Investing Education

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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The time has arrived.

My team and I are delighted to invite Value.able Graduates to pre-register for Skaffold®, our next-generation A1 service.

Skaffold is the stock market like you’ve never seen it before – the world’s best visuals combined with its most reputable information and ideas.

Amazing, incredible, simple. That’s Skaffold.

Those who have already seen Skaffold called it “the missing piece”.

Value.able Graduates will receive a personal invitation today. Keep an eye out for an email from me with the subject line “Your next-generation A1 invitation. Here it is”.

IMPORTANT: It has come to our attention that some @optusnet.com.au email addresses did not receive my invitation. Rest assured, if you have contacted us, posted a comment here at the blog or on my Facebook page, or simply not received your invitation, my team will be in touch.

Posted by Roger Montgomery, Skaffold® member #1.

Skaffold® is a registered trademark of Skaffold Pty Limited.

by Roger Montgomery Posted in Companies, Investing Education.

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With reporting season in full swing, I would like to share my insights into whose Quality Score has improved, and whose has deteriorated. Remember, none of this represents recommendations. It is intended to be educational only. You must seek and take personal professional advice before acting or transacting in any security.

To date, 232 companies have reported their annual results. I am sure you can understand why we feel snowed under. With almost 2,000 companies listed on the ASX, the avalanche still has a way to roll.

We have updated all of our models for each of the 164 companies that we are interested in. As you know, we rank all listed companies from A1 down to C5. The inputs for those rankings always come from the company themselves. I would hate to think how bipolar they would be if we allowed our emotions and personal preferences to infect those ratings (or be swayed by analyst forecasts)!

Rather than arbitrary and subjective assessments, we download some 50-70 Profit and Loss, Balance Sheet and Cash Flow data fields from each annual report to populate five templates. All of these templates employ industry specific metrics to calculate the Quality Scores. This allows us to rank every ASX-listed business from A1 – C5. Its our objective way to sort the wheat from the chaff.

For Value.able Graduates not familiar with our scoring system, company’s that achieve an A1 Score are those we believe to be the best businesses, and the safest. C5s are the poorest performers and carry the highest risk of a possible catastrophic event.

A1 does not mean nothing bad will ever befall a company. A1 simply means to us that it has the lowest probability of something permanently catastrophic. Further, ‘lowest probability’ doesn’t mean ‘never’. A hundred-to-one horse can still win races, even though the probability is low. Similarly, an A1 business can experience a permanently fatal event. In aggregate however, we expect a portfolio of A1 businesses to outperform, over a long period of time, a portfolio of companies with lesser scores.

With that in mind, we are of course most interested in the A1s and – on a declining scale – A2, B1 and B2 businesses.

So, who has managed to retain their A1 status this reporting season? And which businesses have achieved the coveted A1 status? If you hold shares in any of the companies whose scores have declined (based of course on their reported results), please read on.

Of the companies that have reported so far, last year 20 of them were A1s, 28 were A2s, one was a B1 and 13 scored B2. That’s an encouraging proportion, although we tend to discover each reporting season that the better quality businesses and the better performing businesses are generally keen to get their results out into the public domain early.

Its towards the end of every reporting season where the quality of the businesses really drops off. This is always something to watch out for – companies trying to hide amongst the many hundreds reporting at the end of the season. It’s always a good idea to turn up to a big fancy dress party late, if you aren’t in fancy dress.

This year we have seen the number of existing A1s fall to nine from 20, A2s from 28 to 24, B1s rise from one to two and B2s fall from 13 to six.

The first table shows all twenty 2009/2010 A1 companies that have reported to date. You’ll see a number of very familiar names in here, including ARB Corp (ARP), Blackmores (BKL), Cochlear (COH), Carsales.com (CRZ), Fleetwood (FWD), Mineral Resources (MIN), Platinum Asset Management (PTM), REA Group (REA), DWS (DWS), Forge (FGE), K2 Asset Management (KAM), Macquarie Radio Network (MRN), Nick Scali (NCK), 1300 Smiles Limited (ONT), SMS Management & Technology (SMX), Webjet (WEB), JB Hi-Fi (JBH), Navitas Limited (NVT), Saunders International (SND) and GUD Limited (GUD). Nine have maintained their A1 rating this year.

Now, before you go jumping up and down, a drop from A1 to A2 is like downgrading from Rolls Royce to Bently. When we talk about A2s, its not a drop from RR Phantom to a Ford Cortina, not that there’s anything wrong with the old Cortina (if you are too young to know what I am talking about Google it!).

The only big rating decline is GUD Holdings, which made a large acquisition (Dexion) during the year. Indeed, a common theme amongst the higher quality and cashed up businesses this reporting season has been the deployment of that cash towards, for example, acquisition or buybacks (think JB Hi-Fi).

Moving onto the 2009/2010 A2 honour roll: Codan Limited (CDN), Advanced Share Registry Limited (ASW), Commonwealth Bank (CBA), Credit Corp (CCP), CSL Limited (CSL), Decmil (DCG), Domino’s Pizza (DMP), NIB Holdings (NHF), OZ Minerals (OZL), Plan B Group (PLB), RCG Corporation (RCG), Sedgman Limited (SDM), Slater & Gordon (SGH), Super Retail Group (SUL), Wellcom Group (WLL), Argo Investments (ARG), AV Jennings (AVJ), Carindale Property Trust (CDP), Computershare (CPU), Euroz Limited (EZL), Oakton (OKN), Tamawood (TWD), Austal Limited (ASB), LBT Innovations (LBT), Academis Australasia Group (AKG), Chandler Mcleod Group (CMG), The Reject Shop (TRS) and Primary Health Care (PRY).

The businesses that make up this list showed slightly more stability. The biggest fall in quality this year was Primary Healthcare (PRY),which is still struggling to digest the large purchases it made a few years ago. The Reject Shop (TRS) also declined, to B3. TRS is still investment grade and we would lean towards believing this is a short-term decline, given the floods in QLD that caused the complete shutdown of their new distribution center and the massive disruptions subsequently caused. As the company said, you can’t sell what you haven’t got!

Finally, B1 and B2 companies: Leighton Holdings (LEI), Alesco Corp (ALS), Mount Gibson Iron (MGX), Amcom Telecommunications (AMM), Data#3 (DTL), Ansell Limited (ANN), Fortescue (FMG), Little World Beverages (LWB), Stockland (SGP), iiNet (IIN), MaxiTRANS Industries (MXI), Newcrest Mining (NCM), SAI Global (SAI), Gazal Corporation (GZL) and Salmat (SLM).

About half the companies in the B1/B2 list retained or improved their ratings from last year. Mind you, half also saw their rating decline!

The clear fall from grace is Leighton Holdings, whose problems have been well documented in the media and via company presentations.But once again, like The Reject Shop, this could be a temporary situation. If the forecast $650m profit comes through, I expect LEI’s quality score will improve. What the dip will do, however, is remain a permanent reminder that Leighton is a cyclical business. Getting the quote right on a job is important, even more a massive enterprise like Leightons.

Are you surprised by any of the changes? We certainly were!

Sticking to quality is vitally important. That’s what my team and I do here at Montgomery Inc, and its what our amazing next-generation A1 service is all about. Value.able Graduates – your invitation is pending.

If you are yet to join the Graduate Class, click here to order your copy of Value.able immediately. Once you have 1. read Value.able and 2. changed some part of the way you think about the stock market, my team and I will be delighted to officially welcome you as a Graduate of the Class of 2011 (and invite you to become a founding member of our soon-to-be-released next-generation A1 service).

Remember, you must do your own research and remember to seek and take personal professional advice.

We look forward to reading your insights and will provide another reporting season update soon.

Posted by Roger Montgomery and his A1 team, fund managers and creators of the next-generation A1 service for stock market investors, 24 August 2011.

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

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iiNet’s full-year results have been released. I have taken particular interest because communications and data is one sector of the marketplace I believe is relatively less affected, in terms of share-of-wallet, by the ructions in the US Europe.

The results released today (15 August 2011) were marginally below the expectations of several analysts we correspond daily with. Underlying EBITDA was up just shy of 30 per cent to $104.8 million (some analysts were expecting $106 million and a little more).

With DSL (Digital Subscriber Line) – the technology that significantly increases the digital capacity of ordinary telephone lines, and excluding HFC (Hybrid Fiber-Coax network – CABLE) – iiNet is now the number two competitor and the leading “challenger “in the Australian residential telecommunications market. As an investor, I am always interested in the number 1 or 2 player in town. However the gap between number 1 (Telstra) and iiNet (#2) is enormous. iiNet have 641,000 paid DSL subscribers (up 19 per cent). Telstra has 2.4 million.

The company reported its underlying Net Profit After Tax was $39.0m, up 12.4 per cent on FY10, while reported NAPT fell 3.7 per cent to $33.4m (FY10 $34.7m). On a quick glance, I reckon underlying profit was $37 million (you have to add back $3.9 million in deal costs, redundancy costs of $1.2 million and legal costs of $1.4 million but tax effect it). Stripping out the impact of the acquisition, I also estimate cash flow was close to $40 million.

The reason for the less than stellar growth in reported net profit was because iiNet’s tax bill was much higher than last year. The increase in tax wiped out all of the increase in the net profit before tax.

Whilst many analysts will look at the growth in operating profit (EBITDA), I’d look at the net profit before tax. If I add the legal costs in 2010 back to that year’s profit-before-tax and then add the one-offs for 2011, I get a jump in net profit before tax from $43.85 to $53.4 million and a reduction in margins from 9.25 per cent to 7.6 per cent. Hopefully the company’s expected ‘synergies’ (an extra $10 million from porting AAPT customers across to the iiNet billing system?) raise this to 8.5 per cent.

Net debt increased to $96.4m from $56.3m as a result of the AAPT Consumer division. This has had an impact on our Quality Score (the A1-C5 system), which was B2 previously. Gearing will be 40 per cent. And the the balance sheet? It now contains $302 million of goodwill compared to $242 million of equity.

Revenue and operating cash flow was up significantly with the full year’s benefit of the Netspace acquisition and a nine month benefit of the AAPT consumer division. What really would be interesting however is an estimate of what like-for-like revenue and operating cash flow is. Sure iiNet has no ‘stores’, but acquisitions and synergy extraction doesn’t have the same whiff of sustainability as a business that can grow organically. I would like to see how the old business (excluding the acquisitions) is travelling. Value.able Graduates – would you?

And when I hear company say that it is “Ideally positioned for the future“, I want answers as to whether they were previously ideally positioned for ‘now’.

The 19 per cent growth in DSL subscribers includes AAPT’s consumer division, so it doesn’t give us much insight into the organic growth of the company. With ARPU (Average Revenue Per User) largely unchanged, yet network and carrier costs up 56 per cent – above the 47 per cent increase in revenue – some insights into organic growth would be helpful. I suspect subscriber growth will reflect slow organic growth in FY12, and any margin/profit improvement will come from ‘synergies’. While these may be significant ($9 – $12 million from migrating AAPT customers onto iinet billing system), they are not a long-term delivery platform for profit growth.

It is clear that management’s confidence is high. They have significantly increased the dividend from $12.1 million last year to $16.7 million this year and have announced separately a share buy-back of up to 7.6 million shares, or about 5 per cent of the issued capital (about $17 million at current prices), despite the fact that debt has risen substantially by a net $52 million. Perhaps when you have $766 million coming through the door you can afford to be a bit fancy-free with your capital allocation? Thoughts anyone?

I hear whispers in the background… Roger, how do you know all this? Yes, I do listen to company presentations and we do read investor briefings. But nothing compares to the clarity that comes from using our A1 service. It is, quite literally, extaordinary. And we can’t wait to share it with you. Value.able Graduates – expect to receive your invitation very soon. Now, back to the program…

If organic growth is slow and acquisitions begin to thin out, one would expect debt repayment followed by an increase in the payout ratio. Or perhaps the other way around, if share price support is contemplated?

The prices paid for acquisitions does not immediately cause concern for me, because the returns on equity being reported aren’t poor. But they aren’t A1 either.

Investors have tipped in $223 million and left in $15 million. On those amounts, iiNet’s Return on Equity is about 16 per cent.That’s not bad, but are there better opportunities out there. Before you suggest Telstra, keep in mind it is 140 per cent geared and profits are boosted by the failure of the company to recognise software development expenses in the year they are incurred.

The old fashioned Value.able investor in me doesn’t like looking at a balance sheet that reveals the debt-funded acquisition of goodwill. I have witnessed far too many examples of this turning out poorly. Sure, some of you may say that MMS did the same thing? But while debt rose significantly there, the corresponding asset was PP&E, not goodwill. You may instead point out that interest cover is still high at 9 times (20 times last year). That, I accept.

Finally, the NBN. What does it mean for iiNet?

First, some background. An ‘Off-net’ customer is provided a DSL service through another network – usually Telstra wholesale. An ‘On-net’ customer is one that is provided a DSL service through the iiNetwork (iiNet’s own broadband network). The NBN is expected to reduce the average monthly cost of broadband + Voice bundling to $33, which compares favourably to the current off-net cost of $57. This is a potentially major saving, but the reason I am not as excited about this as the company is because as the transition is made, there will be some leakage. It will occur over an unexciting period of time and any number of offsetting factors could adversely impact revenues, costs and profits during that time.

I am more excited about other companies at the moment. A growth by acquisition strategy may offer wonderful potential in the short-term, but it can also be used to mask slow organic growth. The buy-back can be a sign that cashflow will be strong, but it can also be used to merely ‘display’ confidence and support the share price. At Montgomery HQ, we reckon the shares are very close to their Value.able intrinsic value, but iiNet’s fall in quality, from A3 to B2, suggests shifting your attention to other opportunities.

You should be practising your own Value.able valuations. So what do you get for iiNet for 2011, 2012 and 2013?

Posted by Roger Montgomery and his A1 team, fund managers and creators of the next-generation A1 service for stock market investors, 15 August 2011.

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

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