Insightful Insights

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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Has the market’s enthusiasm eroded all the safety out of buying stocks? I think so. In fact, for a few weeks now I have been saying that there are very few (read 1 or 2) quality stocks that are cheap. Equity markets are now selling off as investors get nervous again and start thinking about risk. It does appear to me that the rally has not been justified by the economic fundamentals, but more about the US economy in a minut

If you don’t already know, I have no use for P/E ratios. Let me explain why.

Suppose three companies each have $10 of equity per share, each returns 20 percent on that equity and each is trading on a P/E of 10, which equates to $20. The only difference is that the first company is paying out 100 percent of its earnings as a dividend, the second is paying out 50 percent and the third is paying no dividends. If you were to assume that you could buy and sell the shares at the same P/E of ten, the first company would return 10 percent per annum over any number of years, the second would return 15 percent and third will return 20 percent per annum. The third is clearly the cheapest and yet all three had the same P/E of 10. P/E’s can’t tell you very much about valu

There are however times when P/E’s are at such extremes that they provide support to my preferred analysis of the spread between price and value. This is one of those occasions and so, without recognising the validity of P/E’s, I will provide those of you who use P/E’s with the fix that you need.

By definition, if the US economy is recovering, then we recently experienced the last month of the US recession. It would be worthwhile examining the P/E ratio for the S&P/500 Index on the previous occasions that represented the last month of a recession.

Let me start by noting that currently, the trailing P/E is 27. This seems extreme and out of nine recessions since 1954, it is the highest trailing P/E at the last month of a recession, with the exception of November 2001. The other eight observations ranged from a trailing P/E of 8.3 in July 1980 to 17.2 in March 1991. Now some of the years in which the P/E’s were very low were also years of very high inflation, but even if those years are removed today’s trailing P/E is comparatively high.

Many of you will correctly point out that it makes no sense to use trailing P/E’s if we are coming out of a recession because the trailing ‘E’ is unusually low. In such situations, analysts focus on forward P/E’s. (Of course you know my view; if P/E’s are nonsense, then forward P/E’s, sector average P/E’s and the like are simply nonsense squared).

Nevertheless, on one-year forward estimates, the P/E ratio is at 16 times. This is the highest it has been since 2003. Even at the peak of October 2007, the forward P/E was about 14 and the highest it has ever been is 15.4 times.

But while it seems that multiples have, in six months, surged from historic lows to all-time highs, and while conventional wisdom would suggest that P/E’s are at levels normally reserved for the late stages of a bull market, there is a counter argument; at market peaks, such as October 2007, analysts are unusually bullish about the future, while after a recession analysts will be overly cautious about their forecasts. The result is low relative forward P/E’s at peaks and apparently high P/E’s coming out of a recession.

Confused? I am. That’s why I don’t use P/E’s, because they try to predict what the predictors will predict.

What do I really think? I think the stock market has got ahead of itself and the high quality businesses that I look at are now trading above their current valuations and are trading at their valuations two years out. Based on trailing and forward P/E’s (did I tell you I can’t stand P/E’s?) the US market has behaved as if it is in the late stages of a recovery and yet there is still debate about whether the recession is over. US inflation at this stage does not appear to be a threat. Indeed Target and Walmart have started their sales early… that sounds like deflation to me. In the US, rent, restaurant prices, airfares and the prices for personal care products, education, household appliances and tools, hardware and outdoor equipment, confectionary and soft drinks are all plunging. For the week of October 23rd, mortgage applications fell 12.3%! And this was on top of a 13.7%(!) slide the week before. On top of the fact that the Federal Reserve’s Beige Book has indicated that consumer spending remains weak. as does residential construction, architectural billings and commercial construction activity, this suggests that the market has cast its shadow too far forwar

Imagine what the US economy would look like without a $2 trillion injection!

By Roger Montgomery, 29 October 2009

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What happens when you buy great businesses cheap?

Shares need to be treated as pieces of businesses rather than bits of paper that wiggle up and down on a computer screen. This seems pretty rational and yet professional investors might buy a company that is a manufacturer of pet rocks loaded with debt because its inclusion in the portfolio reduces its overall volatility.

The same professional might not buy shares of a great business when they are truly cheap, having instead to wait until the shares have risen sufficiently to cause them to be included in the S&P/ASX 200. Buying shares this way, or simply buying in the hope they will rise, is not the same as buying a piece of a business.

The purchase of shares on the baseless hope of a capital gain is no different to betting on black or red at the casino.

Perhaps, because it is seen as too difficult, few investors simply purchase at attractive prices, a portfolio of 10 – 20 great businesses. This is despite the fact that such an approach produces substantial outperformance.[1]

To prove that quality counts, back in the June 2009 issue of Money Magazine I listed eleven stocks that I believe constitute great businesses – Cochlear, CSL, all four major banks, Realestate.com, Woolworths, Reece, The Reject Shop and Fleetwood.  Their combined return since July 1 has been 30 percent compared to the S&P/ASX 200 Accumulation Index return of 24 percent. Four of those companies have also risen by more than 40 percent in that time.

In July 2009 I also commenced a portfolio of eight stocks for Alan Kohler’s Eureka Report that included JB Hi-Fi and Platinum Asset Management. An equally weighted portfolio invested in those eight stocks would have risen 27 per cent and Platinum, one of the companies in the portfolio, is up over 53 per cent.

And the shares at the time were not even bargains. Imagine the returns if you had purchased them when they were at significant discounts to their intrinsic values back in February and March this year!

By Roger Montgomery, 26 October 2009

[1] For the year to June 30, 2009, and prior to my resignation, the boutique funds management firm I established, floated and sold, produced a return of +11% for clients with individually managed accounts (IMA). The Listed Investment Company I founded and was Chairman and Chief Investment Officer of produced a return of +3%.  For the same period the S&P/ASX 200 Accumulation Index produced a negative return of -20.7%.

By Roger Montgomery, 26 October 2009

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Dividend stripping involves buying a stock before it goes ex dividend and selling it after. The idea is to pick up the dividend, swapping it for the capital loss (which occurs because the shares usually fall ex dividend by the amount of the dividend). You also get the franking credit, and if the market is strong, you may not get a capital loss at all. If you do get a capital loss, there are tax benefits there too.

Many stocks, particularly the big ones, rally (rise) well in advance of the ex dividend date, so don’t buy the day before. There are also large gains when interest rates are low and when the market is strong, so there is an element of predictability under these conditions.

A warning to eager dividend strippers: If you are going to make more than $5000 in franking credits (equivalent to 5% on $100,000) in the same tax year, you need to appreciate the 45 day rule. In such circumstances you need to own the shares for 45 days, excluding the buy and sell date, to qualify for the franking credits and you can’t hedge away the stock exposure with futures, options or CFD’s.

Usually shares drop by the size of the dividend on the ex dividend date. Because they don’t drop by the dividend and the franking credit’s value, you ‘earn’ the franking credits. International investors, who generally stick to the very large companies, don’t get the benefit of the franking credits so if all goes to plan, they may sell in advance ahead of the dividend (as locals who do receive the franking support the shares) and buy back after the ex dividend date, providing support for the local dividend seller to sell into.

By Roger Montgomery, 17 October 2009

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The US stimulus may have been great for global markets, including our own, but have the benefits to the ‘real’ economy been just as dramatic?

The impact of stimulus packages on the real world appears to be wearing off. By the end of September next year, 70 per cent of the 2009 American Recovery and Reinvestment Act’s $787 billion will have been spent.

According to economics forecaster Moody’s, US stimulus packages contributed ¼% in the first quarter of calendar 2009, 3% in the second quarter, 3.5% in the third quarter (now), and is forecast to contribute ¾% in the next quarter, 1½% in the first quarter of calendar 2010 and ¾% in the second quarter of 2010.

Translation? The Obama stimulus package is having its maximum impact on the ‘real’ economy right now. Data showing the recovery taking root is simply a function of this stimulus. According to Moody’s, this quarter is as good as it will get. The bad news is that from here-on-in, the stimulus will start to wear off.

Now, I am no economist. But there are several prominent experts, like Jim Rogers, who are warning another slowdown is about to occur that will make the recession the US just experienced look like a picnic.

I am equally poor at forecasting stock markets – you will discover over time that it just hasn’t been an essential ingredient in my own investing. But a friend of mine who picked the last market high and low to within a couple of days (please don’t ask me who he is or how he does it), tells me that markets have just seen their medium term highs and have begun another sell-off. This may or may not transpire of course, but he has always impressed me with his uncanny ability to get it right.

So we have some economic forecasters saying be careful, we have a market forecaster saying watch out and now here is my contribution…

I can tell you what a business is worth. I can also tell you that in the short run the stock market is a popularity contest, but in the long run share prices follow values. That’s why it is essential you know the value of the companies you are buying shares in.

When I aggregate all the company values I have estimated, I arrive at an estimated valuation for the All Ordinaries Index of just under 4000 points. This compares to a market that is 600 points, or 15 per cent, higher. That alone however doesn’t mean the market is going down. Valuing a company is not the same as predicting its price, and the reality is that Australia has over 3000 funds chasing less than 2000 stocks. This has the effect of creating a ‘normal’ state that sees the market above its valuation.

But above its valuation it is. So while I am very optimistic about Australia’s future and will never let short-term concerns about the economy or the market stop me from buying shares of great businesses when they are offered at attractive prices, right now I can’t find many great companies that are cheap enough to buy. And some people I have great respect for suggest I should be even more cautious in my optimism. Perhaps you should too.

By Roger Montgomery, 6 October 2009

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My portfolio is full of businesses that dominate their market. Is yours?

Businesses with sustainable competitive advantages not only dominate their market, they are also able to produce significantly better returns using the same amount of capital and effort. Such businesses make great assets if you are trying the build an investment portfolio full of only the best stocks.

Businesses with a competitive advantage can charge higher prices for their products and services because people are willing to cross the road for them, even though the guy on the other side charges less (think iPhone).

Why? The service may be so intimately involved with the daily business of another company or the daily lives of consumers that they cannot possibly leave (Reckon or the banks), or it may be that they are the lowest cost provider and competitors simply cannot match their prices (think JB Hi-Fi). What is the competitive advantage of each of the stocks in your portfolio?

Competitive advantages are a critical recipe for continued high levels of profitability for a business. The next time you are shopping for vitamins, consider why Blackmores products are priced at a premium to their competitors. Maybe its because BKL has a competitive advantage?

By Roger Montgomery, 24 September 2009

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While most buyers and sellers of shares focus on earnings and earnings growth, ‘investors’ take a wide berth around the Profit and Loss Statement and focus instead on the business’ cash flow.

Why? Cash is not the same as profits. I recall the completion of my first year in business and the accountants handed me my first annual report.  Smiling, they said that I should be proud because I had ‘made’ a substantial profit.  Pulling my trouser pockets inside out, I declared “well where is it?”

For many businesses, profits are an accounting construct.  They are the accountants ‘best guess’ about what the true picture of the business is. But business cannot spend accounting profits, it can only spend cash. When a customer buys a product on June 28 the accounts record it as sales revenue. But if the sale was made on 14 days terms, the cash will not be received until the next tax year and even then, only if the debtor doesn’t skip town. So don’t be tricked by a business reporting accounting profits – it can be losing cash at the same time.

If you own shares in a business that reports a profit but does not generate cash on a continual basis, the only thing you need to understand is that you should be concerned.

Take the recently collapsed Timbercorp (ASX:TIM) as an example. Despite the business reporting accounting profits year on year, it was actually losing money for four years in a row.

Many years ago I received a recommendation from a broking-firm’s analyst to buy shares in Southern Dental at around $2.60. The report went on to say that it represented one of the best value plays in the market at the time. Unfortunately, its cash flow materially less than its reported profits so I passed up the opportunity to buy the shares which proceeded to fall below 90 cents.

To avoid these types of businesses compare a business’ reported profits to the Cash Flow Statement. A business that continually pays out more cash than it receives will have negative operating cash flows. If this situation occurs over a number of financial periods then, depending on the cash balance, the cash outflow will need to be supported by borrowings or raising fresh capital. The first increases the risk of the business and the latter dilutes your ownership. Rarely are either positive developments.

Without continued support from bankers or shareholders, a business that continually spends more than it earns cannot survive.

To ensure the ongoing health of your portfolio and avoid companies with an elevated level of risk, seek out businesses that generate positive cash from their operations equal to or greater than the profits being reported.

By Roger Montgomery, 2 September 2009

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

When a listed company announces an acquisition, commerciality is often cited as the reason for failure to disclose the purchase price.  But with Australia’s corporate graveyard littered with the write downs of overpriced acquisitions past (think Fosters, Paperlinx,AMP, Lend Lease, RIO and Valad) it is about time that companies treated their shareholders like kings.

By Roger Montgomery, 1 September 2009

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