourself, of course sticking to the steps outlined in Value.able. The second reason is that Warren Buffett described himself once as 85% Ben Graham and 15% Phil Fisher. Fisher is the author of Common Stocks and Uncommon Profits and liked “scuttlebutt “– insights from customers, employees and competitors. I would like to see you’re your insights published here.

If you are reading this post, let me assure you are not alone. – value investing, it seems, is much more popular in Australia than I anticipated. So instead of shooting your question or insight to me privately in an email, post it here.

If you don’t want me to publish your thought, just say so and I will refrain. When you write something, it doesn’t automatically pop up. It sits in my inbox awaiting my approval. I have to click PUBLISH before anyone will see it. If you ask me not to, I won’t.

I have been positively amazed at the insights, views, opinions and questions I have received via email and most are worthy of posting here. So don’t hold back.  Click LEAVE A COMMENT at the bottom of this post.

This blog is seen by CEO’s, MD’s, CFO’s and the PR people representing some of Australia’s largest public companies, so go ahead and share your thoughts. Please refrain from defamatory or judgemental language. Remember that every time you buy a share, you are purchasing from someone who quite likely disagrees with you, so don’t worry about a difference of opinion or even the risk of being wrong. As Francis Bacon said: “truth emerges more readily from error than from confusion”. We learn more from knowing we were wrong than from never knowing.

Let me kick things off by asking a few questions. Feel free to answer any or all:

• What industry do you work in?
• Who do you regard as the best company in that industry?
• What do you think makes them the best?
• Could anyone eventually knock them off the perch? Who do you think is the most likely to?
• What other industry(ies) do you like? Why?

And use any of these to get our conversation going:

• Do you receive tips?
• How do you test them?
• Do falling shares prices make you freeze?
• Does your share portfolio have so many shares that it looks more like a museum? How did that happen?
• How do you track your portfolio’s performance?
• How do you go about analysing a company?
• What’s has been your process for investing?
• What stock do you like the most? Why?

I hope you will take up my invitation to share your thoughts here and eagerly await commencing our dialogue. Start by clicking the LEAVE A COMMENT link just to the lower right of this post.

Posted by Roger Montgomery, 27 April 2010.

by Roger Montgomery Posted in Companies, Insightful Insights.

• 90 Comments
• save this article
• POSTED IN Companies, Insightful Insights

Serendibite is arguably the rarest gem on earth. Three known samples exist, amounting to just a few carats. When traded at more than $14,000 per carat, the price is equivalent to more than $2 million per ounce. But that’s serendibite, not coal.

Coal is neither a gem nor rare. It is in fact one of the most abundant fuels on earth and according to the World Coal Institute, at present rates of production supply is secure for more than 130 years.

The way coal companies are trading at present however, you have to conclude that either coal is rare and prices need to be much higher, or there’s a bubble-like mania in the coal sector and prices for coal companies must eventually collapse.

The price suitors are willing to pay for Macarthur Coal and Gloucester Coal cannot be economically justified. Near term projections for revenue, profits or returns on equity cannot explain the prices currently being paid.

To be fair, a bubble guaranteed to burst is debt fuelled asset inflation; buyers debt fund most or all of the purchase price of an asset whose cash flows are unable to support the interest and debt obligations. Equity speculation alone is different to a bubble that an investor can short sell with high confidence of making money.

The bubbles to short are those where monthly repayments have to be made. While this is NOT the case in the acquisitions and sales being made in the coal space right now, it IS the case in the macroeconomic environment that is the justification for the  purchases in the coal space.

China.

If you are not already aware, China runs its economy a little differently to us. They set themselves a GDP target – say 8% or 9%, and then they determine to reach it and as proved last week, exceed it. They do it with a range of incentives and central or command planning of infrastructure spending.

Fixed asset investment (infrastructure) amounts to more than 55% of GDP in China and is projected to hit 60%. Compare this to the spending in developed economies, which typically amounts to circa 15%. The money is going into roads, shopping malls and even entire towns. Check out the city of Ordos in Mongolia – an entire town or suburb has been constructed, fully complete down to the last detail. But it’s empty. Not a single person lives there. And this is not an isolated example. Skyscrapers and shopping malls lie idle and roads have been built for journeys that nobody takes.

The ‘world’s economic growth engine’ has been putting our resources into projects for which a rational economic argument cannot be made.

Historically, one is able to observe two phases of growth in a country’s development.  The first phase is the early growth and command economies such as China have been very good at this – arguably better than western economies, simply because they are able to marshal resources perhaps using techniques that democracies are loath to employ. China’s employment of capital, its education and migration policies reflect this early phase growth. This early phase of growth is characterised by expansion of inputs. The next stage however only occurs when people start to work smarter and innovate, becoming more productive. Think Germany or Japan. This is growth fuelled by outputs and China has not yet reached this stage.

China’s economic growth is thus based on the expansion of inputs rather than the growth of outputs, and as Paul Krugman wrote in his 1994 essay ‘The Myth of Asia’s Miracle’, such growth is subject to diminishing returns.

So how sustainable is it? The short answer; it is not.

Overlay the input-driven economic growth of China with a debt-fuelled property mania, and you have sown the seeds of a correction in the resource stocks of the West that the earnings per share projections of resource analysts simply cannot factor in.

In the last year and a half, property speculation has reached epic proportions in China and much like Australia in the early part of this decade, the most popular shows on TV are related to property investing and speculation. I was told that a program about the hardships the property bubble has provoked was the single most popular, but has been pulled.

Middle and upper middle class people are buying two, three and four apartments at a time. And unlike Australia, these investments are not tenanted. The culture in China is to keep them new. I saw this first hand when I traveled to China a while back. Row upon row of apartment block. Empty. Zero return and purchased on nothing other than the hope that prices will continue to climb.

It was John Kenneth Galbraith who, in his book The Great Crash, wrote that it is when all aspects of asset ownership such as income, future value and enjoyment of its use are thrown out the window and replaced with the base expectation that prices will rise next week and next month, as they did last week and last month, that the final stage of a bubble is reached.

On top of that, there is, as I have written previously, 30 billion square feet of commercial real estate under debt-funded construction, on top of what already exists. To put that into perspective, that’s 23 square feet of office space for every man, woman and child in China. Commercial vacancy rates are already at 20% and there’s another 30 billion square feet to be supplied! Additionally, 2009 has already seen rents fall 26% in Shanghai and 22% in Beijing.

Everywhere you turn, China’s miracle is based on investing in assets that cannot be justified on economic grounds. As James Chanos referred to the situation; ‘zombie towns and zombie buildings’. Backing it all – the six largest banks increased their loan book by 50% in 2009. ‘Zombie banks’.

Conventional wisdom amongst my peers in funds management and the analyst fraternity is that China’s foreign currency reserves are an indication of how rich it is and will smooth over any short term hiccups. This confidence is also fuelled by economic hubris eminating from China as the western world stumbles. But pride does indeed always come before a fall. Conventional wisdom also says that China’s problems and bubbles are limited to real estate, not the wider economy. It seems the flat earth society is alive and well! As I observed in Malaysia in 1996, Japan almost a decade before that, Dubai and Florida more recently, never have the problems been contained to one sector. Drop a pebble in a pond and its ripples eventually impact the entire pond.

The problem is that China’s banking system is subject to growing bad and doubtful debts as returns diminish from investments made at increasing prices in assets that produce no income. These bad debts may overwhelm the foreign currency reserves China now has.

Swimming against the tide is not popular. Like driving a car the wrong way down a one-way street, criticism and even abuse follows the investor who seeks to be greedy when others are fearful and fearful when others are greedy. Right now, with analysts’ projections for the price of coal and iron ore to continue rising at high double digit rates, and demand for steel, glass, cement and fibre cement looking like a hockey stick, its unpopular and decidedly contrarian to be thinking that either of these are based on foundations of sand or absent any possibility of change.

The mergers and acquisitions occurring in the coal space now are a function of expectations that the good times will continue unhindered. I hope they’re right. But witness the rash of IPOs and capital raisings in this space. Its not normal. The smart money might just be taking advantage of the enthusiasm and maximising the proceeds from selling.

A serious correction in the demand for our commodities or the prices of stocks is something we don’t need right now. But such are the consequences of overpaying.

Overpaying for assets is not a characteristic unique to ‘mum and dad’ investors either. CEO’s in Australia have a long and proud history of burning shareholders’ funds to fuel their bigger-is-better ambitions. Paperlinx, Telstra, Fairfax, Fosters – the past list of companies and their CEO’s that have overpaid for assets, driven down their returns on equity and made the value of intangible goodwill carried on the balance sheet look absurd is long and not populated solely by small and inexperienced investors. When Oxiana and Zinifex merged, the market capitalisations of the two individually amounted to almost $10 billion. Today the merged entity has a market cap of less than $4 billion.

The mergers and takeovers in the coal space today will not be immune to enthusiastic overpayment. Macarthur Coal is trading way above my intrinsic value for it. Gloucester Coal is trading at more than double my valuation for it.

At best the companies cannot be purchased with a margin of safety. At worst shares cannot be purchased today at prices justified by economic returns.

Either way, returns must therefore diminish.

Posted by Roger Montgomery, 19 April 2010.

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

• 48 Comments
• save this article
• POSTED IN Companies, Energy / Resources, Insightful Insights