Investing Education

On Wednesday November 2 Woolworths held a strategy briefing for professional investors. Woolworth’s effectively asked us to adopt a longer time frame before judging its performance and revealed four strategic priorities that I will describe in a moment.

Prior to the strategy day, the company updated the stock market with a growth outlook that was the lowest in a decade. The market responded negatively to the change and it entrenched previous sentiment by professional investors to switch from Woolworths to Coles.

But Woolworths remains a superior business from a business economics perspective, with high return on equity and it also remains cheaper than its competitor as measured by the larger discount to an estimate of its intrinsic value.

The wider sentiment towards Woolworths Supermarkets is that the period of strong growth is over, and the other businesses, such as Big W, the New Zealand supermarkets, the Masters hardware venture and a possible acquisition of The Warehouse group could be the focus of earnings growth for the company. Gambling pre-committments would not be.

Meanwhile, the Woolworths-owned Dick Smith electronics business appears to have failed to excite consumers and has certainly failed to excite investment professionals. Dick Smith is a relatively weak offering in a market that has been hit particularly hard by the empowerment of the consumer through high Australian dollar.

Moreover, in many ways these businesses are peripheral since the Australian Food & Liquor division accounts for 80% of earnings before interest and tax.

The impact of the company’s lower growth profile on intrinsic value, particularly intrinsic values over the next two years, has been negative and intrinsic value does not appear to be going anywhere in a great hurry (see Skaffold chart below).

This combination of circumstances, in my experience, set Woolworths shares up to be vulnerable to any negative shocks.

Estimating intrinsic value is not the same as predicting price direction, however the above circumstances are not unique historically in putting a lead on price appreciation.

On top of the above combination of factors, there is also the continuing debate in Parliament about the introduction of preset loss limits for poker machines, which, if introduced, would negatively impact Woolworths’ gaming business. Though it is most closely associated with supermarkets, Woolworths is actually the largest poker machine owner in the country, with more than 10,700 pokies.

And a few weeks ago, The Economic Times of India also reported that Woolworths appears to have been dumped by its Indian partner, Tata Group. Woolworths enjoyed a five-year partnership with Tata, introducing Dick Smith-style electronics stores to India under the Infiniti Retail brand. Even though foreign retailers are not permitted to have a direct presence in India, Woolworths partnership offered the hope of growth – albeit with a partner – if the rules were ever relaxed.

Nonetheless, despite these accumulative negative factors, Woolworths is regarded by conventional analysts and investors as a defensive’ company. Its strong cash flows and its status as a major retailer of food makes it an ideal investment in a recessionary or slow or low growth environment. The company also enjoys entrenched competitive advantages over smaller rivals that, until now, the ACCC has done little about. One example of this are the new EFTPOS charges.

From the first of this month, the new Eftpos Payments Australia Limited (EPAL) fees mean retailers incur a 5¢ fee for every transaction over $15 (75% of all EFTPOS transactions). Previously there was no fee and that will still be the case for transactions under $15, which means 25% of transactions.

The retailer’s bank will charge the retailers, some of whom are describing the charges as an “EFTPOS tax”, and they will have no choice but to pass on to the consumer.

Unsurprisingly, EPAL’s members include the major banks, Coles and Woolworths and, because they manage their own terminals, they can opt out of the new charges.

But despite these entrenched advantages, Woolworths has been hit – or so it says – by the state of the economy, noting in its annual report: “Consumer confidence remained historically low as customers reacted adversely to rising utility costs, interest rate hikes in the first half of the year and general global uncertainty, and opted to save rather than spend their money”.

From an investment perspective it is worth noting that retail investors now have a choice of supermarkets, with Coles improving its offering to consumers and taking market share from the incumbent Woolworths.

The investment community is not convinced that further changes to private-label offerings or more innovation around the supply chain will make a dramatic difference to the growth prospects for Woolworths, which set below forecast growth in household income, population and the economy.

One other source of earnings growth is cost-cutting, but the reality is that gains from such strategies are one-offs and again unlikely to excite investors.

Having presented the negatives – which have caused the share price to fall 12% since July, one positive was the strategy briefing’s opportunity to showcase new CEO Grant O’Brien, who replaces Michael Luscombe. The company announced that it planned to extend and defend its leadership in food and liquor, act on the “portfolio” to maximise shareholder value, maintain its track record of building new growth businesses (we’ll ignore Dick Smith) and finally, put in place the enablers for a new era of growth.

In the supermarkets business WOW hopes to grow fresh produce from 28% market share to 36% market share. If achieved this would be an additional $2.5b in sales. Woolies also wants to target a doubling of home brand sales and this aim flies in the face of the ACCC’s stated concerns.

The company will also open 35 new BIG W stores in next 5 years reaching 200 by 2016.

In a reflection of the massive structural shift online, BIG W’s 85,000 in-store SKUs will be expanded and all put online.

And the topic on the tip of everyone’s tongue; Masters. There are now five stores open, another two are due to open in December/January, there are 16 under construction another 100 in the pipeline and the company reported the venture is well ahead of budget.

I also note the advertised sale of $900 million of property ($380 million of which was sold last financial year); and, most recently, the oversubscribed $500 million hybrid note raising that substantially extend the balance sheet strength of the company.

Below we examine the intrinsic value track record and prospects for Woolworths based on current expectations for earnings growth and returns on equity using Skaffold.com

Woolworths (MQR: B2) is currently trading at the same price it was in December 2006 and February 2007, despite the fact profits have risen 11.1% pa, from $1.3 billion to a forecast $2.2 billion in 2012. This growth in profit however is offset by having 16 million more shares on issue; by increased borrowings – up $1.8 billion to $4.8 billion; and by retained earnings, which have risen by $2 billion. The increase in shares on issue and retained earnings have offset the positive impact on return on equity rising profit would normally have.

The latest estimate of its intrinsic value, of $23.23, is forecast to rise modestly over the next two years. For investors looking at opportunities to investigate only when a meaningful discount to intrinsic value is presented, a price of $19 or less for Woolworths would represent at least 20 per cent.

Posted by Roger Montgomery, Value.able author and Fund Manager, 17 November 2011.

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

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You don’t normally expect to get investment tips from a mothers’ group get-together, but that’s what happened to me recently when the conversation turned to retail operations.

Relaxing with a glass of pinot gris the women, who have met regularly for a decade, were explaining why they spend less time in Harvey Norman stores than they used to. Why? Tired stores, tired layouts and uncompetitive prices have served the retailer only with the need to revamp its entire offering. And that, it hasn’t done.

Retailing in Australia has been in the eye of a perfect storm for some time. As I’ve written previously, the strong Australian dollar has encouraged overseas travel and online purchases from overseas businesses; and the two-speed economy has ensured that credit growth (the borrowing of more money to buy stuff) is muted.

I’ve always been suspicious of a company that issues a report to the market after the close of trade. On Monday 31 October, a major retail business in Australia did just that. After closing time, Harvey Norman released its sales and earnings for the first quarter of the 2012 financial year. Given its timing, the announcement was almost certain to be negative. Indeed, the stock fell 4% the next day.

Instead of focusing on the retailing offer, refreshing store designs and improving range, company representatives focus on property, horse racing (Gerry Harvey is one of the country’s biggest bloodstock owners), goading the Reserve Bank of Australia to cut rates in “the national interest” and campaigning to have Australians pay GST on items they buy overseas for less than $1000.

Harvey Norman’s first-quarter sales were down 3.8%, as were like-for-like sales. In Australia, like-for-like sales were down 2.8%, in New Zealand down 10.6%, down 8.9% in Slovenia and down 11.1% in Northern Ireland. A stronger currency against the New Zealand dollar, the Euro and the pound has exacerbated the results. Profit before tax – a very important measure to us when estimating intrinsic value – was down by … wait for it, 19.3%!

Harvey Norman claims the strong Australian dollar and the closure of 34 Clive Peeters stores contributed to the poor result. I would argue that a failure to reinvent the offering also contributed. More worryingly, this latter factor is unlikely to go away any time soon.

Compounding this problem is the very likely scenario that the declining iron ore price – recently at about $115 a tonne – will seriously crimp margins for the only sector that has been running at full capacity in this country. Australia’s stock market has become the tail that wags the dog. Its wealth-effect on Australians and the impact on sentiment are important determinants of activity and in particular, retail activity.

With the All Ordinaries index dominated by resource companies and financial services companies it is possible, if not probable, that a declining iron ore price leads to lower stock prices and lower economic activity. I am no economist, but I can understand some experts’ calls for further rate cuts.

Back to Harvey Norman, and like-for-like sales declines of 2.8% compares favourably with JB Hi-Fi’s decline of 3.5%. Indeed, if it became a trend, one would argue Harvey Norman is winning back market share from JB Hi-Fi.

But before you get too excited about this comparison, you have to realise JB Hi-Fi’s profits are higher than they were last year and last year’s profits were higher than the year before that. In Harvey Norman’s case, profits before tax are down 19.3% compared to the same time last year, and last year first-half profits were down 16.5% from the year before that! One retail analyst I know and respect made the point that at this rate Harvey Norman will produce an average profit slightly ahead of the first-half profit made back in 2004, when it generated sales revenue of 62% of today’s sales.

My intrinsic value estimate for Harvey Norman is about $2.00 a share against today’s share price of $2.17. However this is based on earnings per share of 23¢ for 2012 and that is, quite possibly, optimistic. Over the next few weeks, analysts will bring their earnings after tax estimates down for 2012 materially. This will have a negative impact on intrinsic values and I suspect we will discover a price above $2 is a premium to intrinsic value. Most interestingly, for followers of any rational approach to calculating intrinsic value, Harvey Norman’s updated intrinsic value is no higher today than it was nine years ago, in 2003.

This can be seen in the following chart, which plots the share price of Harvey Norman against its estimated intrinsic value. Generally, we look for companies that have a demonstrated track record of rising intrinsic values and are available at a large discount to the current year’s intrinsic value (see 2006 in the graph).

The lack of any real change in intrinsic value and prices (which follow intrinsic value in the long run) reflects the maturation of the business. You can see that in the short run (in 2007 and again in 2009-2011) prices can get ahead of themselves thanks to many factors including irrational exuberance.

In the long run, however, the market’s weighing machine will do its thing and prices generally revert to intrinsic value. That’s why having a rational method for estimating intrinsic value is so important!

The forecast change in intrinsic value may also decline now that Harvey Norman has provided lower guidance. And it’s not unusual for analyst forecasts to be “hockey-stick” optimistic at the commencement of the financial year.

But long-term, Harvey Norman is a mature business in a small country and it continues to swim upstream against the online retailing avalanche. This is a structural shift rather than a short-term trend and Harvey Norman will need to respond by convincing Australian women in mothers’ groups all round the country that it is fresh, new and competitive.

Posted by Roger Montgomery, Value.able author and Fund Manager, 17 November 2011.

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

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I have not discovered a method for predicting the short term direction of share prices.  Once we purchase an A1 company’s shares at a discount to intrinsic value, we cannot know what the share price will do in the short term.  We do know that provided the prospects for intrinsic value growth remain bright, the weighing machine that is the market will eventually cause share price and intrinsic value to converge.

Thats why it is so valuable to have an current and future intrinsic value estimate for every company updated daily.  Having a long term demonstrated track record of intrinsic value growth can also provide us with insights into management’s capital allocation decisions.  Knowing what the cash flow profile of a company looks like and whether the company has profitably employed capital entrusted to it by shareholders can further ensure you aren’t overstaying the party.

Soon you too will able to simply and confidently navigate the noisy distraction of the stock market to be shown those securities that deserve your time and avoid those that have a higher probability of permanently impairing your returns.  Skaffold is launching now (so keep an eye on your inbox today!)

Last week I spoke on CNBC with my old friend and peer Matthew Kidman.

You can watch the interview here: http://video.cnbc.com/gallery/?video=3000054986

Our view about the market is influenced by how many companies we can find that are both high quality and cheap.  I remember back in April this year, we had just started investing on behalf of investors in our fund but we could only find a small group of suitable companies.  That was enough to suggest that the other 2050 listed companies were either expensive and or of unsuitable quality.  A similar thing appears to be happening now.  The lower credit growth and declining iron ore prices have impacted the growth rates of future intrinsic values for banks and resource companies and these dominate our stock market index.

If you are following the Value.able-style approach to value investing, you would only be interested in high quality companies with bright prospects at substantial discounts to IV. If that fact changes as a result of the constant process of re-evaluating the prospects for the businesses in which we are interested, then one must act accordingly.

I cannot tell you whether the market is going to rise or fall in the weeks and months ahead but it does seem that value is a precious and rare commodity.  With that in mind, what are the companies that may be most at risk?

We will update this post with a table shortly but here is the short list (keep in mind the issues that have caused the companies to be in this predicament may be temporary):  Tap Oil, Neptune Marine, AACo, Somnomed, Elders, Centro and Gunns.  I will update soon with a more comprehensive list of expensive C4s and C5s soon.

The current list is not exhaustive, what I have done is taken C4 and C5 companies and sorted them by those that most recently reported cash flows that were unable to cover interest.  There are many more but these are the names that piqued my interest and I thought they might pique yours.

Posted by Roger Montgomery, Value.able author and Fund Manager, 09 November 2011.

by Roger Montgomery Posted in Investing Education.

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Value.able investors can be forgiven for giving up.  You wait so long for value to be presented and then when it appears it just hangs around, remaining ‘good value’ for what seems an age.  Value can sometimes nag and nag and by the time action becomes urgent, the newest and least patient value investors are no longer listening.  I can see it in the statistics of my friend’s financial services businesses and no doubt it’ also being felt by tip sheets purveyors and CFD merchants.  For all the talk of value investing, few really have the patience to succeed.

Value.able-style investors can be forgiven for giving up.  You wait so long for value to appear and then when it does, its just hangs around.  STocks that were expensive, become cheap and then, simply, boringly, stay cheap.  Value can sometime nag and nag and by the time action becomes urgent, the newest and least patient investors are no longer listening.  I have no doubt this is impacting the revenues of the tip sheet purveyors and the CFD merchants, indeed any business in financial services whose revenue is dependent on investors maintaining the faith.

That is the situation I was recently delighted to observe as the Cochlear share price plunged another 14% to $51.30, or about 40% since its April 2011 high of $85.

Recently I ascribed to Cochlear’s shares, a valuation of $59. Since 2004 the price has been persistently above my intrinsic value estimate, which means the combination of circumstances that have pushed the share price below value most recently are worth exploring.

Cochlear has the largest market share for cochlear hearing implants worldwide and, after announcing a voluntary recall of its flagship Nucleus CI500 implant range recently (the Nucleus accounts for more than 70% of sales), investors voted with their feet and the stock fell more than 20%.

The recall was voluntary and relates only to those devices that have not been implanted. The devices have a fail rate of about 1% and the fault – due to moisture on 1 of 4 diodes from loss of seal – is not believed to be harmful in any way, the device simply shuts down.

With about 25,000 of the units in use globally, that implies around 250 recipients of the implant will be affected and although that is significant, the proactive and patient-focused response of the company should ensure the reputational damage is contained.

As Cochlear’s technicians work to isolate the problem with the Nucleus 5 range, the company will dust off the Nucleus Freedom range, which it has marketed successfully for many years against products such rivals as Advanced Bionics and Med-El.

Med-El is gaining market share in the US generally but patients waiting for implant surgery have switched to the Cochlear Freedom product and apparently with no delays.

At the same time as Cochlear’s recall, Advanced Bionics received FDA approval to sell its product (which was itself recalled in November last year) into the US market. This turn of events is not unusual for the industry … but it is unusual for Cochlear and that’s why the news came as such a blow. Cochlear is one of the highest-quality companies trading on the ASX today. The company that almost never puts a foot wrong appears to have tripped itself up and investors became spooked.

And in that reaction a potential opportunity may be presented.

The financial impacts of these events won’t be fully known until later in the year but is expected currently to be $130 – $150 mln, translating to an after tax impact of about $20 mln.

Over the past decade, Cochlear has increased profits every year with the exception of 2004. Net profit was just $40 million in 2002 and most recently the company reported profits of $180 million for 2011.

Operating cash flow over the same period has risen from less than a $1 million (an exception for 2002) to more than $201 million, allowing debt to decline to just $63 million from nearly $200 million in 2009. Net gearing is now minus 1.86%.

Those impressive economics have resulted in an intrinsic value that has risen by nearly 18% each year since 2004. If your job as a long-term investor is to find companies with bright prospects for intrinsic value appreciation – believing that in the long run prices follow values – then it quite possible that Cochlear is being served up on a plate.

The recently reported net profit figure of $180.1 million for 2011 was up 16% and in line with consensus analyst estimates, although this occurred despite sales of $809.6 million exceeding analysts’ estimates. It seems the analysts did not expect the EBIT and NPAT margins that were reported. These were flat, which given a very strong Australian dollar, suggests impressive efficiency gains in the operations.

If only that blasted “Australian peso” would go down and stay down!

Back on August 19, 2009, I wrote in the Eureka Report: “Fully franked dividends have risen every year for the past decade, growing by almost 500% (or 22% pa) since 2000. These are not numbers to be sneezed at; the company has produced an impressive and stable return on equity since 2004 of about 47% with very modest debt. Clearly this is a company worth some significant premium to its equity.”

Nothing changed really for 2011. A final dividend of $1.20 per share was 70% franked and up 14%.

Importantly, it seems Cochlear’s market is growing. Unit sales volumes were up 17% for the year and, given in the first half they were up 20%, it suggests the second half were up 14%. Double digit growth was reported in sales volumes for all major regions and Asia was the most impressive, rising more than 30% to the point where it makes up 16% of total revenues.

This really is impressive stuff. Just two years ago the company reported unit sales growth of only 2%, to 18,553 units, and many analysts were blaming slow China sales. Nobody expected the company to ever repeat its 2007 and 2008 volume growth of 24% and 14% respectively, and certainly not off a higher base. Growth has always been viewed as being limited by the high cost of the devices and the reliance on insurance and healthcare schemes to subsidise the costs and those of surgery to implant to them.

According to the World Health Organization however, almost 280 million people suffer from moderate to profound hearing loss and an ageing population means this figure will rise. Cochlear is one of a handful of companies that actively contributes to improving the quality of life of its clients.

When great companies stumble, the impact can be exaggerated by the reaction of shareholders who never believed it could happen. Then comes a wave of selling amid doubts that the company will ever regain its mantle.

But strong market share and strong cash flow, high returns on equity and low debt, are rarely offered at bargain prices so I picked up some Cochlear stock for the Montgomery [Private] Fund. It is expected that I will to add to this position over the coming weeks and months (provided value remains) when the full financial impact of the recall is known.

I must confess I didn’t bet the farm on this particular investment because the financial impact of the recall remains uncertain; when that changes it will impact my intrinsic value estimate.

Whatever the impact, it will be temporary, even though it won’t necessarily preclude lower prices from this point. During the GFC, Cochlear shares fell from $78 to $44. No company is immune to lower share prices and I don’t know when or in what order they will transpire.

What I do know is that in 2021 we aren’t likely to be thinking about this recall, just as nobody now talks about the Wembley Stadium delays that dogged Multiplex back in 2006. Mercifully, investors’ memories tend to be short.

Recalls, competition, marketing gaffes and wayward salary packages are all part of the cut and thrust of business and if lower prices ensue for Cochlear shares, it will be important to determine whether the recall will inflict permanent scars. My guess is that it will not. I wonder whether you are listening for value?

Posted by Roger Montgomery, Value.able author and Fund Manager, 19 October 2011.

by Roger Montgomery Posted in Companies, Health Care, Investing Education.

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by Roger Montgomery Posted in Companies, Investing Education, Technology & Telecommunications, Value.able.

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This journey began with the simple question Will David beat Goliath?

Value.able Graduate Scott T resolved to take up a fight with conventional investing, by tracking the performance of a typical and published ‘institutional-style’ portfolio against a portfolio of companies that receive my highest Montgomery Quality Ratings.

By 30 June 2011 the A1 portfolio was up 1.8 per cent compared to the XJO, which was down 2.9 per cent. As for the conventional ‘institutional’ portfolio, the bankers were down 6.2 per cent.

Over to Scott T for his third quarter update…

“For new readers to Roger Montgomery’s Insights Blog, welcome. Here at Roger’s blog we are conducting a 12-month exercise measuring the performance of a basket of 10 stocks recommended by Goldman Sachs, against a basket of 10 A1 or A2 businesses that were selling for as big a discount to Intrinsic Value as we could find.

“Nine months have now passed since our twin brothers each invested their $100 000 inheritance, and it has been a very turbulent time in the market.

“Our Queensland regional accountant has had his head down at the office for the entire quarter. The end of the financial year had come and gone and hundreds of clients where sending in their tax documentation, calling with questions and chasing their refunds. Time flew by in the office, and he hardly had time to try to attract new clients, let alone watch the daily gyrations of the global equities markets. By the end of September when he was finally able to take a breath and look at the performance of his portfolio.

“He was surprised at how poorly his portfolio of A1 and A2 companies, acquired at prices less than they were worth, had faired. But he quickly realised the overall market had done even worse. Loosing 12 per cent, or $12 000, YTD was bad. But it could have been worse, much worse.

“His twin brother was in a world of pain. The federal department he worked for felt like it was under attack. The mood in the department was that the media seemed hell bent on criticising everything the government did. No initiative was well received and every announcement was instantly compared to last months failure. To top it all off, every night he would check his portfolio, to see how much more of his inheritance had vanished. The red negative number on his spreadsheet just seemed to steadily increase. With little information to go on, and a feeling of helplessness washing over him, he thought seriously about visiting his financial advisors, desperately seeking reassurance, and perhaps changing the mix of the stocks held. He resounded, “Buying what they advised would be good for 2012”.

“As per the first half of the year, dividends will be picked up in the fourth quarter, when shares have finished going ex-dividend and the dividends have actually been received.

“In summary for the nine months to 30 September 2011:

The XJO ​​is DOWN 15.5 per cent
The Goldman Sachs Portfolio​​​is DOWN 19.7 per cent
The A1 and A2 Portfolio ​​is DOWN 12.0 per cent
The A1 and A2 Portfolio has achieved an OUTPERFORMANCE of 3.5 per cent over the XJO and 7.7 per cent over the Goldman Sachs portfolio.

“Here are the portfolios in detail, including cash dividends received in the first half (click the image to enlarge)

“We will visit the brothers again at the end of December for a final wrap up of their first year, and discuss their strategies for 2012

“All the Best
Scott T”

Thank you Scott.

How is your A1 portfolio performing?

Posted by Roger Montgomery and his A1 team, fund managers and creators of the next-generation A1 stock market service, 6 October 2011.

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

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With school holidays well and truly underway, plenty of my peers are also taking a few days off here and there to take their kids to the football finals, duck up to the beach or entertain. That offers plenty of time to review your portfolio with recurring profits in mind.

Stability and predictability are two key words that many investors are unlikely to have heard in recent times and two important components of the ‘toolkit’ that may have gone astray. But at all junctures of the business cycle, stability and predictability are helpful investment partners.

Irrespective of whether you are building a portfolio from the ground up or are reviewing your current holdings, it is vital that you ensure your portfolio is always pointed in the right direction. Few, if any are able to reliably and predictability predict short-term share prices so there is relevance, if not necessity, in ensuring the very best opportunity is given to your portfolio. When a recovery transpires and investors are willing to accept risk again, the portfolio constructed from businesses with some stability and predictability to their revenues and earnings streams will have an excellent chance of outperformance.

While there are many definitions of what constitutes ‘stable’ and ‘predictable’, in terms of business analysis, recurring revenue would be the one I would use. And if you built a portfolio of such businesses, would it matter if this week a country defaulted on its debt or another had its credit rating downgraded? These issues are both temporary in nature and only likely to impact share prices, not the economics of the business.

Long-term contracts are the best form of recurring revenues and these contracts take many forms; There are of course the obvious long-term contracts, such as a mobile phone plan, internet or TV subscription, a car lease or a property tenancy, but less obvious are the long-term contracts we have with our own bodies to feed them, clean them and take out the waste. We have a long-term contract with our teeth, our cutlery and our toilets and these contracts ensure Coles and Woolworths, Kelloggs, Procter & Gamble and Kimberley Clark have millions of customers buying their consumables frequently and with monotonous regularity. In other words – recurring revenue.

Knowing that a percentage of revenue can be relied upon to come in the door each year allows a business to budget, rewarded staff consistently and plan expansions with fewer surprises.

And if you are buying a small piece of such a business, you can sleep more comfortably at night ‘knowing’ that your share will always have value even if the share price halves or worse.

The following two businesses are examples of companies we hold in The Montgomery [Private] Fund, and that we believe display the characteristic discussed.

M2 Telecommunications is a reseller of telecommunications equipment and services into the $6 billion SMB Telecommunications market. While dominated by Telstra (ASX:TLS) with 80 per cent market share, M2 is the seventh largest Telco in Australia with a 4.5 per cent share.

Two thirds of the business’s revenue is recurring via traditional fixed voice services, mobile (phone and broadband) and wholesaling services. Typically, contracted revenue is on 2-4 year terms giving management a significant amount of predictability.

It is due to this predictability that management have forecast 15 per cent earnings growth for FY12 and have the ability to self-fund a couple of large acquisitions, which Vaughn Bowen has moved aside from day-to-day duties to focus on.

Credit Corp – With new management installed and a demonstrated focus on transparency and sustainable growth, 70 per cent of collections are now on recurring payment arrangements.

This frees up collection staff to focus on those clients that are finding it harder to repay their liabilities and drives efficiencies across the group. Not only this, but the degree of certainty has allowed management to invest in even more self-funded ledger purchases and forecast earnings of $21m-$23m in FY12.

Additionally, the businesses offer the following financial metrics:

High Montgomery Quality Ratings (MQR), high forecast ROE’s, low debt levels, a Safety margin and high, recurring revenues have attracted us. After conducting your own research and seeking and taking personal professional advice, I’d be interested to know whether these companies or any others meet your recurring revenue test.

Go ahead and use this blog post as the beginning of a thread listing companies with solid recurring revenue and earnings.

Given the time to be interested in stocks is when no one else is, now is the time to go through your portfolio and determine those holdings that have a component of revenues that are recurring.

Posted by Roger Montgomery and his A1 team, fund managers and creators of the next-generation A1 stock market service, 30 September 2011.

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

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It’s not unusual for stock market investors, including Value.able Graduates, to assume, incorrectly, that I’m against high dividends.

It comes from the position I take: companies that generate high rates of return on equity would make their shareholders a lot more money in the long term if they retained their profits (rather than paid them out as dividends) and continued to earn those high rates.

Not all companies, however, have the ability to sustain high rates of return on incremental equity, and so not all companies have the ability to retain all their profits at high rates of return.

A man with a hammer thinks every problem is a nail, and so given large amounts of cash, a CEO may go and do something silly. Understandably, many Australian investors prefer their Boards of Directors to pay the cash out in the form of a dividend.

There is another method that produces similarly attractive returns as retaining and compounding, but allows for the distribution of accumulated franking credits. For investors on tax rates lower than the corporate tax rate, it makes sense for a company to pay out all of its profits (to the extent that they are fully franked, which rules out a few companies) and replace the capital by way of a renounceable rights issue.

Arguably, a non-renounceable rights issue would be less dilutive on your stake in the business, but may fail to replace all the capital paid out.

As a Value.able Graduate confirmed recently, this only works where the costs associated with the capital raising are less than the tax benefit from paying fully franked dividends out. But that is not the subject of this post.

Don’t get me wrong, I like dividends!

Simply, I prefer to see companies with the ability to generate high rates of return on incremental equity (i.e. strong growth opportunities) retain more capital, borrow less and raise less capital. Borrowing increases risk and capital raisings (acknowledging of the above discussion) dilute ownership.

Dividends are Boring

Stepping aside from the stock market rollercoaster and taking the long-term view, a ‘growing dividends’ route to wealth is hardly an exciting proposition. Indeed, it’s akin to walking around Ikea without a wallet.

Yet many investors who lose money on the stock market, going for the quick buck, keep going back for more (akin to going back to Ikea again) and fail to realise that there is a slow but sure way to riches.

Did you know the stock market is trading about where it was in December 2004? Googling that shocked me – nearly seven years of zero appreciation… it seems zero is indeed the new normal!

Over those same seven years many companies have significantly increased their dividends (I should say that comparison is commonly used by the advisory community and the commentariat but it fails to recognise that there are many companies whose share prices are up three, four and seven fold in the last seven years).

Notwithstanding the weak comparison, it is indeed true that some companies have grown dividends significantly, despite a generally lacklustre market. The Reject Shop grew dividends by 394 per cent between 2005 and 2010 from 17 cents per share to 67 cents; M2 by 800 per cent from 2 cents to 16 cents and JB Hi-Fi by 1100 per cent from 7 cents to 77 cents.

Identifying extraordinary companies – those that generate lots of cash – has the power to make you very happy, just not overnight. In that sense it’s pretty unexciting. Mind you, I am yet to find a book or manual that says investing has to be exciting.

When it comes to investing, what is exciting is the effect of compounding. If you could find a portfolio of companies that paid a 5 per cent dividend yield and was able to grow those dividends by 10 per cent per year, your initial $20,000 portfolio earning $1000 would be generating $6,727 in 20 years – a 34 per cent yield on the initial purchase price. And if The Reject Shop could keep growing dividends at 31 per cent per year (unlikely without hiccoughs), they’d be generating dividends of $53.95 in another 15 years (you see why I said unlikely).

Extraordinary businesses paying attractive dividends

Following you will discover ten extraordinary companies that meet the criteria for high return on equity combined with attractive dividend yields: Imdex (B1), Cabcharge (A3), Retail Food Group (A3), Credit Corp (A2), Seymour Whyte (A1), M2 Telecommunications (A1), Breville Group (A2), Thorn Group (A2), JB HiFi (A3), NRW Holdings (A3).

How did I produce this list?

The goal was to find companies with the potential to significantly increase their dividends in the future. I logged into Skaffold®  and refined my search to companies that generate high rates of return on equity (>15 per cent), have little or no debt (interest cover of more than 4 times) and have the strongest expected growth in earnings for at least the next year (EPS growth > 5 per cent).

And because I simply cannot advocate paying more than intrinsic value, I have also selected those that appear to be trading at a rational price (Safety Margin > 15 per cent).

For the record, I only selected A1, A2 A3, B1, B2 and B3 companies. From 1 November, you will be able to conduct searches like this yourself – high ROE, low debt, specified safety margin – the parameters are endless. Your resultant list of companies will quickly help you navigate the 2080 listed companies to find your own income champions.

What other companies make your income champion list?

Posted by Roger Montgomery and his A1 team, fund managers and creators of the next-generation A1 stock market service, 29 September 2011.

Skaffold® is a registered trademark of Skaffold Pty Limited.

by Roger Montgomery Posted in Investing Education.

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If you’re sitting at home or in your office wondering if the party is over and it’s all turned to pumpkins and mice, allow me to offer you a few insights.

I know of seasoned market practitioners that have deferred the upping of stumps to set up new businesses because they believe there is worse to come. I also know of prominent Australians that are cashing up and I have met with many professional investors who liken the current conditions to those preceding a severe recession or even depression. Berkshire Hathaway shares are trading below $100,000 for the first time in a while (not that it matters). And Bill Gross at Pimco reckons the fact that you can get a better yield over two years by ‘barbelling’ – putting 10 per cent into 30 year bonds and 90 per cent into cash – and beat the yield on 2yr T-Notes is destroying credit creation and so low yields are having the opposite effect to the stimulation they are intended to generate.

Ok. So what do I think?

These are the times to prepare yourself for the possibility of another rare opportunity to buy extraordinary businesses at even more extraordinary discounts to intrinsic value. You have to be ready, you have to have your Value.able intrinsic valuations prepared and your preferred safety margins calculated.

In the short term (6-12 months), on balance, I think shares could get even cheaper (As I write those words, I log on to see the European markets down five per cent and the Dow Jones opening down more than 3 per cent and I am conscious of the fact that an outlook can be tainted by the most recent price direction). But our large cash proportion/position in The Montgomery [Private] Fund since the start of the calendar year has reflected for some time the impact of this possibility on future valuations and our requirement for larger discounts to intrinsic value.

Longer term, I like some of the research put out by McKinsey. The new infrastructure, such as roads, ports, railways and terminals that developing countries such as China, India and South America will need, will require tens of trillions of dollars. McKinsey Global Institute analysis reckons that by 2030 the supply of capital could fall short of demand to the tune of $2.4 trillion – a credit crunch that will slow global GDP growth by a percentage point annually. Even if China and India cool off, a similar gap could occur.

Back to the immediate outlook and there is a simple mental framework that I have been using to think independently about all the ructions impacting our portfolios.

I am no economist, but its pretty easy to see that if trend line US economic growth is barely 1 per cent, then any slowdown in the business cycle will push the economy towards the zero growth line. One per cent is quite simply very close to zero and the business cycle can push growth rates around more than the difference between them. Every time there is a whiff of a slowdown, there will, at the very least ,be fears of another recession. Again, I am not forecasting a recession nor am I forecasting slow growth. Indeed, I am not forecasting at all. I am simply pointing out the fact that tiptoeing on the edge of a precipice (the US at 1 per cent growth) is more frightening than doing circle work in a paddock a long way from any edge at all (China at 7, 8 or 9 per cent growth). Bill Gross’s comments about the destruction of credit further feeds the idea of a slowdown.

On balance I believe there will be some very attractive buying opportunities in the next six to twelve months. Before you read too much into this statement, I should alert you to the fact that I say it every year.

Analysts are prone to optimism too.

I think it’s also appropriate to remember that analysts typically are generally optimistic about earnings forecasts at the start of a financial year. This can be seen in another McKinsey research note (as well as thousands of other similar studies), where analysts commented:

“No executive would dispute that analysts’ forecasts serve as an important benchmark of the current and future health of companies. To better understand their accuracy, we undertook research nearly a decade ago that produced sobering results. Analysts, we found, were typically overoptimistic, slow to revise their forecasts to reflect new economic conditions, and prone to making increasingly inaccurate forecasts when economic growth declined.

Alas, a recently completed update of our work only reinforces this view—despite a series of rules and regulations, dating to the last decade, that were intended to improve the quality of the analysts’ long-term earnings forecasts, restore investor confidence in them, and prevent conflicts of interest. For executives, many of whom go to great lengths to satisfy Wall Street’s expectations in their financial reporting and long-term strategic moves, this is a cautionary tale worth remembering.”

And concluded:  “McKinsey research shows that equity analysts have been overoptimistic for the past quarter century: on average, their earnings-growth estimates—ranging from 10 to 12 percent annually, compared with actual growth of 6 percent—were almost 100 percent too high. Only in years of strong growth, such as 2003 to 2006, when actual earnings caught up with earlier predictions, do these forecasts hit the mark.”

Demand bigger discounts

Those thoughts provide the ‘Skaffolding‘ in my mind around which I construct an opinion of where the landmines and risks may be for an investor. I tend to 1) look for much bigger discounts to intrinsic values that are based on analyst projections for earnings and 2) lower our own earnings expectations for those companies we like best.

Cochlear is one example of this. Many analysts have forecast a 10-20 per cent NPAT decline from the recent recall of their Cochlear implant. Only one analyst has considered and forecast a 40-50 per cent NPAT decline. The truth will probably be somewhere in between. Such a decline however would come as a shock to many investors if it were to transpire. And so it is important to be aware of that possibility when calibrating the size of any position in your portfolio. In other words, be sure to have some cash available for such an event because intrinsic value based under that scenario is between $23 and $30.

Your “Top 5”

Earlier this month I asked you to list your “Top 5” value stocks – those that you believed represented good value at present. I was delighted to receive so many contributions.

On behalf of the many Value.able Graduates and stock market investors who read our Insights blog thank you for sharing with us the result of all your fossicking, digging and analysis.

There were more than 115 suggestions. The most popular was Forge Group with 16 mentions.

The following table presents the Quality Score, FY2011 ROE, FY2011 Net Debt/Equity and 2012 Value.able Intrinsic Value for Forge Group (FGE), BHP, Cochlear (COH), M2 Telecommunications (MTU), Woolworths (WOW), ARB Corp (ARP), CSL , Data#3 (DTL), Matrix (MCE), Fleetwood (FWD), JB Hi-Fi (JBH), Mineral Resources (MIN), Blackmores (BKL), Flight Centre (FLT), Lycopodium (LYL), Monadelphous (MDN), Integrated Research (IRI), 1300 Smiles (ONT), ThinkSmart (TSM) and ANZ.

As you know these quality scores and the estimates for intrinsic values can change at a moments notice (just ask those working at Cochlear!) so be sure to conduct your own research into these and any company you are considering investing in and as I always say, be sure to seek and take personal professional advice.

Posted by Roger Montgomery and his A1 team, fund managers and creators of the next-generation A1 stock market service, 23 September 2011.

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

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I’m always looking for Value.able contributions that will enahnce the value of our Insights blog.

Scott’s comparison of the performance of a Value.able A1 portfolio and a conventional portfolio promoted by a large bank over the last six months is one such example. Nick’s contribution here about independent thinking is another. Take it away Nick…

“Most people would rather die than think, in fact they do so.” Bertrand Russell

The title of this post which Roger has kindly let me write for his blog may seem like such elementary and common sense advice that it need not be written at all – kind of like telling a friend to make sure he looks both ways before crossing the freeway.

Is thinking independently when it comes to investing really so obvious? And do people practice it consistently? I would say not. Just because something is obvious does not mean it will be practiced and not thinking independently, by which I mean not thinking for yourself and making up your own mind on an issue (not necessarily having a contrary opinion for the sake of having a contrary opinion), is one of the surest ways to destroy wealth and end up dissatisfied as an investor (aside from the strong likelihood of losing money you will also lack autonomy over your future). I have made this mistake in the past and can speak from experience.

Ben Graham once said “You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right.”

And in the 1985 Berkshire Hathaway Annual Letter to Shareholders, Warren Buffett shares with his readers this story passed down from Ben Graham which illustrates the lemming-like behaviour of the crowd: “Let me tell you the story of the oil prospector who met St. Peter at the Pearly Gates. When told his occupation, St. Peter said, “Oh, I’m really sorry. You seem to meet all the tests to get into heaven. But we’ve got a terrible problem. See that pen over there? That’s where we keep the oil prospectors waiting to get into heaven. And it’s filled – we haven’t got room for even one more.” The oil prospector thought for a minute and said, “Would you mind if I just said four words to those folks?” “I can’t see any harm in that,” said St. Pete. So the old-timer cupped his hands and yelled out, “Oil discovered in hell!”. Immediately, the oil prospectors wrenched the lock off the door of the pen and out they flew, flapping their wings as hard as they could for the lower regions. “You know, that’s a pretty good trick,” St. Pete said. “Move in. The place is yours. You’ve got plenty of room.” The old fellow scratched his head and said, “No. If you don’t mind, I think I’ll go along with the rest of ’em. There may be some truth to that rumour after all.”

This is not the fate you want for yourself!

And don’t let hubris get in the way. Intelligence alone will not keep you away from the dangers of crowd behavior and emotion. One of history’s most gifted minds and scientists, Sir Isaac Newton, was caught up in the emotion and chaos of crowd behavior which resulted in him losing his fortune in the South Sea Shipping Company Bubble. Sir Isaac Newton had previously made a packet on this very same company although after selling and watching the share price continually keep rising, he reinvested everything he had before the crash. For as long as he lived he forbid the words South Sea Shipping Company to ever be mentioned in his presence. It was not a lack of intelligence which brought Sir Isaac unstuck, it was, I argue, his lack of independent thought on the merits of the South Sea Shipping Company as a suitable investment.

“An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.” Ben Graham.

Once you have determined to think independently and make up your own mind on a company’s current strengths and weaknesses, and its current and future earnings prospects, how do you best do this? Perhaps the most effective way is to follow the advice of the famous algebraist Carl Jacobi who said ‘Invert, always invert.’ So if from your reading you believe company XYZ to be possible investment material (either from Roger’s blog, the newspaper, a friend, your stockbroker) read everything you can and formulate as strong a case as you can on why it would make a lousy investment. If, after having made as strong a case against the company as the information allows, it still looks pretty good and is selling at an attractive price, then it is worthy of further consideration. It has also been useful to me in the past having friends help me out with this. Usually before making an investment I’ll ask my most intelligent and able friends for their opinion on why I shouldn’t invest in company XYZ. This will not mean that you’ll never make a mistake again, although when you do at least you’ll be able to understand why (having studied the reasons against making the decision in the first place).

“I want to be able to explain my mistakes. This means I do only the things I completely understand.” Warren Buffet

Charlie Munger, in a speech given at USC (which you can all view on YouTube) says “I have what I call an iron prescription that helps me keep sane when I naturally drift to preferring one ideology over another and that is I say I am not entitled to have an opinion on this subject unless I can state the arguments against my position better than the people who are supporting it.” This is great advice, and to tailor it to investing all you need to do is replace the word ‘subject’ with ‘company.’

Charlie Munger also likes to talk about the importance of having a latticework of mental models in your head and how the big ideas from across a broad range of disciplines can often be used in sync to best analyse a particular problem. I won’t expand on this now, although can recommend his speeches and essays which are easily available on the internet.

Having a great interest in investing, I find this blog is a wonderful source of ideas and learning and really enjoy reading the comments written every day. That said, one way in which I believe it could be improved is for there to be more argument and questioning, something which is happening more and more as the share price of recent blog favorites has dropped. If someone says they believe XYZ to be a great quality company without providing reasons they should be held to account and asked why? If the only response is that Roger has it as an A1 then a fail grade would be mandatory. If someone says they believe that company XYZ has excellent earnings prospects they should again be asked why? And if their response is that the analysts consensus on Comsec says so then again, another F.

I hope that this post may have been of some interest and if you have some stories of success as a result of independent thinking, I would be very interested in reading them.

Nick Mason

Roger’s Note: And if you have a similarly lucid and instructive idea that you would like share here at our Insights blog, go ahead and submit. Not every contribution can be published as a post, but we will certainly post those we like.

Posted by Roger Montgomery and his A1 team, fund managers and creators of the next-generation A1 stock market service, 23 September 2011.

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

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