Insightful Insights

The following article first appeared in  Alan Kohler’s Eureka Report on December 9, 2009.

Stocks in aggregate are no longer cheap. They were much earlier in the year, but based on the present levels of profitability they are not cheap any more. Those buying today are doing so in a patently perfunctory manner or are simply motivated by the fear of continuing to miss out. In the short term, losses rather than profits are more likely to ensue for those buying today.
Before you go selling your holdings in a fit of panic, remember there are always at least two views about the market’s short-term direction.

In one corner are the bulls, who say that the equity market’s recent strength is the beginning of a multi-year rally that owes its ongoing support to the fact that looming inflation will deliver negative returns from cash, which, combined with the massive expansion of the monetary base, represents a free, low-doc loan from the government.

In this environment many suggest that asset class inflation is assured. Indeed, just under $20 billion a week has been creeping out of the bomb shelters and into assets such as shares and gold.

In the other corner sit the economic bears, such as Nouriel Roubini, David Rosenberg and Marc Faber, who say the same inflationary and expansionary balance sheet policies of the West have given the US dollar an intrinsic value of zero, which will bankrupt America and produce a complete horror show that makes the last downturn look like a picnic.

Yield Curves.

So who was it that said two people looking at the same set of facts could not arrive at vastly different conclusions? Listening to and reading the apologetics and protestations of these extraordinarily successful investors must make the morning chat with your broker about whether AMP is paying too much for AXA seem inane. (Postscript:  AMP was paying too much for AXA – Nab’s purchase is even more ridiculous).

Perhaps more importantly, to whom do you listen? You cannot base that decision on who is smarter because both groups have geniuses in their ranks; nor can you base your decisions on previous successes because both groups have extremely wealthy proponents.

The answer does not lie with replicating the financial and reputational bets taken by the economists, strategists and traders. Indeed, it lies in not taking a view at all but allowing an entirely different group of facts to dictate your actions.

Those facts are the book values or the equity of companies on a per-share basis, the anticipated profitability of those book values, the manner in which profits are currently retained and distributed (in others words, capital allocation by management) and a reasonable required rate of return.

On these measures most companies are no longer cheap and many are downright expensive. This has occurred for two reasons, that combined, reflect the typical short-term focus of both professional and amateur investors.

The first reason is that share prices have obviously risen. They have risen because Australia has sidestepped a recession, interest rates remain accommodative, our output is in demand and overseas markets have recovered.

The second reason is that shareholders who may have stayed on the sidelines, have pumped money into attractively priced dividend reinvestment plans, placements and rights issues as many of Australia’s largest companies collectively raised $90 billion in the 2009 financial year.

And who can blame the investor who bought shares in Wesfarmers at $29 for wanting to bring down their average price and participate in an entitlement offer to buy three more shares at $13.50 when the rest of the shares they own are trading at $16?

But while the reduction of debt, associated strengthening of balance sheets and stag profits are attractive, there is a nasty downside to all of this.

If I have a company with $100 of equity on the balance sheet and 100 shares on issue, each share is entitled to $1 of the net book value of the assets. If, however, my company’s shares are trading at 10¢ because of the global financial crisis and my bankers ask me to reduce my $100 of debt to $50, I may choose to issue 500 shares at 10¢ to raise the required $50.

The first thing that happens of course is that company equity rises by $50 but more disturbing is that there are now 600 shares on issue. Where once each shareholder owned $1 of equity for every share they held, they now own just 25¢ worth of equity.

And if you are a small shareholder from whom the company couldn’t conveniently raise money, your holding has just been diluted because the institutions got the lion’s share of the placement.

Further, the money raised went to pay down debt rather than investment, so the earnings will only increase by the post-tax interest saved. As a result, the return on equity declines as well and because the true value of a company is inextricably related to the profitability of its book value, company valuations decline.

Valuations have thus declined and yet share prices have risen. As Benjamin Graham said, in the short term the market is indeed a voting machine. And I am not talking about one tiny or obscure corner of the market. Rights issues and placements, according to Paterson’s research, now account for more than 6.5% of total market capitalization: the highest level in more than 20 years.  (Postscript:  figures compiled by trade-futures.com show that 80% of small traders are bullish – the same level as when the market peaked in November 2007).

In the current environment, many value investors will succumb to temptation and their lack of discipline and reduce their discount rates. In doing so they try and keep their valuations from looking out of touch with ever-increasing share prices but really they’re playing catch-up. And when share prices fall slightly, value apparently and suddenly appears.

But the margin of safety is illusory and with returns from stocks unlikely to sustain returns so far out of whack from everything else, real value is some distance below. Only a demonstrated track record can prove otherwise.

Posted by Roger Montgomery, 9 December 2009

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I had a call yesterday from one of my brokers (who also happens to have become a friend). He informed me that the restrictions have come off all the broker’s so that they are now able to write research about Myer. As you would expect so soon after its widely supported float (A float that lost money for the thousands of investors who sold out in the first weeks), the research has been predictably bullish. It is not however the views of the analysts that is interesting. What is interesting is the reference in several of the reports to a relative P/E. The argument goes that because Harvey Norman and David Jones have a higher P/E than Myer, that the gap should narrow and Myer’s P/E should rise, pulling the price up with it. See any weaknesses in the logic?

Its like saying that there’s a Ferrari and there’s a VW Combi and the VW combi will get faster because the Ferrari is too fast compared to it.  Clearly such conclusions are flawed.

The performance of management, the economics of businesses and their prospects all affect their values and the sentiment towards them, which in turn, affects prices in the short term.

Buffett has frequently said that academics where correct in observing the market was frequently efficient.  In other words, a lot of the time, the price is right and perhaps in the case of Myer it should be on a lower P/E than David Jones.  This post should be read in conjunction with my previous posts on Myer that discuss its intrinsic value.

Roger Montgomery, 10 December 2009.

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Another viewer question I would like to share…

Roger,

A few questions (assume for all questions below that I am referring to stocks with low debt and high return on equity):

1) If you see the market as overvalued and most stocks you look at above their intrinsic value, do you just stay in cash until they become cheaper, even if you could be waiting years (like the 2003-2007 period)?

RM – I look at individual companies rather than the market. If there are no individual companies that are cheap, the answer is yes.

2) I know you like stocks that pay no dividends, but what happens if management does something stupid and the stock price plummets? At least you have got something from your investment if you have received dividends.

RM – You have misunderstood my stance on dividends, which is quite a common misunderstanding. My position is that all things being equal, a company with a high ROE that can retain its profits and compound them at a high rate is worth more than a company with the same ROE but paying some proportion of its earnings out as a dividend.

I am quite happy to buy companies that pay dividends – I bought Fleetwood earlier this year on a dividend yield of more than 20% – but the price I must pay for them is lower.

On the second part of your question, you are right. The assumption is that if management is going to retain profits they must generate high returns on those retained earnings. The track record of management doing stupid things however is long so I can understand shareholder reticence towards management hanging onto the cash.

3) Do you have any concerns about buying a stock that has low liquidity (as it could be difficult to sell if something goes wrong)

RM – Even when managing more than $100 million I bought shares with low liquidity, but I was right in those cases and their superior performance eventually attracted increased liquidity. Had I been wrong then yes, the illiquidity would have been a problem. They key is to worry more about being right, then you don’t have to worry about the liquidity.

Posted by Roger Montgomery, 3 December 2009

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Yesterday an investor who likes his commodities, James, posted the following comment to the blog:

Hi Roger,

Following you on the TV shows is really helpful to my investment decisions, so thanks very very much.

I’d also like to have your view on current commodity bull trend. I understand that you like to value companies based on ROE, RR, etc, but do you ever try to reasonably predict the metal / commodity / gold price for next year? While you may say that is speculation, but a reasonable prediction based on supply / demand would also help in determining the company value?

James

Following is my response:

I am interested in commodity companies.

There’s something in the fact that billionaire Jim Rogers has been saying expect new highs in virtually all commodities over the next decade. There’s also something ominous in Warren Buffett’s purchase of a railroad company. Both men believe that oil prices will rise substantially.

I think its impossible to predict prices of anything in the short term, however I do believe that over longer periods there are supply/demand considerations that are easier to discern.

With regards to taking advantage of this, I have so far been biased to investing in the commodity itself rather than stocks. Companies that mine, plant or otherwise produce a commodity have risks associated with them that are unrelated to the commodity’s price itself.  For example for an exploration company, there are funding risks and execution risks, not to mention management risk and stock market risk.

It is quite possible that you believe that the gold price is going up, but the gold explorer whose shares you have just bought doesn’t find any gold! You may believe that the oil price will rise and yet the particular company you have bought shares in has an environmentally  catastrophic spill.  The wheat or corn price may be going to go up, but the farm you just bought had its crop wiped out by a flood resulting in no revenue and a higher future capital expense. There are simply risks that aren’t related to the commodity price.

For these reasons, where I have had a view about a commodity, I have thus far taken interests in the commodities directly rather than through stocks.

Posted by Roger Montgomery, 3 December 2009

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Today I had an interesting piece of correspondence from ‘Victor’.  Victor writes:

You talk about value of a Company, but reality is the value of an asset is what a buyer will pay for it, so is it not true that at any moment in time, the value of a Company is what the market is willing to pay for it. During the .com days, that was all that counts, there were no intrinsic value at all.

What Victor is suggesting that the value of an asset is simply what someone else will give you for it.  In other words the price. But an asset is not worth what someone else will pay you for it.  What someone else will pay you for something is the Price.  Price and Value are two different things.  Go and research the company NetJ.com.  Its IPO price was 50 cents, it listed in November of 1999 on the OTCBB in the US around $2 and at the peak of the internet bubble traded at a price of more than $8.00 but according to its prospectus, it actually “conducted no substantial business activity of any description” and “had no plans to conduct any substantial business activity of any description”.  So was NetJ.com ever worth $2, or $8.00?  Of course not.  The price was $8.00 but the value was much, much lower.

Price is not value. Your job as an investor is to buy great businesses when their price is less than the value you receive.  The difference between a price that is lower than the value, is known as the Margin of Safety.  Warren Buffett and Benjamin Graham argue that those three words are the three most important words in investing.

Posted by Roger Montgomery, 3 December 2009

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ASX Investor Update has published more than 130 stories this year to help investors and traders. Here are 10 stories from 2009 to read over the holiday break for those who want to learn more about share investing or trading, and missed these topics earlier in the year: Number 1 is How to pick great stocks by Roger Montgomery, independent analyst. Read article.

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Last week I invited those of you who have registered to receive emails from me to let me know what headline grabbing events you would like me to comment on. I am currently collecting all the requests on this page and those that are the most popular, I will put up on my blog over the comings months.

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I find investing intellectually and financially stimulating, and being able to share the process equally rewarding.

A large number of investors, financial planners, stockbrokers, and a very observant plumber have emailed me requesting the various insights that I mentioned on Market Moves with Richard Gonclaves and Nina May’s Your Money Your Call on the Sky Business Channel.

Many of you have also asked for individual stock recommendations or how I might be able to advise you. Here is the official response…

As you can imagine, I have received innumerable requests to manage funds, provide share market advice, review and establish share portfolios and the like. Having recently resigned (June 30) from the financial services and funds management businesses I founded, listed on the ASX and sold, I am not currently able to assist with these requests, however, with your permission, I will keep your details and let you know when I am in a position to assist.

In the meantime you can follow my thoughts by tuning in to Ross Greenwood’s Money News program on 2GB (NSW), ABC Statewide Drive (NSW) with John Morrison, watching the Sky Business Channel, reading my weekly Value Line column in Alan Kohler’s Eureka Report and visiting my blog, Roger Montgomery Insights.

If you have registered your details at my website, www.Rogermontgomery.com, I will contact you when my guide book to showing you how to identify great businesses and value them is available for purchase in late February or early March.

Until then, I have written an eight-page note on how to construct a share portfolio using my approach to identifying great businesses and valuing them.

I have also uploaded an article I recently wrote for Alan Kohler’s Eureka Report about airlines and why their accounting will make you sit up and take notice.

Enjoy your reading and investing and keep in touch.

Roger

Posted by Roger Montgomery, 30 November 2009

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While chatting with Nina May on her Sky News program Your Money Your Call, a viewer called in to ask about Crane Group (ASX: CRG).

My curiosity was piqued because somewhere back in 2006 I owned the shares, but shortly after I changed my mind and never looked at them again. When my valuation model spat out the numbers I could immediately see why it hadn’t come up on my radar again.

Ten years ago the business was generating 10.4% returns on its equity – nothing to write home about. In 2012 it is forecast to earn the same, up from about 7.5% today.

For anyone reading my Roger Montgomery Insights blog for the first time, an ROE of 7.5% is not much better than you can get in the bank, and given the risks associated with owning a business and the fact that there are businesses we can invest in that are generating 20%, 30% even 40% and trading at small multiples of their equity (and without vast amounts of debt or accounting goodwill), it makes no sense to sell something in my portfolio that is first grade for something that is not.

CRG was worth about $6.00 ten years ago and today its worth about $5.00. If the analysts are right with their earnings forecasts, my value of the business will not rise much more than 7.5% in 30 months time to just under $5.40.

With the price today at almost $9.00, there is no incentive to buy the shares.

For new visitors to my blog, a caveat and a little background: My valuation is not a price prediction. I do not know what the price is going to do. Whilst I can tell you the value of a share with a high degree of confidence, I cannot accurately predict the future price. The price could rise or fall substantially and I simply cannot know.

My objective instead is to buy high quality businesses – those with little or no debt, high returns on equity and sustainable competitive advantages – at prices well below their intrinsic values. If, after buying the price falls and I still have confidence in my valuation, then the fall represents an opportunity rather than a reason to be fearful and sell.

For the year to June 30, the funds I founded and ran (I have since sold and resigned from these businesses) returned 3% to 11% in a year that the market fell about 21%. Since June 30, my portfolios (you can track them in Alan Kohler’s Eureka Report and Money Magazine) have risen 26% and 31% respectively, whilst the market is up 19%.

Posted by Roger Montgomery, 30 November 2009

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Some time ago Peter Switzer invited me on to his program to discuss five stocks for the long term that met my criteria for quality at least, and value if possible.

We didn’t end up with enough time to cover them so I was asked back on October 28. By that time the market had rallied hard so the three I could find were MMS ($3.99 back then) now $4.44, JBH (then $21.50) now at $22.96 and WOW (then $28.82) now $28.42.

The other two I mentioned, to satisfy the more speculative viewers, were ERA (then $24.70) now $24.46 and SXE ($1.62) now $1.63.

The 2009 valuations for MMS, JBH, and WOW are $4.69, $25.76 and $27 respectively. For ERA and SXE the 2009 valuations are $33 and $1.97 respectively.

At all times I have deliberately based these valuations on consensus analyst’s estimates so that there is no favouritism. But keep in mind analysts estimates are prone to change and therefore so are the valuations.  Further, it is worth remembering that when I run my aggregate valuations over the market, it tells me that the market as a whole is about 15 percent above its valuation.  In other words the market in aggregate is no bargain and may be a little expensive.

Also keep in mind that if you go and transact in any security in any way based on these opinions, you do so at your own risk. I really do mean it when I recommend that you seek advice from a professional adviser, broker or planner that knows your financial circumstances.

By Roger Montgomery, 19 November 2009

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