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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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Believing completely in my valuation model and approach, I now rarely read about “the world’s greatest living investor” Warren Buffett and his legendary investment company Berkshire Hathaway.

But perhaps I should pay more attention? Because it seems that each deal or media appearance is worthy of further scrutiny and the well-reported $US26 billion buyout of railway company Burlington Northern Santa Fe is no exception.

This largest-ever Buffett investment, combined with a strong Australian dollar and a controversial 50-for-1 split of the Berkshire B class shares (which lowers their share price from $US3325 per share to about $US67) makes a back-of-the-envelope valuation of Berkshire Hathaway an interesting exercise.

So, with enthusiasm, I offer my value of Berkshire Hathaway.

The average annual compounded rate of growth in Berkshire’s book value – its equity – is equal to its return on equity. We can thus approximate the true rate of return on equity for Berkshire by examining the actual rate of change in book value.

Post acquisition, intrinsic value will not increase by the attractive rate it has in the past, unless returns on equity of the past can be maintained as the book value of the company continues to expand. The law of large numbers applies here. It is relatively easy to achieve 20% on $1 million – I can think of two stocks right now that will do that for you over the next two years (and I’ll be writing about these companies in the coming weeks for Alan Kohler’s Eureka Report), but achieving 20% on the $US118 billion of book value Berkshire has today will be a lot more difficult. That is why Buffett needs elephants, and elephants at the right price.

In the four or five decades since 1964, book value has grown by a compounded rate of 20.1 percent – a startling effort – and because of the high rate of return on equity that it reflects, each dollar retained has created more than a dollar of long-term market value. That is why the share price of Class A shares now stands at over $US100,000 per share.

But Buffett has always warned that, in the future, the massive amounts of capital at his disposal means that while you and I have a universe of thousands of companies that can have a material positive impact on our wealth, his investment universe is a few hundred at best. He needs elephants, and if he doesn’t get them his return on equity must inevitably fall. Recently return on equity has averaged 7.5%.

In valuing the shares, there is the A-class, which trade at over $US100,000 each, and the B-class, to which I referred earlier. The simplest way for me to convey the value is to estimate an A-Class equivalent valuation. And to cut to the chase, the value – based on an assumed 12% return on equity (optimistic perhaps) – is approximately $US108,000.

Given that the B-class shares, as an investment, are 1/30th the value and are about to be split 50-for-1, the value of them based on the optimistic return on equity is $US72. If, however, you assume that Berkshire Hathaway continues to achieve the average 7.5% returns on equity it has recently, the valuation falls dramatically because Buffett is retaining profits and generating a rate of return on them that is less than I can achieve elsewhere.

In such circumstances, the only price to pay is a discount to the forecast $US82,000 per-share book value of the company – about $35 per post-split B-class share.

By Roger Montgomery, 13 November 2009

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