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