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Investing Education

  • What do I think these A1 companies are really worth?

    Roger Montgomery
    July 6, 2010

    If you recently ordered my book Value.able, thank you and welcome! You have joined a small band of people for whom the inexplicable gyrations of the market will soon be navigated with confidence and far more understanding. If you have ever had an itch or the thought; “there must be a better way”, Value.able is your calamine lotion.

    Its hard to imagine that my declaration to Greg Hoy on the 7.30 Report that Myer was expensive as it listed at $4.10, or elsewhere that JB Hi-Fi was cheap and Telstra expensive has anything to do with the 17th century probability work of Pascal & Fermet.

    The geneology of both modern finance and separately, the rejection of it, runs that far back. From Fermet to Fourier’s equations for heat distribution, to Bachelier’s adoption of that equation to the probability of bond prices, to Fama, Markowitz and Sharpe and separately, Graham, Walter, Miller & Modigliani, Munger and Buffett – the geneology of value investing is fascinating but largely invisible to investors today.

    It seems the intrinsic values of individual stocks are also invisible to many investors. And yet they are so important.

    My 24 June Post ‘Which 15 companies receive my A1 status?’ spurred several investors to ask what the intrinsic values for those 15 companies were. You also asked if I could put them up here on my blog so you can compare them to the valuations you come up with after reading Value.able. Apologies for the delay, but with the market down 15 per cent since its recent high, I thought now is an opportune time to share with you a bunch of estimated valuations.

    I have selected a handful from the 15 ‘A1’ companies named in my 20 June post and listed them in the table below. The list includes CSL Limited (CSL), Worley Parsons (WOR), Cochler (COH), Energy Resources (ERA), JB Hi-Fi (JBH), REA Group (REA) and Carsales.com.au (CRZ).

    If you are surprised by any of them I am interested to know, so be sure to Leave a Comment. And when you receive your copy of my book (I spoke with the printer yesterday who informed me the book is on schedule and will be delivered to you very soon), you can use it to do the calculations yourself. I am looking forward to seeing your results.

    The caveats are of course 1) that the list is for educational purposes only and does not represent a recommendation (seek and take personal professional advice before conducting any transactions); 2) the valuations could change adversely in the coming days or weeks (and I am not under any obligation to update them); 3) these valuations are based on analysts consensus estimates of future earnings, which of course may be optimistic (or pessimistic, and will also change).  They may also be different to my own estimates of earnings for these companies; 4) the share prices could double, halve or fall 90 per cent and I simply have no way of being able to predict that nor the news a company could announce that may cause it and 5) some country could default causing the stock market to fall substantially and I have no way of being able to predict that either.

    With those warnings in mind and the insistence that you must seek advice regarding the appropriateness of any investment, here’s the list of estimated valuations for a selection of companies from the 15 A1 companies I listed back on 20 June.

    Posted by Roger Montgomery, 6 July 2010

    by Roger Montgomery Posted in Companies, Investing Education
  • Did you notice a change to my blog? Buy Now

    Roger Montgomery
    June 30, 2010

    Value.able can now be pre-purchased online at my website, www.rogermontgomery.com. My book is on the printing press and will be delivered in about 21 days.

    There will only be one print run.

    In Value.able I share my stock investing rules for long-term value investing and online trading that you can follow to reproduce my excellent stock market returns (have a look at the June issue of Money magazine).

    Click here to pre-purchase your copy today.

    Posted by Roger Montgomery, 30 June 2010.

    by Roger Montgomery Posted in Companies, Insightful Insights, Investing Education
  • Which 15 companies receive my A1 status?

    Roger Montgomery
    June 24, 2010

    As you would all know by now, I like to invest in great quality companies when they are cheap. Nothing too special about that because that is true of a line of value investors from Buffett and Munger, all the way down to us. For me, ‘quality’ is not difficult to ascribe to a company, provided you remove the subjective elements. You can decide, for example, to simply look at the return on equity, but of course that alone will not be enough to separate two companies that each share the same return on equity. One company could have more debt, or two retailers with the same return on equity could have very different inventory turns or different cash flows from working capital. One retailer’s inventory management may be improving and the other declining. The absolute value of many ratios and their trends can all help to determine quality in an absolute and relative sense. That is how I arrive at my A1 ratings (not to mention A2, A3….C5 etc) – ratings that you have seen me discuss on the Sky Business Channel and heard me chat about on 2GB.

    Perhaps the simplest way to think about quality is the way that Buffett has done it using his subscription (complimentary for life one presumes) to Value Line, which was launched in 1931 in the United States.

    Applying Buffett’s approach to an Australian company is delightfully simple. Start by having a look at the profit some time ago – lets use ten years. Compare that ten year-old profit to the most recent one, or even next year’s expected profit. Is it up or down? In his 1996 Chairman’s letter to shareholders Buffett said; “Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily-understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now. Over time, you will find only a few companies that meet these standards – so when you see one that qualifies, you should buy a meaningful amount of stock. You must also resist the temptation to stray from your guidelines: If you aren’t willing to own a stock for ten years, don’t even think about owning it for ten minutes. Put together a portfolio of companies whose aggregate earnings march upward over the years, and so also will the portfolio’s market value.”

    So the first step is to compare the change in earnings over a reasonable period of time. Ideally you would like the profits to be “marching upwards” and be confident that the future holds the same pattern.

    The next step is to look at the change in the contributed equity. The reason you want to do this is explained with a simple example. Lets say I start a business with $10 million and in the first year I earn $2 million. The next year I earn $4 million and the year after I earn $6 million, and so on. I suspect you would be as thrilled as me with the decision to start this business. What if we started another business that produced the same profits over time as the first example, but in addition to the initial $10 million to get things started, we were required to inject many millions more in equity back into the business, annually? My guess is that you would be far less excited.

    Airlines are particularly adroit at performing these riches-to-rags economics. But having harped on about that for a decade, you already know my thoughts on airlines.

    How about we take a look instead at Incitec Pivot (IPL)? Here is a business that in 2002, after two years of losses, reported a profit of $18.3 million. Equity contributed by shareholders amounted to $65 million at that time and retained earnings (profits that shareholders had not received as dividends) had built up to $84.4 million. Now fast forward to 2010 and Incitec Pivot is forecast to earn about $400 million. So in just 8 years profits have grown more than 20-fold!

    As an owner of the whole business, you would be pretty happy with this result, particularly in light of Buffett’s comments about “marching upwards” and all. The real questions however are 1) have you had to contribute any additional money to the business or leave any in there? and 2) How much?

    While profits have grown by $382 million, the amount of money the shareholder/owners have had to contribute to produce this result is even more startling. Imagine owning a business that grew profits from $18 million to $400, but required an initial investment of $65 million and then an additional $3.2 billion! And we haven’t yet mentioned that borrowings have increased from $120 million in 2002 to $1.6 billion at the end of 2009.

    These sorts of economics do not receive my A1 accolade. The only A they get is the one for ‘Agony’. By comparing the increase in profits to the increase in equity, you can get an understanding of the returns the additional capital has generated. In the case of Incitec Pivot that number is about 11%. If the debt is included, the return on additional capital is 8%. Not as shockingly low as other companies (I can think of half a dozen off the top of my head), but not anywhere near the 30% rates achieved by Woolworths, for example.

    At the 1998 Berkshire Annual Meeting, Buffett said: Time is the enemy of the poor business and the friend of the great business. If you have a business that’s earning 20%-25% on equity, time is your friend. But time is your enemy if your money is in a low return business.”

    He was perhaps referring to Graham’s own metaphor about the market being a weighing machine over long periods. Over long periods of time, prices tend to track the underlying performance of the business. If returns in the business are low, so will be the returns be from owning the shares.

    And thats why I like to stick to A1s. And there’s not that many. So who are the A1’s?  Well, here is fifteen. They’re ranked in order of market capitalisation (biggest to smallest). And don’t forget, this is a purely didactic exercise. Its educational, so you must seek and take personal professional advice before doing anything. Also remember I am offering no assessment about whether the shares will go up or down. The shares could all halve (or worse). I have no way of predicting what the shares will do.

    One of the most frustrating things about having high standards is that the pond gets very small. There just aren’t as many “fish in the sea” as your parents may have led you to believe. But as John Maynard Keynes said in a letter to F. C. Scott on August 15, 1934: “As time goes on, I get more and more convinced that the right method in investment is to put fairly large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes. It is a mistake to think that one limits one’s risk by spreading too much between enterprises about which one knows little and has no reason for special confidence… One’s knowledge and experience are definitely limited and there are seldom more than two or three enterprises at any given time in which I personally feel myself entitled to put full confidence.” My quality ratings can and do change. Not often, but they will. Recently, for example, quite a number of companies raised capital to pay down their debt. Even before they report their full year results, I can see that the raisings will dilute return on equity and dilute intrinsic value, but I can also see that the balance sheet will be stronger and so, the quality rankings will rise. Importantly however for me, my A1’s are those companies in which ‘I personally feel myself entitled to put full confidence’ (in terms of quality, not share price direction or prediction!).

    If you have a list of companies in which you have full confidence and are happy to share, feel free to leave a comment.

    Posted Roger Montgomery, 20 June 2010

    by Roger Montgomery Posted in Companies, Investing Education
  • Did you receive mail yesterday?

    Roger Montgomery
    June 23, 2010

    Thank you. Thank you for waiting, thank you for your encouraging support and most of all, thank you for inspiring me to share my new way of investing with you.

    If you have purchased your copy of Value.able, it will arrive in approximately 21 days, straight off the printing press.

    If you didn’t receive an email from me yesterday and would like to purchase your reserved copy before it is released for sale next week on my website, please write to me – roger@rogermontgomery.com – and I will send you the special link.

    Posted by Roger Montgomery, 23 June 2010.

    by Roger Montgomery Posted in Investing Education
  • Is your inbox ready?

    Roger Montgomery
    June 21, 2010

    Keep an eye out for my email to you tomorrow.

    If you have pre-registered for a copy(s) of Value.able, I will be sending you a special link to purchase your reserved copy(s) before it is released to the general public next week.

    The price of $49.95 includes GST and postage anywhere in Australia (allow 21 days) and you can probably claim a tax deduction, although you may want to check.

    I have enjoyed writing Value.able for you immensely. I trust you will find it just as enjoyable and easy to read and I look forward to hearing your thoughts after you have read it.

    Posted by Roger Montgomery, 21 June 2010.

    by Roger Montgomery Posted in Insightful Insights, Investing Education


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  • Who has time favoured the most?

    Roger Montgomery
    May 21, 2010

    I was in Melbourne last week filming this year’s The Path Ahead DVD with Alan Kohler and Robert Gottliebsen. This is the third time Alan has asked Monique and I to participate, and in addition to enjoying it immensely, I am incredibly humbled by the invitation.

    We sit around the breakfast table, enjoy some wonderful pastries, fruit and cheeses (a welcome break from my Dr Ross Walker breakfast regime) and I get to debate and hear a range of views about markets and the big picture issues for investors. The dialogue becomes quite animated at times, and I have to admit to often forgetting the four or five cameras recording our every utterance.

    Tony Hunter from the ASX holds court, and directs questions that have been received by Alan to the panel, and almost always without notice. I thought I would write about this year’s experience only because one of the questions got me thinking about the clichés that investors often have at the back of their mind when making investment decisions.

    Relying on investing clichés can be dangerous, if not because they are prevarications, but because they are the domain of the lazy who seek to grab the attention of those whose concentration has been diminished by the constant noise of the markets – much of which is useless and information-free (the noise that is).

    Here is a few that came to mind immediately (some are useless but perhaps others aren’t); Sell in May and go away.  Buy the rumour, sell the fact. Don’t catch a falling knife. Feed the ducks while they’re quacking. Buy dips. Buy low and sell high. Only buy stocks that go up. This time its different. The trend is your friend. You can’t go broke taking a profit. Its time in the market not timing the market that counts.

    You may have a few too, and I would love to hear them. Let me know if any have helped or hindered and feel free to add them by clicking ‘Leave a Comment’ at the bottom of this post.

    There is no doubt you have heard many, if not all, of them before. They have become part of investing lore and yet they lead more to pain and suffering than they do to enlightenment. So why do they survive? Is it because there is truth in them?

    I believe it is because there is a steady stream of new investors entering the market for whom the cliché has not yet become one. They run the risk of seeing the investing cliché as a truth – to be memorized and applied – and in doing so, they are guaranteed to repeat the mistakes made by the many that came before them.

    Cliché 1:  You can’t go broke taking a profit

    Think about the statement, You can’t go broke taking a profit; A new investor is almost certain to go broke doing just that. Why? Because a new investor will inevitably purchase a share only to see the price decline. Buying a low quality company (not one of my A1’s for example) or paying too a high a price (not estimating the intrinsic value of a company) will inevitably lead to a permanent loss of capital. The share price goes down and the investor, not wanting to accept a loss, holds on in the hope that one day the shares will recover. Then suppose the next investment decision leads to a gain; do you think the investor will hold this share for very long? The short answer is no. The fear of repeating the first mistake, resulting in another loss, is just too great. Better to take a small profit now than to see the shares fall again and have another loss.  The end result of repeating this numerous times is that the investor has several large losses and several small profits. The net result, of course, is a loss. You can go broke taking a profit just as surely as you can go broke saving money buying excessively-priced items that are on sale.

    A further example refers to inflation, and its effect on the purchasing power of your money. Trading frequently involves substantial frictional costs. Brokerage, slippage and spreads seriously impinge on the returns otherwise available from a buy and hold strategy. Earning 15 per cent from buying and holding is always preferable to 15 per cent from trading, and that’s even before tax is factored into the equation. Suppose however, you don’t even achieve 15 per cent from trading frequently; after 20 years, you merely match the rate of inflation. Arguably, you have not lost purchasing power, but you have not gained any either. You have been taking profits but have not made any.

    Similarly, if you sell a stock (using rising or trailing stops, for example) and make a 100 per cent return, but the shares rise 400 per cent, I would argue you have left a great deal of money on the table. You have certainly lost money taking a profit.

    Cliché 2:  Its ‘Time in the market’ not ‘Timing the market’ that leads to success.

    Another cliché that comes to mind is the idea that time in the market is the key to success rather than timing. At the outset, let me state that I don’t believe that timing the market or share prices works. Nor do I believe that time in the market works always, and if it sometimes does, the time can be so long that the returns are meaningless. Take for example the investor who purchased shares in Macquarie Bank at $90 some years ago; they are still waiting for a positive return. Or what about the investor who bought shares in Great Southern Plantation when the company listed? No chance of a positive return at all. If you purchased shares in Qantas or Telstra ten years ago, you would now have an investment with less value than you what commenced with.

    Time in the market is no good if you buy poorly performing businesses or pay prices that are far above the intrinsic value of a company. For the seventeen years bound by 1964 and 1981 the Dow Jones rose just 1/10th of one percent. Time, it seems, was not the friend of the merely patient investor. I can show you equally long periods of low returns on the Australian market too.

    The point however is that time is only the friend of the investor who buys wonderful businesses at large discounts to intrinsic value. Otherwise, time is an enemy that steals returns just as surely as it steals a great day.

    Don’t use time then as a band-aid to heal your investing mistakes. Stick to A1 businesses bought at discounts to intrinsic value and time will be your friend. So what are the businesses that time has befriended the most? What businesses have been increasing in intrinsic value the most over the last three, five or ten years?

    The following Table should offer the answers.

    Remember, these companies may be higher quality (Some are my A1’s), but they might not currently be cheap and I have not discussed the path of their intrinsic values in the future, which arguably is more important for the investor.  Be sure to seek personal professional advice before transacting in any security.

    Company ASX Code Annual Gain in Intrinsic Value Company ASX Code Annual Gain in Intrinsic Value
    MND (Monadelphous) 30% CAB (Cabcharge) 25%
    WOR (Worley Parsons) 61% ANG (Austin Eng) 98%
    BTA (Biota) 38% WEB (Webjet) 24%
    COH (Cochlear) 18% SUL (Supercheap Auto) 17%
    RKN (Reckon) 29% REX (Regional Express Airlines) 47%
    CRZ (Car Sales) 124% CPU (Computershare) 36%
    REA (Realestate.com) 78% TRS (The Reject Shop) 28%
    CSL (CSL) 39% REH (Reece) 21%
    NMS (Neptune) 25% IRE (Iress market tech) 19%
    ORL (Oroton) 27% ARP (ARB) 19%
    JBH (JB Hi-Fi) 85%

    The table reveals the companies that have demonstrated the highest growth in intrinsic values over the years and perhaps unsurprisingly, if my method for calculating intrinsic value is any good, you will find a very strong correlation between the increases in values and the increases in share prices.

    If you have any questions of course, or would like to contribute a cliche you once thought of as a lore to live and invest by but now see it for what it is, feel free to share by clicking the ‘Leave a Comment’ link below.

    Posted by Roger Montgomery, 22 May 2010

    by Roger Montgomery Posted in Investing Education
  • Whose Intrinsic Values will rise the most?

    Roger Montgomery
    May 15, 2010

    It was as a young boy that I became enamoured with the outdoors and the unique landscape of Australia. I discovered the easiest way for me to experience it was by participating in cubs and scouts. I will never forget the motto “be prepared”. It has served me well in many ways, and while nothing is ever failsafe, it is sound advice when it comes to investing.

    The market and its associated commentary is on tenterhooks. You can attribute that to the supertax’s contribution to a foreign investing exodus, nerves surrounding the property bubble in China, rising interest rates, or whatever else seems to be fashionable on the day with which to attribute the market’s conniptions to. I believe however, quite simply, that prices are generally expensive compared to my estimates of intrinsic value. That means that the performances of the underlying businesses do not justify current prices.

    Of course if you are a trader of stocks valuations don’t matter. You will sell on the emergence of the Greek storm-in-a-teacup and buy the day after, when another bail-out package is revealed. Alternatively, you will buy when one newsletter says the coast is clear and sell when yet another contradicts it. The people pointing out worries about China today are those that said the banks would rise to $100 before the GFC hit. One of the easiest things to observe in the markets is that predictions of a change in direction are far more frequent than they are accurate. And anyone can explain what has happened, but few seem to be able to look far enough ahead to be positioned well.

    With arguably the exception of my warnings earlier this year about the impact of a decline in infrastructure spending in China (thanks to an unsustainable commercial property and capital investment scenario) on the demand for Australian resources, I don’t try to predict the direction of markets or the macro economic determinants. I simply look at whether there are many or any good quality businesses available to purchase below intrinsic value. If there aren’t many or any great businesses to buy cheaply, the only conclusion must be that the market is not cheap.

    I cannot predict what the market will do next, but its worth being prepared. When the market is expensive compared to my valuations, one of two things can happen. On the one hand, share prices can drop. That is more likeley to be the case if values don’t rise – which of course is the second scenario. Valuations could rise and make current prices represent fair values (or even cheap if values rise substantially).

    In the event that prices fall (remember I am NOT making any predictions), I thought its worth looking at some of the big cap stocks (not necessarily A1’s) and how much their current intrinsic values are expected to rise over the next two years. These estimates of course can change, and its worth noting that none of the companies are trading at a discount to their current intrinsic value.

    Big names and their estimated changes in intrinsic value
    Company Name Current Margin of Safety Estimated change in intrinsic value 2010-2012
    RIO Tinto No 8% p.a.
    Commonwealth Bank No 16% p.a.
    National Aust. Bank No 22% p.a.
    Telstra No 2% p.a.
    Woolworths No 7% p.a.
    QBE No 10% p.a.
    AMP No 9% p.a.
    Computershare No 5% p.a.
    GPT No 3% p.a.
    Leightons No 13% p.a.

    My estimates of intrinsic value  don’t change anywhere nearly as frequently as share prices, but they do change. I expect some adjustments to start flowing through as companies begin what is called ‘confession season’ – that period just ahead of the end of year and the release of full year results, when companies either upgrade or downgrade their guidance to analysts for revenues, market shares and profits. These adjustments could, in aggregate, make the market look cheap, but that will require 2011 valuations to rise significantly.

    If prices fall (I am not predicting anything), and one is not overly concerned about quality, then one strategy (not mine) may be to buy the large cap companies expected to lead any subsequent recovery. Many investors and their advisers still subscribe to the idea that ‘blue chips’ exist and are safe. They tend to think of the largest companies as blue chips (I don’t) and if they are going to buy any after a correction, we might expect they will buy those whose values are going to rise the most. Of course, they may not know nor care about my valuations, nor do they know which companies are going to rise the most (in intrinsic value terms), but over the long term, the market is a weighing machine and prices tend to follow values. It follows on this basis then that Telstra’s value increase of just a couple of percent per year over the next two years may not put it in an as attractive a light as, say NAB.

    I think you get the idea. To share your thoughts click “Leave a Comment”.

    Posted by Roger Montgomery, 15 May 2010

    by Roger Montgomery Posted in Companies, Investing Education
  • Do these three companies represent the last of good value?

    Roger Montgomery
    May 4, 2010

    Fifteen months ago I was shouting it from the rooftops; “we will look back on this time as one of rare opportunity”.  Since then, and as the All Ordinaries Accumulation Index rallied 61 per cent, there has been a fall in my enthusiasm for the acquisition of stocks.

    Now, let me make it very clear that I have no idea where the market is going, nor the economy. I have always said you should never forego the opportunity to buy great businesses because of short-term concerns about those things. Even my posts earlier this year about concerns of a property bubble in China need to be read in conjunction with more recent reports by the IMF that there is no bubble in China. Take your pick!

    My reluctance to buy shares today in any serious volume comes not from concerns about the market falling, or that China will cause an almighty slump in the values (and prices) of our mining giants. It comes from the fact that there is simply not that many great A1 businesses left that are cheap.

    So here’s a quick list of companies that do make the grade for you to go and research, seek advice on, and on which to obtain 2nd, 3rd and 7th opinions.

    * Note: Valuations shown are those based on analyst forecasts and a continuation of the average performance of the past.

    In addition to these companies, investors keen to have a look at some lesser-known businesses, that on first blush present some attractive numbers, could research the list below. I have not conducted any in-depth analysis of these companies, but my initial searches and scans are suggesting at least a second look (I have put any warnings or special considerations in parentheses).

    • CogState (never made a profit until 2009)
    • Cash Convertors (declining ROE forecast)
    • Slater&Gordon (lumpy earnings profile)
    • ITX (trying to identify the competitive advantage)
    • Forge (Clough got a bargain now 31% owner and a blocking stake)
    • Decmil (only made a profit in last 2 years and price up 10-fold)
    • United Overseas Australia (property developer).

    What are some of the things to look at and questions to ask?

    • Is there an identifiable competitive advantage?
    • Can the businesses be a lot bigger in five, ten, twenty years from now?
    • Is present performance likely to continue?
    • What could emerge from an external force, or from within the company, to see current high rates of return on equity drop? For example, could a competitor or customer have an effect or are there any weak links in the balance sheets of these companies?

    Of course I invite you again – as I did in last week’s post entitled “What do you know?” – to offer any insights (good, bad or in-between) that you have about these or any other company you know something about, or even about the industry you work in.

    Posted by Roger Montgomery, 4 May 2010

    by Roger Montgomery Posted in Companies, Consumer discretionary, Investing Education
  • Is Value.able ever going to be available?

    Roger Montgomery
    May 4, 2010

    I have discovered through the book publishing process that being a perfectionist is costly. I have also discovered that being reasonably adept at investing does not make one even remotely adept at being the foreman of a book publishing project.

    I pulled the book out of the jaws of the printer when a few typos were spotted. Correcting the text of course threw the alignment out so it was back to the typesetters. The typesetters are an impressive group of designers and proofreaders and from them I learned that hyphenated sentences aren’t acceptable, and the top of a page can’t begin with the last word of the last sentence from the previous page. Who would have known?

    The changes impacted the index so the book couldn’t go to the indexer until every word was in its final resting place. I didn’t even know there were “indexers”, let alone final resting places and even ‘widows and orphans’. Investing it seems is not the sole domain of jargon and lingo.

    Happily my work is done and Value.able will be with the printer next week.

    Patience is the hallmark of the world’s best investors. It appears patience is also the hallmark of every investor who has visited my blog or written me an email. Thank you.

    Good things come to those who wait, and provided you have pre-registered with me you will soon receive an email announcing the opening of the ordering window and inviting you to claim your reserved copy of Value.able for $49.95, including GST and shipping anywhere in Australia.

    If you are ordering from overseas, that’s no problem; country-specific delivery rates will be available. Finally, for those who have reserved multiple copies, as gifts for family and friends, don’t worry, your additional copies have been registered along with your copy.

    I am only printing First Editions for those who have pre-registered at www.rogermontgomery.com so be sure to register. I look forward to your thoughts after you have read Value.able.

    Posted by Roger Montgomery, 4 May 2010

    by Roger Montgomery Posted in Insightful Insights, Investing Education
  • Should a value investor imitate Ben Graham?

    Roger Montgomery
    April 30, 2010

    Whilst many use Ben Graham’s models for intrinsic value to evaluate the attractiveness of companies, I don’t. Let me explain why.

    Just before I begin though, I want you to know that I am a little nervous about publishing a post advocating against a strict Graham-approach, as it may put a few noses out of joint. So, unlike many of my other posts, I have referenced what I believe to be the pertinent quotes that I have read and that brought me to or reinforced my conclusion that value investors should move on from many parts of Graham’s framework.

    In the 1940’s Benjamin Graham (who passed away in 1976) was regarded “as a sort of intellectual dean of Wall Street, [and] was one of the most successful and best known money managers in the country.”[1] In 1949, an eager Warren Buffett read Graham’s book The Intelligent Investor and the rest, as they say, is history.

    Warren Buffett regards Graham’s book Security Analysis as the best text on investing, regularly referring investors to that piece and his other seminal The Intelligent Investor. Many of you will also know one of my favourite Graham publications, The Interpretation of Financial Statements.

    Yet whilst Buffett remains an adherent and advocate of Graham’s Mr. Market allegory and the Margin of Safety, thanks to his long time partner at Berkshire Hathaway, Charlie Munger, he has moved far from the original techniques taught and applied by the man described as the ‘father of value investing’.

    Ben Graham advocated a mostly, if not purely, quantitative approach to finding bargains. He sought to buy businesses trading at a discount to net current asset values – what has been subsequently referred to as ‘net-nets’. That is, he sought companies whose shares could be purchased for less than the current assets – the cash, inventory and receivables – of the company, minus all the liabilities. Graham felt that talking to management was sort of cheating because smaller investors didn’t have the same opportunity.

    Whilst the method had been very successful for Graham and the students who continued in his tradition, people like Warren Buffet, Walter Schloss, and Tom Knapp, Graham’s ignorance of the quality of the business and its future prospects did not impress Charlie Munger. Munger thought a lot of Graham’s precepts “where just madness”, as “they ignored relevant facts”.[2]

    So while Munger agreed with Graham’s basic premise – that when buying and selling one should be motivated by reference to intrinsic value rather than price momentum, he also noted “Ben Graham had blind spots; he had too low of an appreciation of the fact that some businesses were worth paying big premiums for” and “the trick is to get more quality than you pay for in price.”[3] When Munger referred to quality, he was likely referring to the now common belief held by many sophisticated investors that an assessment of the strategic position of a company is essential to a proper estimation of its value.

    In 1972, with Munger’s help, Buffett left behind the strict adherence to buying businesses at prices below net current assets, when, through a company called Blue Chip Stamps, they paid three times book value for See’s Candies.

    See’s is a US chocolate manufacturer and retailer – whose product I have purchased and eaten more than my fair share of, whose factory I have toured and whose peanut brittle ranks with the best I have ever tasted.

    Buffett noted; “Charlie shoved me in the direction of not just buying bargains, as Ben Graham had taught me. This was the real impact he had on me. It took a powerful force to move me on from Graham’s limiting view. It was the power of Charlie’s mind. He expanded my horizons”[4] and, “… My guess is the last big time to do it Ben’s way was in ’73 or ’74, when you could have done it quite easily.”[5]

    So Buffett eventually came around, and the final confirmation, for those still advocating the Graham approach to investing, that a superior method of value investing exists was this from Buffett; “boy, if I had listened only to Ben, would I ever be a lot poorer.”[6]

    Times in the US were of course changing as well, and it is vital for investors to realise that the world’s best, those who have been in the business of investing for many decades, do indeed need to evolve. In the first part of the twentieth century industrial manufacturing companies, for example, in steel and textiles, dominated the United States. These businesses were loaded with property, plant and equipment – hard assets. An investor could value these businesses based on what a trade buyer might pay for the entire business or just the assets, and from there, determine if the stock market was doing anything foolish.

    But somewhere between the 1960’s and the 1980’s many retail and service businesses emerged that had fewer hard or tangible assets. Their value was in their brands and mastheads, their reach, distribution networks or systems. They leased property rather than bought it. And so it became much more difficult to find businesses whose market capitalisation was lower than the book value of the business, let alone the liquidating value or net current assets. The profits of these companies were being generated by intangible assets and the hard assets were less relevant.

    To stay world-beating, the investor had to evolve. Buffet again:  “I evolved…I didn’t go from ape to human or human to ape in a nice, even manner.”[7]

    Many investors cling to the Graham approach to investing even though some, if not many of his brightest and most successful students, moved on decades ago.

    If you are reading this and want to adopt a value investing approach, there is no doubt in my mind that your search for solutions will take you into an examination of the traditional Graham application of value investing. It is my hope, however, that these words will serve as a guide towards something more modern, more relevant and, whilst can’t be guaranteed, more profitable.

    If you have tried to adopt the Graham approach and had some successes (or failures) and are keen to share, I would be delighted if you post your own experiences here at my blog. Alternatively, if you have reached your own conclusions about the best approach to value investing, feel free to post a comment by clicking the Leave a Comment link just below and to the right.

    Posted by Roger Montgomery, 30 April 2010.

    [1] Damn Right.  Janet Low.  John Wiley & Sons 2000.  Pg 75

    [2] Damn Right.  Janet Low.  John Wiley & Sons 2000.  Pg 77

    [3] Damn Right.  Janet Low.  John Wiley & Sons 2000.  Pg 78

    [4] Ibid

    [5] Robert Lezner, “Warren Buffett’s Idea of Heaven” Forbes 400, October 18, 1993 p.40

    [6] Carol J. Loomis, “The Inside Story of Warren Buffett,” Fortune, April 11, 1988 p.26

    [7] L.J.Davis, Buffett Takes Stock,” New York Times Magazine, April 1, 1990, pg.61.

    by Roger Montgomery Posted in Insightful Insights, Investing Education