Investing Education

Week after week our email inbox is filled with investor’s questions: A reasonably frequent one is about the performance of a portfolio of stocks that I wrote about last year filled with companies whose revenues had a large recurring component to them. If you know anything about the recurring patterns in fractal geometry, you know how beautiful the recurring theme can be.

The lift in the market over recent months has heightened anticipation. Today I will outline the performance of the six stocks I chose at the start of October last year.

But first: do you remember what we wrote about back then? The market was down 20% and radio news programs led with stories of large losses overnight in foreign markets. Shortly afterwards the market officially entered a “bear” market.

And then it promptly bounced. I remember this period because it was when we started a new Sub-Portfolio with six stocks that had one thing in common: a high percentage of recurring revenue. We called it the Recurring Value.able Portfolio.

As I wrote back then: “All the companies selected enjoy high rates of return on equity; they all have manageable, little or no debt; and they all enjoy the benefits of low levels of capital intensity, helping to generate copious cash.

“But what really marks these companies: Hansen, Iress, REA, Reckon and M2 Communications as a little special is the significant levels of recurring revenue. Iress (ASX: IRE, MQR: A1), enjoys close to 80% recurring revenue through the supply of its information and trading platforms; Hansen (HSN, A1) close to 70% through the supply of billing platforms and software; Reckon (RKN, A1) close to 60% through its provision of online accounting, personal finance and practice management software; and M2 Telecommunications (MTU, A1) close to 67% through telecommunications and internet access plans.

“Think of the advantages of running a business that begins each year with a material amount of its revenue locked in for the next 12 months. It is these recurring revenue streams that help derisk a company through strengthening balance sheets. The solid financial position then enables a business to comfortably expand current operations and take maximum advantage of other opportunities as they arise.”

A year ago I wrote that a portfolio constructed from high recurring revenue businesses and purchased at prices representing a margin of safety, should outperform the index. It was on that basis that I created a second Value.able portfolio called the Recurring Value.able Portfolio. Sitting within the Value.able portfolio its purpose is simply to demonstrate to you the relative performance of these holdings compared to the market.

You may recall I also overweighted the stocks that were trading at the largest discounts to my then estimate of intrinsic value and said: “I don’t believe the level of recurring revenue will change materially if Greece defaults and even if equity risk premiums increase because of more frequent recessions in the US” …adding “these holdings should perform as true defensives”.

Since I penned those thoughts, what has been the performance of each of the six companies’ shares? Hansen, Thorn Group and M2 were all trading at discounts to our then estimate of intrinsic value and M2 at the largest, while Iress, Reckon, and REA Group, were all at premiums to intrinsic value. The following table shows the share price increases and decreases for each of the six.

What I have done, is grouped those same companies by premium or discount to intrinsic value.

Those that were cheap are in the top half of the table, and produced a simple average return of 11.01%. Those that were expensive produced an average simple return of 7.63%. In other words, those with a high level of recurring income that were also cheap outperformed the All Ordinaries index; while those with a high level of recurring income but were expensive, on average, underperformed the All Ords.

Now, if you’ve been reading my column here long enough, you’ll know that a short period is not long enough to measure relative or absolute performance and neither is a small sample, but nevertheless, we have to start somewhere and the reality is we have plenty of experience to support the notion that quality and value combined leads to outperformance over the long run.

As an update to our October piece on this subject, find following the Skaffold intrinsic value line charts for each of the six companies. They describe where the current price is compared to Skaffold’s estimate of intrinsic value and whether, based on current forecast earnings, intrinsic value is expected to rise materially in coming years.

What are your favourite recurring revenue companies?  By thinking laterally you may discover a couple of companies that wouldn’t normally be thought of as enjoying recurring revenues.  To leave a comment click on the link below and enjoy reading the two further new posts below.

Posted by Roger Montgomery, Value.able author, Skaffold Chairman and Fund Manager, 15 March 2012.

by Roger Montgomery Posted in Companies, Investing Education.

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Do BHP Billiton (BHP), Rio Tinto (RIO), Dominoes Pizza (DMP), Myers (MYR), Range Resources (RRS), IRESS (IRE), Acrux (ACR), Haranga Resources (HAR) QBE Insurance (QBE), Westpac (WBC), Credit Corp (CCP), Matrix Composites (MCE), Caltex (CTX) Graincorp (GNC) and Seek (SEK) make Roger’s coveted A1 grade?  Watch this edition of Sky Business’ Your Money Your Call broadcast 14 March 2012 to find out.  Watch here.

by Roger Montgomery Posted in Investing Education, Talks.

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Roger Montgomery discusses why ‘watching the Directors’ is a “Value.able” strategy when assessing future business performance in his March 2012 Money Magazine article.  Read here.

by Roger Montgomery Posted in Companies, Intrinsic Value, Investing Education, On the Internet.

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Do BHP Billiton (BHP), Fortescue Metals (FMG), Seek (SEK), Bluescope Steel (BSL), GR Engineering (GNG), CSL (CSL), Peak Resources (PEK), Harvey Norman, (HNN), Buru Energy (BRU), The Reject Shop (TRS), ASG Group (ASZ), Tatts Group (TTS) and  Webject (WEB) make Roger’s coveted A1 grade?  Watch this edition of  Sky Business’ Your Money Your Call broadcast 29 February 2012 to find out.  Watch here.

by Roger Montgomery Posted in Companies, Energy / Resources, Investing Education, TV Appearances, Value.able.

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

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

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

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

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

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

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

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

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Bloomberg:

Biography: While Walter Schloss’s name is not nearly as ubiquitous as Warren Buffett, Schloss was arguably one of the best investors ever. Like Buffett, Schloss was a student of Ben Graham, worked at Graham’s firm with Buffett , and is one of ” Super Investors” mentioned by Buffett in his famous essay The Super Investors of Graham-And-Doddsville.

Here’s a table of Schloss’s returns to 1984.

Walter Schloss was born in 1916. At 18 years old he worked as a Wall Street runner for on Wall Street. While he didn’t attend college he enrolled in several classes given by legendary investor Benjamin Graham. Schloss eventually went to work for the Graham-Newton Partnership. In 1955 Schloss launched his own value fund. He ran the fund until 2000.

Schloss was reportedly very frugal. In one year, legend has it that his total office expense was $11,000 while his partnership generated a net profit of $19,000,000.

Schloss stopped actively managing other people’s money in 2003 and was a treasurer for the Freedom House a non-profit group devoted to furthering democracy, and human rights.

Over the 45 years Schloss managed his fund he trounced the S&P 500 by producing returns of 15.3% versus 10% for the S&P 500. A $10,000 initial investment in Schloss’s fund would have grown to $12,344,268, compared to an initial investment of $10,000 in the S&P 500 which would have produced $1,173,909.

Farewell and Thank You.

Posted by Roger Montgomery, Value.able and Skaffoldauthor and Fund Manager, 21 February 2012.

by Roger Montgomery Posted in Investing Education.

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Click on the image at left to see a close up of the stocks we like.

I reckon 2012 will be the year to get set and fill your portfolio with high quality businesses, demonstrating bright prospects for intrinsic value growth and a margin of safety. That will be the topic of my talk today as I kick off the ASX’s 2012 Investor Hour series. Here are the details:

Topic: Buying opportunity

When: Tuesday 21 February
Where: Wesley Conference Centre, 220 Pitt Street, Sydney (venue location)
Time: 12 noon – 1pm. Please arrive by 12.00 noon for start
Details:

The time to get interested in share investing and make good returns is precisely when everyone else isn’t. But know that the key to slowly and successfully building wealth in the sharemarket is to avoid losing money permanently.

At this event Roger will set out his principles for stock selection.

Roger Montgomery is a highly-regarded value investor, analyst and author and a regular contributor and commentator across the media. Roger is an analyst at Montgomery Investment Management Pty Ltd.

Presenter(s): Roger Montgomery, www.Skaffold.com, www.Montinvest.com

Posted by Roger Montgomery, Value.able and Skaffoldauthor and Fund Manager, 21 February 2012.

by Roger Montgomery Posted in Companies, Investing Education, Market Valuation.

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Roger Montgomery thinks not, and discusses why in this article published in The Sydney Morning Herald on 7th February 2012.  Read here.

by Roger Montgomery Posted in Energy / Resources, In the Press, Intrinsic Value, Investing Education.

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There has been a bit of action on the IPO front over the past few months. Sixteen stocks have been added to the main board of the ASX, as set out below with their actual listing date.

I thought it might be a worthwhile task to run the ruler over them and see if any are potential investment candidates among the newcomers.

Let’s start our exercise at the more speculative end of the investment spectrum. I don’t gamble with money, so let’s eliminate those that are involved in exploration activities given their high risk/high reward dynamics. There are 12 exploration businesses among this group. I will leave these to others who are more suitably qualified in working out whether any opportunities exist here and whether they will find something before their cash runs out.

Of those remaining, well-known NZ website Trade Me and RXP Services are involved broadly in the IT space, Alliance Aviation is involved in mining services and finally Chorus, another NZ company, specialises in Telecommunications. These are the four businesses we will focus on. A brief review of these follows.

Alliance Airlines (AQZ)

I will start with a sector I know well – airlines. A capital intensive industry with lots of competition rarely makes for wonderful business economics (Qantas, Virgin) and despite Alliance operating in a niche market of fly-in, fly-out operations for the mining sector, my view remains the same: I will never invest a dollar into this sector.

Alliance has grown quickly since its formation in late 2002. From nothing, to a fleet of 20 Fokker 100 and Fokker 70LR jets as well as five Fokker 50 turboprops with established, long-term, profitable blue-chip relationships with BHP Billiton, Santos, Incitec Pivot, and Newcrest. That’s an outstanding achievement by management. A distinguishing feature is that approximately 75% of Alliance’s 2010-11 revenue was subject to medium to long-term contracts – recurring revenues.

No matter. Any airline cannot escape competition or its high level of ongoing capital requirements. And for a niche space, four other competitors (Cobham, Network aviation, Qantaslink, Skywest) appear to be a handful in terms of the prices they can charge, competition for future contracts (especially when 44% of 2010-11 revenue was from one client, BHP), ongoing operating margins and future market share gains.

A total 47.6% of Alliance’s forecast for 2011-12 EBITDA will be consumed on refurbishments, maintenance, rotables, new aircraft and property, plant and equipment. This leaves just over 50% to pay taxes, interest and for working capital requirements. And once all is paid for, only a little will be left over for future dividends, buybacks, etc. It is not surprising, therefore, that the prospectus does not forecast a dividend to be paid in 2012.

Despite a pro-forma forecast of $18.1 million NPAT, or 20.1¢ earnings per share, and the shares trading below what the business may be worth, if you ever see me buying an airline, please put me in a straitjacket.

RXP Services (RXP)

Unfortunately, this business has a very, very short history and no real track record. It was formed in October 2010, just 15 months ago, with the purpose of establishing an information & communications technology (ICT) business with a focus on medium/large enterprises and the government.

The founders have done this, but with one drawback. Rather than building a business organically, the purpose of the float was mainly to raise funds to acquire two unlisted businesses in Vanguard and Indigo Pacific. The rollup of these has seen RXP service capabilities expand overnight from nothing into a broad range of management, business and ICT consulting, delivery and support services.

With a number of already listed ICT businesses already competing for market share – SMX, CSG, OKN, many of which have had a chequered operating history as listed entities – the space appears to be a little crowded. I can’t see how RXP will differentiate a commodity product offering.

And turning to its financials, despite the consolidated accounts in the prospectus showing how the businesses may have looked had Vanguard and Indigo been owned in the past, they weren’t; what we see is what would have been a profitable little businesses. But as we have little to go on as to how they will actually function together going forward under new stewardship, we will watch this one from the sidelines for now.

Chorus (CNU)

Chorus is a spin-out from Telecom New Zealand. It is New Zealand’s largest telecommunications utility company, a technical way to describe a business that builds, maintains and repairs existing phone and broadband lines.

Following the demerger, Chorus is a business whose sole focus is on bringing fibre within reach to as many New Zealanders as possible – kind of like our own NBN Co., but not run by the government, even if it has been chosen by the Crown to build NZ’s ultra-fast broadband (UFB) network to 830,000 urban premises, as well as extend fibre further into rural New Zealand through the Rural Broadband Initiative (RBI) by the end of 2019.

Having so far deployed some 2500 kilometres of fibre optic cable, upgraded hundreds of local telephone exchanges with new broadband equipment and installed or upgraded about 3600 roadside cabinets, a target of 20,000 kilometres of fibre optic cable to deliver ultra-fast broadband will probably be met. Management’s recent experience in rolling-out ADSL2+ broadband is coming in very handy and helping to build New Zealand’s fibre future.

There are some obvious tailwinds here, with the long-term nature of this contract and ratings agency Moody’s has assigned Chorus a Baa2, stable issuer and senior unsecured rating. A rating similar to Bulgaria and Kraft foods.

Look under the hood, however, and you can see that about $NZ1.7 billion of net interest bearing debt was outstanding as at December 2011, all current. On just $NZ422 million of equity, it appears that Telecom New Zealand may have also let go of some unwanted baggage in the de-merger.

While 2011 cash flows appear to be well managed and interest payments well covered, I can’t help but be reminded of another infrastructure asset in Asiano when it was demerged from Toll holdings in 2007. It too was saddled with a large debt burden and at the end of its first trading day; Asciano had a market capitalisation of $7 billion. Today it is $4.5 billion.

Trade Me (TME)

Last but not least is the well-known NZ website Trade Me. Similar to eBay international, Trade Me is now dual-listed on both the New Zealand and Australian Stock Exchange.

While this is another spin-off, Fairfax Media Limited (ASX:FFX, SQR B3) has retained a shareholding of 66% – generally a good sign.

On one reading this might be the pick of the recent floats. The business has an  moderately geared balance sheet, produces a significant amount of free cash with low levels of ongoing capital expenditure now that the website is mature and has a history of earnings growth which any shareholder, and that includes Fairfax, would be truly happy with. On top of this, with Fairfax retaining a material level of ownership in the business, they are still highly incentivised to continue promoting the website via its vast media network.

On another reading Fairfax paid $750mill for Trade Me (TME) and have just sold 34% of it for $363.5 mill or a total ‘value’ of $1.07Bln.  This will help them justify the carrying value on their own balance sheet.  Further, since 2007 TradeMe has made net profits totalling $276mill, the bulk of which has been taken out as dividends.  So FFX have made an IRR of about 17% per annum.  Given FFX have set up the company with market cap of about $1 billion, equity of $631 mill ($721 mill goodwill and therefore negative NTA) and debt of $164 mill, the expected return on equity is just over 10 per cent means FFX have got a return that you might not.

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

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