Value.able

Thank you for your support in 2011 and for all of your wonderful contributions to the knowledge bank.

I am delighted to finish the year on a positive note with Cochlear (see post below) announcing it has identified the source of the malfunction of its Nucleas CI500 cochlear implant.  This will also be positive news for many Cochlear implant recipients who put their quality of life in the company’s hands.

I have also published a recent column on the possibility of a convergence of Eurozone default, economic slowdown, a decline in consensus earnings estimates and a throwing in of the towel by investors who are fed up with low returns and heightened volatility (see below).

Hopefully that will stimulate some serious contemplation over the Christmas break.

Next year I am hoping to reconfigure the Insights Blog.  My idea is to create  and share the publishing role with any number of you who wish to write 300-600 word columns of an investment topic of your choice.  I will remain editor and I am looking for twenty six (26) Graduates who can contribute two columns each in 2012.  Of course if you wish to contribute more, be my guest.

We also intend to restructure the blog to allow easier searching and viewing of multiple threads.  Stay tuned and if you would like to contribute send an email to me at roger@rogermontgomery.com with “CONTRIBUTOR” in the subject heading.

I am delighted that, in 2011, so many investors have found Value.able and Skaffold so useful. Many Graduates have said the Skaffold approach to investing is at once easy to understand and rational. And according to Daman’s feedback, Value.able!

“On Friday the 16^th Dec, Bendigo announced a takeover of the Australian arm of a Greek bank at purchase price reflecting a return on equity around the same as a 12 month term deposit with Ubank. Alongside this was a $96M or so write down to its Margin Lending Business (due to the poor economic conditions). Today, its appears upon recommencing trading and Mr Market being nervous in general  the share price of BEN has fallen over 6%.

Good news is that I sold my holdings in BEN  on the 7^th of December. Thanks to your teachings on the importance of ROE I was able to recognise that this business does not have superior performance characteristics, among several other factors. As a result I secured a somewhat reasonable profit of 14% on my holdings and a 2,740% ROB (return on [your] book).”

If you have not already secured your copy of Value.able or become a member of Skaffold and want to kick 2012 off the Skaffold way, go to www.Skaffold.com.

To the Value.able Graduates and Skaffold members (Skaffolders?), thank you for taking the time to share with me just how much you have been impacted by each. I am delighted to hear your amazing stories of investing success and I am pleased we can look forward to 2012 with enthusiasm.

I will return in late January. Our team will continue to publish your comments here at the blog, post new videos to my YouTube channel, reply to your emails and take your calls.

We leave 2011 with one of the world’s most successful billionaire hedge fund managers telling his clients; “Trust has been lost, confidence in the system is being lost, and the ultimate consequence of this break down – sovereign defaults – are imminent.”

In the meantime may your Christmas be filled with the love of family and friends.  I look forward to corresponding with you again beginning February 2012.  I will always be enthralled by Caravaggio’s work. The Adoration was painted in 1609.

Posted by Roger Montgomery, Value.able author and Fund Manager, 20 December 2011.

by Roger Montgomery Posted in Skaffold, Value.able.

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We have talked here at the blog about hypothecation, re-hypotecation and hyper-hypothecation, about credit default swaps about a Chinese property bubble bursting, about lower iron ore prices, slower economic growth, increased savings and declining rates of credit expansion and a European sovereign default.  Always the value investor, we are on the look out for anything that can impact the values of companies and those things that might offer the prospect of picking up a few bargains.

If your portfolio still has some rubbish in it, then being able to identify it is a key part of preparing for cheaper prices if they eventuate.

I recently wrote a column for the ASX and pondered the possibility of a climactic event coinciding with a complete throwing in of the towel by equity investors who are simply fed up with poor medium term returns and increased volatility recently.

The ASX200 hasn’t generated a positive capital return since 2005 but quality companies have.  The ASX200 contains stocks that are rubbish so it is no wonder that an index based on that rubbish has gone nowhere.  Step 1 then is to clean up the portfolio and step 2 is to be ready for quality bargains when they arise.

This is just one of many scenarios and frameworks I am operating with and I wonder what would transpire if the poor returns or the recent heightened volatility continues for a little longer?  Will investors simply throw in the towel, leave equities and believe all those advisors offering their own brand of ‘safe’, ‘secure’ and stable investments?  On the one hand, I hope so.  It would mean certain bargains.

Here’s the Column:

As global sharemarkets decline, remain volatile and produce poor historical returns compared to other asset classes, it will be easy to be swayed by the latest investment trend – to move out of shares. I believe the trend away from shares will gather pace soon as more and more “experts” use the rear-view mirror to demonstrate why sharemarket investors would have been better off somewhere else.

In 1974 US investors had just endured the worst two-year market decline since the early 1930s, the economy entered its second recessionary year and inflation hit 11 per cent as a result of an oil embargo, which drove crude oil prices to record levels. Interest rates on mortgages were in double digits, unemployment was rising, consumer confidence did not exist and many forecasters were talking of a depression.

By August 1979, US magazine BusinessWeek ran a cover story entitled ‘The Death of Equities’ and its experts concluded shares were no longer a good long-term investment.

The article stated: “At least 7 million shareholders have defected from the stockmarket since 1970, leaving equities more than ever the province of giant institutional investors. And now the institutions have been given the go-ahead to shift more of their money from stocks – and bonds – into other investments.”

But be warned. The time to get interested in share investing and make good returns is precisely when everyone else isn’t.

Your own once or twice-in-a-lifetime opportunity may not be that far away and Labor’s promised tax cut on interest earnings may sway even more to give up shares and put their money in a bank, providing the opportunity to obtain even cheaper share prices.

If prices do fall further – and they could – you will need to be ready and will need some cash. The very best returns are made shortly after a capitulation.  Cleaning up your portfolio becomes crucial and this article looks at how to do that.

Rule one: Don’t lose money

The key to slowly and successfully building wealth in the sharemarket is to avoid losing money permanently. Sure, good companies will see their shares swing but the poor companies see the downswings more frequently.

Therefore, the easiest way to avoid losing money is to avoid buying weak companies or expensive shares. One of the simplest ways I have avoided losing money this year in The Montgomery [Private] Fund has been to steer clear of low-quality businesses that have announced big writedowns.

These are easy to spot using Skaffold.

Not-so-goodwill

I have often seen companies make large and expensive acquisitions that are followed by writedowns a couple of years later. Writedowns are an admission by the company that they paid too much for an asset.

When Foster’s purchased the Southcorp wine business in 2005 for $3.1 billion, or $4.17 per share, my own valuation of Southcorp was less than a quarter of that amount. Then in 2008 Foster’s wrote down its investment by about $480 million, and then again by another $700 million in January 2009 and a final $1.3 billion in 2010.

When too much is paid for an acquisition, equity goes up but profits do not and you can see that too much was paid because that ratio I have worked so hard to make popular, return on equity (ROE), is low.

These low rates of return are often less than you can get in a bank account, and bank accounts have much lower risk. Over time, if the resultant low rates of return do not improve, it suggests the price the company paid for the acquisition was well and truly on the enthusiastic side and the business’s equity valuation should now be questioned. If return on equity does not improve meaningfully, a large writedown could be in the offing. This will result in losses if you are a shareholder, and you have also paid too much.

Just remember one of the equations I like to share:
Capital raised + acquisition + low rate of return on equity = writedown.

When return on equity is very low it suggests the business’s assets are overvalued on the balance sheet. That, in turn, suggests the company has not amortised, written down or depreciated its assets fast enough, which in turn means the historical profits reported by the company could have been overstated.

Scoring bad companies: B4, B5, C4 and below…

These sorts of companies tend to have very low-quality scores and often appear down at the poor end of the market – the left side of the screen shot in Figure 1 below.

Figure 1. The sharemarket in aerial view (Source; Skaffold.com)

Each sphere in Figure 1. represents a listed Australian company and there are more than 2000 of them. The diagram is taken from Skaffold. Their position on the screen can change daily as the price, intrinsic value and quality changes. The best quality companies and those with positive estimated margins of safety (the difference between the company’s intrinsic value and its share price) appear as spheres at the top right.

Companies that are poor quality (I call them B4, C4 and C5 companies, for example) are found on the left of the screen and if they have an estimated negative margin of safety, they are estimated to be expensive and will be located towards the bottom of the screen.

Highlighted with blue rings in Figure 1 are eight of the companies that announced this year’s biggest writedowns. Notice they tend to be at the lower left of the Australian sharemarket, according to my analysis.

If your portfolio contains shares that are red spheres and on the lower left, you could also be at risk because these companies tend to have low-quality ratings and are also possibly very expensive compared to their intrinsic value.

As is clear from Figure 1, this year’s biggest writedown culprits were all already located in the area to avoid.

The impact of owning such a business outright would be horrendous. Table 1 below reveals the size and details of these writedowns and as you can see, collectively the losses to shareholders amount to $4.6 billion.

Table 1. Predictable losses?

Warren Buffett once said that if you were not prepared to own the whole business for 10 years, you should not own a piece of it for 10 minutes.

Clearly you would not want to own businesses that pay too much for acquisitions and subsequently write down those assets. If you are not willing to own the whole business, don’t own the shares. Although in the short run the market is a voting machine and share prices can rise and fall based on popularity, in the long run the market is a weighing machine and share prices will reflect the performance of the business. Time is not the friend of a poor company, and companies Skaffold rates C4 or C5 are best avoided if you want the best chance of avoiding permanent losses.

Look at Figure 2 below. Those big writedown companies not only performed poorly but so did their shares. These companies (shown collectively as an index in the blue line below) produced bigger losses for investors than the poorly performing indices of which they are part. And that’s just over one year.

Figure 2. The biggest writedowns compared to the market

Take a look at the companies in your portfolio. Do they have large amounts of accounting goodwill on their balance sheet as a portion of their equity? Have they issued lots of shares to make acquisitions and are they producing low and single-digit returns on equity? If the answer to all these questions is yes, you may have a C5 company.

Cleaning up your portfolio not only lowers its risk but will produce cash that may just prove handy in coming months.

If you have made it this far then here’s evidence of the giving up I referred to in the column:  http://www.smh.com.au/business/investors-turn-to-term-deposits-in-shift-away-from-equities-20111219-1p2ir.html

Posted by Roger Montgomery, Value.able author and Fund Manager, 20 December 2011.

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Aside from fears of reputational damage, one of the big concerns surrounding Cochlear’s recall earlier this year, was how long it would take to return to market.  As you know we purchased shares after the announcement that it had recalled its Nucleus CI500 cochlear implant much to the chagrin of some investors who follow our musings here at the Insights blog.

In NSW every child receives a hearing test within two days of birth.  Those identified as having profound hearing loss are often assisted by Cochlear.  And thats just NSW.  Cochlear sells its devices in 100 countries.  Once implanted changing devices is not easy.  Changing brands may be even harder.  Audiologists and speech pathologists are involved and the devices are finetuned to ensure the device suits the individual.

As Matthew pointed out here on the blog a few days ago:  “A family member [of Matthews’s] is a key member of a large Australian charity that does a lot of work with children that are deaf and many get the implants. All the equipment they use to “map” or finetune the device after implanting is specific to that company. For example the only brand they have is Cochlear. Recently they had a child from the US that they began to support that had a different brand implanted – they had to change many things to be able to help them. When thinking about market share with these devices I think it is important to know that the decision isn’t solely with the surgeon or specialist, because all of the support people have to change too. I don’t think market share will change quickly or by very much because of these barriers.”

Analysts at Macquarie recently surveyed 389 US-based Audiologists. Despite the product recall, Cochlear is still the world leader in CI devices and retains 60% market share selling into 100 countries.  The broker also believes the market is growing at 12 per cent per year.

Many of you know we purchased shares in Cochlear after the September recall (see below), confident this was a temporary issue being treated as permanent by a perennially short-term-focused market.

That now appears to be the case as today’s announcement, posted on the ASX platform by the company reveals; 20122011_COH CI500 impant update

The company previously covered the subject in its AGM presentation here: http://www.cochlear.com/files/assets/corporate/pdf/agm_presentation_18102011.pdf

Analysts were subsequently concerned that 1500 units are going to have to be removed through surgery and another 2800 units have been pulled from shelves. They also worry that an inventory shortfall across the entire market will lead to market share losses from insufficient inventory as well as damage to reputation.

Today’s announcement reveals any small market share loss (we estimate five percent and some analysts suggest between five and ten per cent overall) will be now stemmed by the timely identification of the manufacturing issue that resulted in the failure of 1.9% of devices and their subsequent recall.

Cochlear has ramped up production and its early intervention has enhanced its reputation rather than damaged it as evidenced by several surveys with clinicians.  In fact, 93% of doctors surveyed by Macquarie felt that Cochlear handled the recall well, while only 8% believe the company’s reputation has been tarnished.

Ultimately the company’s intrinsic value is determined by its profit and we expect there will be an impact on profit of some import.  Cochlear has already created a provision of $130-$150 million and an after tax cash cost of $20 to $30 million.  Given the news flow that will now transpire, one expects these costs may be treated by analysts as a ‘one-off’ and investors may have to wait for another temporary setback before being able to buy shares cheaply again…

For those of you interested in following our thoughts back in September 14 (COH $51.30), I wrote the following :

“Imagine spending years waiting patiently for the opportunity to buy that rare coin, vintage bottle of wine or celebrated painting, only to be outbid when it finally comes up for auction.

Sometime later the opportunity presents itself again and you are outbid once more, this time by much more. Successive auctions only take the price further out of your reach – if only you acted sooner!

Then one day you stumble across that very thing you desire being offered for sale by someone who appears to have no interest in its long-term value, for a price you regard as a fraction of its real worth.

Would you buy it?

That is the situation I find myself in today as the Cochlear share price plunges another 14% to $51.30, or about 40% since its April 2011 high of $85.

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.

Overnight one of those rivals 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 this week 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 are spooked.

The financial impacts of these events (and there will be an impact) have yet to be quantified so until they are why don’t we look at how the company has performed in the past and see if we can’t learn something about it in the interim.

Over the past decade, Cochlear has increased profits every year with the exception of 2004. Net profit was just $40 million in 2002 and last week 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: “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 is 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 yesterday for the Montgomery [Private] Fund. It is likely that I will to add to this position over the coming days and weeks 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 – and there will be one – remains unclear; when that changes it will impact my intrinsic value estimate (UBS has revised its forecast net profit for 2012 by 10.5% to $179.5 million).

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.”

Posted by Roger Montgomery, Value.able author and Fund Manager, 20 December 2011.

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In 2010 here at the Insights Blog I wrote:

“a bubble guaranteed to burst is debt fuelled asset inflation; buyers debt fund most or all of the purchase price of an asset whose cash flows are unable to support the interest and debt obligations. Equity speculation alone is different to a bubble that an investor can short sell with high confidence of making money.

The bubbles to short are those where monthly repayments have to be made. While this is NOT the case in the acquisitions and sales being made in the coal space right now, it IS the case in the macroeconomic environment that is the justification for the  purchases in the coal space.

China.

If you are not already aware, China runs its economy a little differently to us. They set themselves a GDP target – say 8% or 9%, and then they determine to reach it and as proved last week, exceed it. They do it with a range of incentives and central or command planning of infrastructure spending.

Fixed asset investment (infrastructure) amounts to more than 55% of GDP in China and is projected to hit 60%. Compare this to the spending in developed economies, which typically amounts to circa 15%. The money is going into roads, shopping malls and even entire towns. Check out the city of Ordos in Mongolia – an entire town or suburb has been constructed, fully complete down to the last detail. But it’s empty. Not a single person lives there. And this is not an isolated example. Skyscrapers and shopping malls lie idle and roads have been built for journeys that nobody takes.

The ‘world’s economic growth engine’ has been putting our resources into projects for which a rational economic argument cannot be made.

Historically, one is able to observe two phases of growth in a country’s development.  The first phase is the early growth and command economies such as China have been very good at this – arguably better than western economies, simply because they are able to marshal resources perhaps using techniques that democracies are loath to employ. China’s employment of capital, its education and migration policies reflect this early phase growth. This early phase of growth is characterised by expansion of inputs. The next stage however only occurs when people start to work smarter and innovate, becoming more productive. Think Germany or Japan. This is growth fuelled by outputs and China has not yet reached this stage.

China’s economic growth is thus based on the expansion of inputs rather than the growth of outputs, and as Paul Krugman wrote in his 1994 essay ‘The Myth of Asia’s Miracle’, such growth is subject to diminishing returns.

So how sustainable is it? The short answer; it is not.

Overlay the input-driven economic growth of China with a debt-fuelled property mania, and you have sown the seeds of a correction in the resource stocks of the West that the earnings per share projections of resource analysts simply cannot factor in.

In the last year and a half, property speculation has reached epic proportions in China and much like Australia in the early part of this decade, the most popular shows on TV are related to property investing and speculation. I was told that a program about the hardships the property bubble has provoked was the single most popular, but has been pulled.

Middle and upper middle class people are buying two, three and four apartments at a time. And unlike Australia, these investments are not tenanted. The culture in China is to keep them new. I saw this first hand when I traveled to China a while back. Row upon row of apartment block. Empty. Zero return and purchased on nothing other than the hope that prices will continue to climb.

It was John Kenneth Galbraith who, in his book The Great Crash, wrote that it is when all aspects of asset ownership such as income, future value and enjoyment of its use are thrown out the window and replaced with the base expectation that prices will rise next week and next month, as they did last week and last month, that the final stage of a bubble is reached.

On top of that, there is, as I have written previously, 30 billion square feet of commercial real estate under debt-funded construction, on top of what already exists. To put that into perspective, that’s 23 square feet of office space for every man, woman and child in China. Commercial vacancy rates are already at 20% and there’s another 30 billion square feet to be supplied! Additionally, 2009 has already seen rents fall 26% in Shanghai and 22% in Beijing.

Everywhere you turn, China’s miracle is based on investing in assets that cannot be justified on economic grounds. As James Chanos referred to the situation; ‘zombie towns and zombie buildings’. Backing it all – the six largest banks increased their loan book by 50% in 2009. ‘Zombie banks’.

Conventional wisdom amongst my peers in funds management and the analyst fraternity is that China’s foreign currency reserves are an indication of how rich it is and will smooth over any short term hiccups. This confidence is also fuelled by economic hubris eminating from China as the western world stumbles. But pride does indeed always come before a fall. Conventional wisdom also says that China’s problems and bubbles are limited to real estate, not the wider economy. It seems the flat earth society is alive and well! As I observed in Malaysia in 1996, Japan almost a decade before that, Dubai and Florida more recently, never have the problems been contained to one sector. Drop a pebble in a pond and its ripples eventually impact the entire pond.

The problem is that China’s banking system is subject to growing bad and doubtful debts as returns diminish from investments made at increasing prices in assets that produce no income. These bad debts may overwhelm the foreign currency reserves China now has.”

I now wonder whether we are seeing the bubble slip over the precipice?  Falling property prices (10 per cent of the Chinese economy) leads to lower construction activity, leads to declining demand for Australian commodities, leads to falling commodity prices, leads to bigs drops in margins for a sizeable portion of the market index…

Watch this video and decide for yourself.

Posted by Roger Montgomery, Value.able author and Fund Manager, 8 December 2011.

by Roger Montgomery Posted in Energy / Resources, Insightful Insights, Market Valuation, Property, Value.able.

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This is a retail business that I’ve known for a long time, indeed in a past life I influenced one of its largest shareholdings.

At that time the company was leveraging its 90% brand awareness; increasing its return on equity every year, from 40% to ultimately more than 70%, without any debt; it was rolling out stores; it appeared to have perfected its buying strategy; and the share price had risen from $2.40 to a high of $18.60.

More than a year since I wrote that The Reject Shop shares were among the most expensive retail stocks and they touched their high, the performance has been somewhat unsurprising: declining to a closing low of $9 recently – a fall of just over 50%.

For those of you who have been fortunate enough to have been following us since 2009, you may recall in September 2009 when I wrote about the reasons why I decided to sell The Reject Shop:

“I can’t stop thinking that the value of the business just cannot rise at a fast enough clip to justify the current price. I really don’t like trading things that I have bought but I don’t think the value of the business can continue to rise indefinitely. With a share price of $13.45 (intraday today) and a valuation of $11.27, the shares are 24% above their intrinsic value. This combination of factors tells me we are safer in cash.”

Today the shares trade at about my current estimate for intrinsic value (see graph) of $9.22 and in anticipation of a possible big discount being presented, it’s worth reviewing our stance to determine whether we need to change it for this company.

Since I last wrote about the Reject Shop, a number of events have served to deliver sufficient concerns to market participants – analysts as well as investors – that they have turned their back on this once market darling.

First, the Queensland floods closed the Queensland distribution centre, seriously denting any supply chain efficiencies the company had built. Second, the company has doubled its equity base since 2006, from $26.6 million to $53 million, and this has been entirely due to the retention of earnings rather than less-desirable capital raisings. In the absence of an equivalent increase in profits, return on equity would be expected to decline. One way to stave off a decline in the all-important return on equity measure of performance is to increase leverage. The problem for the Reject Shop’s intrinsic value is that leverage has indeed increased – 34-fold – and yet return on equity next year is forecast to be lower next year than in 2006.

The Reject Shop still enjoys its high brand awareness but, as is typical in many store roll out stories, as the offer matures the later sites are less profitable than the early sites.

This doesn’t fully explain the fact that during a period in the economy where one would expect a bargain offering to shine, it hasn’t. Eighty percent of Australians still know the brand but I believe consumer experience and mismanagement has done it some damage.

According to one report, 20% of the population believe the company offers rubbish – cheap Chinese junk that quickly breaks after use and fills our tips. It’s the very reputation China itself is trying, but frequently failing, to shake off.

The other reason for damage to the brand is confusion brought on by mismanagement. Several years ago the average unit price was about $9 and basket size was $11, but over the years one cannot help but have noticed many higher-priced items creeping into the stores.

The Reject Shop was originally the place you went to for discounted seconds and end-of-line items. Under lauded retailer and merchant Barry Saunders, The Reject Shop successfully transitioned to a discount variety retailer, offering everyday lines at cheaper prices than the incumbents. Grey market (“parallel import”) Colgate toothpaste for $2 a tube and toilet paper for a few cents a roll ensured repeat business, higher inventory turnover and higher margins from consumers filling their baskets with other higher-margin items.

The company had successfully implemented the Walmart and Woolworths profit loop. Adding more expensive items, some in the $30, $40 and $50 bracket, confuses the offer and damages the brand. Simultaneously, inventory turnover falls and working capital costs increase.

Higher-priced items should at least partly explain why the company has not been performing well in the two-speed economy (I prefer to call it the one-cylinder economy) that would normally lend itself to the “bargain” offer. The other reason for the declining performance, including declining same-store sales growth, is the enthusiastic emergence of competitors. It’s really a second wave: The Reject Shop had put an end to Millers and the Warehouse Group previously. But now BIG W, Kmart, Target, Bunnings, a reinvigorated Mitre 10 and Masters will compete directly with The Reject Shop; you may have already seen some of their aggressive Christmas advertising.

If The Reject Shop’s offering had not been confused by the inclusion of higher-priced items, the company would have been in a much better position to defend its turf. The misguided product mix, however, appears to have left the gate open and the well-funded competitors have rushed in, as have Crazy Clarke’s, Sams Warehouse, Chicken Feed, GO-LO and more than 35 others. Of course these competitors will also compete for sites, potentially relegating The Reject Shop to less preferred sites or having to pay more for the best of the remaining locations.

That, and the possibility of a fall in the Australian dollar, represents the bad news. The good news is that The Reject Shop still has terrific brand awareness, many more stores to open, a reinvigorated marketing campaign and the reopening of the Queensland Distribution Centre ahead of the Christmas peak selling period.

On balance, if the company can hit its targets it could increase its intrinsic value by more than 15% per annum over the next three years and many believe the bad news and bearish case is factored into the share price. But I would like to see a decline in debt or a greater margin of safety or both, before buying its shares.

Rest assured that a rising tide (a rally in the stock market) will lift the price of the company’s shares. To be certain of a good return rather than be hopeful of an excellent one, we simply need a bigger discount, as the graph illustrates.

Posted by Roger Montgomery, Value.able author and Fund Manager, 3 December 2011.

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I have just returned to the office after appearing on CNBC with my old friend Matthew Kidman.  We were in agreement on virtually all points (which perhaps surprisingly made the program very interesting).  If the market does indeed provide a once-in-a-lifetime opportunity, in the next 12 months, to buy excellent value industrial companies, then you may want to be aware of the companies that are either really poor quality or extremely overpriced now.

Stay tuned over the next few days, as I will be publishing our list of companies whose shares are in the hot seat.  Some of them may shock you.

If you would like to pre-empt the report, with some of your own suggestions, go right ahead and list them by clicking on the Comments link below.

Posted by Roger Montgomery, Value.able author and Fund Manager, 03 November 2011.

by Roger Montgomery Posted in Value.able.

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There’s something in the air…. And you may be able to assist.

Skaffold® is set to go live and I am incredibly proud of what Team Skaffold have achieved.

Before Skaffold, the stock market was noisy and confusing. Very soon, all that will change.  Skaffold will reinvent and reignite the way you invest.

The data that automatically updates Skaffold each day is from arguably the world’s most reputable source (that’s right, not all data is the same!). With customers that spend hundreds of millions of dollars a year for our provider’s data, we have been delighted with their fascination and interest in Skaffold.

As you may already know, Skaffold’s designers and developers have been recognised by design awards and industry accolades and already work for Nintendo, EA Games – the world’s biggest games company, Google, HTC, and Porsche. Like us, they are immensely proud of Skaffold and are putting together their own video for the launch to showcase Skaffold to international IT media and judges. Their Managing Director is even flying to Sydney for the launch!

Here at home, we are building a team with amazing international credentials and their task is simple: make sure Skaffold stays at the cutting edge of stock market applications.

Here is how you could help: We’re still searching for someone super smart, who can mentor, teach and lead a team, who knows, understands and loves the stock market, can be RG 146 compliant and is truly passionate about talking one-on-one with and helping private and professional investors. If that’s you, or you know someone that fits the bill, we want to hear from you!

A1 or C5, Skaffold’s Quality Scores are powered by more than 40 years of published academic research into the predictors of company failure and and investment returns. And the secret herbs and spices in Skaffold’s valuations – and the ways they change – have won me over time and time again.

I must confess to having a bit of fun recently… I uploaded some international data, and looked at IBM, Apple, Google and Microsoft and… nothing surprising. Skaffold just worked. No whacky valuations either like the $800 for Apple or $400 for IBM or $60 for Microsoft that I have seen elsewhere. In time, I imagine we’ll be able to switch on Turkish stocks, if that’s what you want!

The team and I have been genuinely encouraged by your excitement. What’s also been really amazing is the anticipation, not only from private investors like you and me, but from brokers, other fundies, planners and advisers who have expressed a real need to independently ’stress test’ their own research or the stocks on their approved lists.

One friend recently said we had developed a Ferrari that Volvo drivers will love to drive. I reckon that’s about the sum of it. And congrats, by the way, to Ian –  one of very first investors who jumped the gun, sent in his cheque and guaranteed himself Member #2 status for life.

Get ready to enjoy looking at the Australian stock market like you have never seen it before. Put 1 November 2011 in your diary to Join Skaffold and be part of our mission to make every investor a professional.

Skaffold is the world’s most reputable company data married to half a century of leading investment thinking and the world’s most exciting and easy-to-use interface for investors. We can’t wait to hear what you think of Skaffold after you have made it part of your investment routine.

Posted by the Skaffold Team, 28 October 2011.

Skaffold® is a registered trademark of Skaffold Pty Limited

by Roger Montgomery Posted in Companies, Value.able.

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With high salaries, higher rents, a strong Aussie dollar and ‘level-playing-field’ policies, are Australian manufacturers being unwillingly and inexorably dragged to doormat status?

We are in a race to the bottom and run the risk of ultimately being chewed up and spat out when our commodities are no longer required with such urgency.

Driven by a belief that economists are right and the way to measure happiness is by the consumption of “stuff”, government policy in Australia is set to keep the masses happy by making that “stuff” as cheap as possible.

Our way of life, and the quality of that life for our kids, is at risk if we continue to be apathetic. Driving around Sydney’s Eastern Suburbs and Lower North Shore, its apparent there isn’t a communal approach to the solution. Instead there is an individual race to accumulate more “stuff” to protect oneself. “Forget about the neighbours”. “Look after number one”. “If I have plenty in the bank, the kids and grandkids will be set up. What do I care if the rest of Australia goes to pot?”

It’s like watching seagulls fighting over a Twistie.

When competing against a country with an ethos that puts ‘the people’ first, what hope does a country whose constituents are clambering over each other for the next short-term dollar have?

Manufacturing in Australia needs help. I am not suggesting protection or a hand out. I am suggesting a leg-up.

Singapore rolls out the red carpet for new businesses with tax-free holidays for the first few hundred thousand in profits. What does the Australian government do for new businesses in Australia? A TAFE course? R&D tax breaks are a start, but helping big business roll out classrooms at $5000 per square metre helped who exactly?

Unemployment in Australia’s wealthiest suburbs is creeping up because we don’t need so many bankers and Merger & Acquisition experts when there aren’t any businesses left to merge and acquire.

Can our current way of life survive without manufacturing? It seems we may just find out. What will we do without manufacturing?

The commodity boom will end one day and we are selling large tracts of arable land to foreign investors. Without manufacturing, will we be running around serving each other lattes? Is that it?

Australia is still the home of ingenuity. Just look at programs like the ABC’s New Inventors. The best and brightest should be receiving generous awards and access to incubator programs that ensure the international success and that the commercial benefits flow back to Australia.

One American recently lamented “10 years ago we had Steve Jobs, Bob Hope and Johnny Cash. Now we have no jobs, no hope and no cash”. If we don’t want to end up in the same place, Australia needs to do more to help incubate, nurture, commercialise and protect our best ideas.

And what are we doing bringing the brightest foreign students into Australia, giving them some of the world’s best education and sharing our IP and then, when they graduate, telling them they cannot work here and sending them home to compete with us?

“Go Australia”? Or “Go, Get Out of Australia”?

We also have some amazing established manufacturing businesses – paint, water heaters, bull bars, truck tippers, caravans, mattresses, wine, beer, pharmaceuticals, chemicals, anoraks, toilets.

The list of those producing attractive products and results is nothing short of A1.

A company that…

1) Has built a brand and or reputation for quality, value or innovation;
2) Is vertically integrated – owning the distribution channel;
3) Is manufacturing a highly specialised or customised product and not competing solely on price;

…has a chance to succeed in manufacturing in Australia. And while it’s a shame our government has gradually allowed manufacturing to ‘die’, there are pockets within which Value.able Gradutes can find extraordinary businesses, especially when the market’s manic phase turns to depression.

Many of the manufacturers listed in the following table have a long history of operating through a variety of economic conditions. They are ranked from A1 down to C5 – you can immediately see the broad spread of quality. I find looking at the ‘tails’ to be particularly insightful.

While declining in volume, manufacturing in Australia is not dead. Indeed some businesses are positively ‘raking it in’.

Manufacturing is tough and because inflation is always running against a business with a high proportion of fixed assets, smart managerial decisions are constantly required.

Ironically, with so many winds against manufacturers, those that have little or no debt, high rates of return on equity, bright prospects for future growth in intrinsic value and are trading at substantial discounts to current intrinsic value, may just prove to be Value.ablely positioned to leverage a broader economic recovery, locally and globally.

Who’s your top pick for Australia’s best manufacturer? I also want to hear your stories about manufacturing here. Are you a business owner that makes something we should be proud of? How is government policy or a monopoly customer affecting you? What changes need to be made to give Australia a fighting chance?

The universe of great businesses to invest in will inevitably decline unless something is done.

I look forward to your stories. They will be read by the who’s who in banking, management and government, so jot down your thoughts and share your Value.able experiences.

Posted by Roger Montgomery and his A1 team (courtesy of Vocus Communications), fund managers and creators of the next-generation A1 stock market service, 13 October 2011.

by Roger Montgomery Posted in Insightful Insights, Manufacturing, Value.able.

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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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