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Cochlear update

Cochlear update

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.


Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.

This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.

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  1. Remember we are looking for businesses whose fundamental qualities justify the purchase of the entire business for 10 years – stock market closed.

    Whilst the stock market gives us the luxury to adapt to permanent changes in the outlook for the business without the 10 year impediment, the decision to purchase should be conducted as though it were not so.

    For me, this means margin of safety. As attractive as the COH business may be, this margin of safety is just not apparent (to me – others may have different required rates of return). You do tend to pay a high price for a cheery consensus and thus I am happy to wait for a better discount.

    MCE on the other hand is being heavily discounted for what I believe will be short term revenue and cash flow issues. I doubt that in 2021 anyone will be concerned about the 2012 revenues, they will be focused on the competitive advantages and growing returns of the business in 2021.

    Finally, to JBH. My tracking spreadsheet update after the FY11 results were announced indicates analyst projections for FY12 ROE over 70% and an implied growth of 29%. In the comments column I have written that neither is sustainable long term and thus the $20 plus IV for 2012 is meaningless.

    I am not claiming to have any special skills in forecasting the future, and no one can reliably claim to know with any precision what the world will look like 10 years into the future. But we can apply what we do know and use some common sense about the future outlook for the products and services the company provides so we can consider the value of ownership over an extended period. Then we can evaluate what represents a fair price to own that company and wait until it becomes available at a reasonable discount.

    Let us hope some bargains await us in the new year.

  2. Roger

    A simple thank you for educating, at no charge, value investing. I’ve made mistakes in holding MCE and others for too long.

    What I’ve now done is draw up a list that includes csl, arp, mnd, mtu, bhp, anz, Csl, min, cpb and wor and I’ll wait for 20% discounts to the conservative scaffold intrisnsic values before I buy. I have also set up alerts for new news on each share so I don’t lose track of each share.

    Before this I would have purchased shares on p/e ratios.

    Merry Xmas and I wish you, your family and the great team behind
    you a welcome break.

    Hopefully you will still put out a retail fund early in the new year as I only trust you outside of myself with investment decisions and the world is becoming a harder and harder place to grapple with from a financial aspect!

    Kind regards

  3. Hi Roger,
    Thank you for the article on Cochlear.

    After the recall and corresponding significant share price decline I bought some shares, even though my assessment wasn’t the breadth of your fine assessment. I sold the shares on Wednesday for a gain of around 23%.

    I know some may say to me and others, who bought shares after the recall, we got lucky (just on speculation). I think your article dispels that theory.
    A few things I would like to mention of my assessment before buying were
    – Cochlear’s 60% market share has been built not just on the Nucleus 5.
    – Doubtfulness would be rife on a rival’s product – causing pain, returning to the market even though it has been approved.
    – A hearing implant is a product for improving the quality of life.
    – People waiting for an implant would be keen to use Cochlear’s older proven Freedom unit rather than remain deaf longer.
    Cochlear is what I call a popular extraordinary company who investors – institutional and retail like to have it in their portfolio. This wide popularity has driven the share price to a very high premium to the intrinsic value over a long period of time and will in the future.

    You seem to have copped some flak these last few months just not only on Cochlear, Matrix was one the other companies. Back in around July this year I posted a blog on the topic of buying Matrix and Forge shares last year. The share price increases of both by the end of financial year 11 (FY11) contributed to 7% of my 22% return. I eventually sold Forge because I came concerned when Clough became involved. I held onto Matrix to late August selling at an overall loss – minus 7% compared to a plus 43% FY11. I only blame myself for this for the following reasons.
    – Insufficient time to keep tabs on my portfolio of stocks.
    – Using some of the available time to assess other potential buying prospects
    – Forgetting that Ashley raised concerns about their cashflow pressures building because of no new orders, and also forgetting Roger’s comments, here on this site and a segment on Sky TV, how long it takes for the money to flow in after an order is received.

    A lesson to be learned from my experience, is if you haven’t sufficient time to manage your portfolio, then either don’t have one or only have a number of stocks equivalent to a conservative time you belief you have to adequately manage your portfolio.

    It is too easy to say once you have bought an extraordinary company at a large discount to sit back and ignore the hype of the share-market.

    You only ignore the hype only if the reasons for buying shares in an extraordinary company haven’t changed.

    Repeating Page 57 of Value.able, Chapter 5 Pick Extraordinary Prospects, “The factors you are looking for in a business are, bright long-term prospects, a high rate of return on equity driven by sustainable competitive advantages, solid cash flow, little or no debt, first class management”. On page 58, not in Roger’s exact words, if a company fails to match this criteria, even if it is only one factor, then the business cannot be described as extraordinary business.

    Getting back to Matrix, as I have mentioned new orders dried up suddenly and alarm bells were raised on cashflow. This relates to the above factors for picking extraordinary prospects – solid cashflow, and loss of revenues relates to it affecting another factor – a high rate of return on equity.

    Therefore Matrix factors changed and ceased to be an extraordinary company. Matrix is not the first company to change and won’t be the last either because time can bring change.

    I’ll add one more point on Matrix, I have lost count of the number of times Roger has stated he is under no obligation to keep us updated on intrinsic values, and I will add to this – Have we forgotten all the tools required are covered in Value.able?

    This is a lengthy blog. I would like to add more about the comments re the value.able method isn’t working and you have even stepped away from it. I will post more comments shortly in another blog.

    Ron F

    • Thanks Ron. A friend of mine who manages another fund is, I suspect, feeling much worse than you.

      He notes: “I have aged a lot over the last week!
      Monday – (ASX:TWO) – downgrade – down 55%
      Tuesday – sweet, sweet relief
      Wednesday – CSV – failed bid – down 40%
      Thursday – KMD – downgrade – down 23%”

      We at least are grateful Value.able has not shown these stocks to meet our criteria.

      Separately, I read a newsletter today that noted: “The share market is cheaper than at the GFC trough, with a dividend yield on shares higher than term deposits and expected 3 year profit growth of close to 10%”

      I would like to counter this with a few points:

      1) The banks were trading in the teens during the GFC trough and today they are not. Moreover they have issued many more shares and despite profit growth their return on equity is lower. ANother company Fleetwood traded at $3.50 in the GFC trough and after recovering by June 2009 was on a P/E of 8. Today it trades at 13 times earnings (not that anyone is looking at P/Es here). There are many many more examples. Don’t look at indices and averages, look at individual companies and their shares.

      2) The problem is also the earnings growth assumption. At 10% per annum it seems too high. The comment fails to recognise something everyone here at this blog knows; aggregate analyst forecasts have a tendency to be optimistic. They are consistently revised down. Also, the government brought down their budget mid year review and forecast multi billion dollar surpluses in 2013 and 2014. They did this even though the September review had already been released showing a $22 billion deficit! Tax receipts it seems are not as strong as hoped or advertised. That 10% profit growth figure stands in stark contrast to the growing deficit, lower tax revenues and interest rate cuts already witnessed.

      3) Tens of thousands of jobs are now expected to be lost in retailing and financial services early in the new year….Christmas is the busiest time of year for retailers and yet they are in a serious funk (JBH, KMD, TRS, BBG). What will retail sales look like in January, when Christmas is over?

      4) Over in China – the driver of our one-cyclinder economy – banking assets have grown by 50% of GDP per annum 2 years in a row. This is tantamount to the US lending $14 trillion. If the US banks lent $14 trillion internally – Kyle Bass noted the US’s GDP growth would be more than 8% per annum. China’s FX reserves are seen as something we can all hang our hat on but non performing bank loans now amount to just 1%. Historically they have been 19%. If they go back to that level that would be $3 trillion in losses that would wipe out the fx reserves. I have written here about the slump in construction and property prices in China and so we could be expecting non performing bank assets to rise. This, I expect, is the thesis of Jim Chanos who I believe is shorting BHP and RIO et al. (note also the iron ore price has again fallen). Kyle Bass counters that banking assets amount to two times GDP. Could they lend more and take that balance to 3X GDP (say another $5 trillion) into the banking sector? Yes they could. That could keep the party going a little longer. But Europe = recession next year. US may not be able to grow significantly without Europe = recession? I don’t know of course, I am not an economist. IF Euro and US = recession, then commodity prices fall, then our one-cylinder economy stops. According to the government’s own stats we seem to be slowing sharply already.

      So perhaps our market is cheap?

  4. It’s a nice little Christmas present when something actually goes up. Also happy present for somebody going into surgery for an implant knowing that they are going to get the best and a more certain outcome. Feels quite unnatural seeing something go up at the moment with the gravity of the stockmarket.

    I was guilty of buying at approx $68 for my first slice of Cochlear and used the ensuing recall to average down to $55. This is all small movements in the scheme of things when I want to be watching what this company does over the next 10 years. Yes, I am a slothful investor also guilty of being too slow to clean out the rubbish on the other side of the ledger. It was May 11th when Roger asked us to clean out the portfolio. I am finally all up to investment grade and now only have to worry about my problem A1,2’s and B1,2’s in JBH and MCE. Getting the bright prospects right is the secret sauce, the penny in the Christmas pud’.

    Merry Christmas Everyone and thanks to the contributors, Roger and the team behind the scenes for a great forum. It’s great to see so many blogs up in such a short time Roger. It will be a long hard drought until February.

  5. I would not get too excited about COH finding what we knew they would — What are the latest estimates on what it will cost shareholders $200 million ???? and will they have to raise funds.

    • Have a look over history at how often COH has traded at a discount to its intrinsic value. COH is one of the highest quality companies listed in Australia. We are prepared to think in terms of future valuations.

  6. Confession time. I have made a huge mistake. The Cochlear update came one day too late for me, and on Monday I sold three quarters of my holding as part of a plan to be ready with cash for the downturn everyone and his dog senses is imminent.

    Okay I bought at $50.13 and sold at $55, but frankly I’m ticked off that in all the time from the recall in September to yesterday there wasn’t a dicky-bird of updating from management apart from some market-neutral remarks from the Chairman on 18 October to guide me in my decision. What I missed out on yesterday would have paid for a great big overseas holiday. My instinct told me that a long silence after a product recall was not good, but I was wrong. Others were not so unlucky, because the price started to shoot skyward yesterday hours before the good news was announced by the ASX, so Happy Christmas to all those insiders who were in the know. I’m tempted to sell the rest just because of my grubby mood, but I won’t. I must remind myself. I’m stupid, but not insane. I’ll hold them. And to get my mind off the total insanity that is the world of high finance I will go to lunch today and then have a game of bridge with my friends.

      • Whoa-a-a-a. Just a cotton-picking minute here, please Roger. Like you I suspended caution for a moment to buy a small slice of this beaut company at above my estimate of intrinsic value, but when 2 months of resounding silence followed the chairman’s October address I began to think that a further 10% rise in the absence of further good news was looking like a signal to unload a few. Long term investing is just fine but if you don’t sell when the signals say to do so, where are you? You are like investors in JB Hi FI who sat on their thumbs from mid-2007 until now and are right back where they started from. Or maybe you bought CBA In Feb ’07, WBC and ANZ in Jan ’05, WOW in Feb ’07 or DJS in Feb ’06 or BHP in July ’07. Where are they today? Right back where they started from! Or MCE or VOC this year without regard for the changes since, and getting the heck out in good time. I’m with “Mike” who questions whether the purchase of COH by you and me was “value investing” . I think it was mildly speculative and I probably deserve to miss a windfall profit, expecting to be updated with a little note of encouragement from the CEO, perhaps a week or so ahead of the good news of this Tuesday, when in reality nothing at all that could have been reported to the ASX, was reported. But enough about me, what about the poor sods who had bought COH at $70 or $80 and sold this Monday at $55? They’re the ones I’m really sorry for, because I think there’s more upside yet. Although who really knows?

      • I know I run the risk of boring others senseless, but I want to stress the following regarding COH: (Please see my 2 recent blogs)

        I believe my purchase at $50 in September was speculative, and not in general accord with value investing principles. “Mike” agrees, and I would like to know if others do too.

        I therefore believe Roger’s investment was also speculative, though he may of course disagree. He refers to “future valuations” in his 10:40am blog today but I do not know what these were/ are, or how they may be assessed as of now..

        I believe the “sell” signal that prompted me to sell 75% of my holding on Monday was misplaced, but not faulty in terms of Value.able guidelines. If however, my purchase was speculative, then Value.able guidelines would be ipso facto null and void, and I have no one to hold to account but myself.

        Roger says he has had no signal to sell. This could mean that he believes that IV has shifted quite dramatically upward in a minisculely small space of time, or it could mean that he knows something I do not, or it could mean something else entirely.

        Whatever it does mean, however, I wish I knew, because generally I place great value on his views, but I am totally perplexed by his three responses to my blogs on this subject timed at 10:39am, 7:21pm and 7:23pm today,as well as his response to Mike timed at 3:41pm and I hope that before he goes on vacation, we can have his response to this one.

      • Eventually a day comes when the facts and valuation changes. That 24 hour window will always be a “minisculely” small space of time. So be it. And don’t forget as I have said all year, do your own homework, seek and take personal professional advice, and arrive at your own conclusions. We don’t provide any advice here, I am under no obligation to keep you up to date with my own views or positions and I may own or sell any stock mentioned here. I indeed hope your views and conclusions will often be different to mine.

        My peers in funds management often ask me why I write here? I enjoy it…mostly. You have to understand I don’t seek your agreement nor your approval and I am delighted for you to disagree. If you believe there are inconsistencies and you cannot reconcile them, then you must form your own approach that you are completely comfortable with. All the best and Happy Christmas. 3.25pm.

      • as usual Roger, covering all your bases!
        talk is cheap!
        you often talk about a company after it has tanked – like your recent article on BBG after the profit downgrade even you have it as an A5 not even in the C category
        you conveniently disposed of ZGL in the valuable portfolio because it was hurting your return and you no longer were beating the index
        it’s only after readers pointed it out that you decided to somewhat ‘explain’ why suddenly it no longer was in your portfolio
        At least the Speculator David Haselhurst is transparent in his dealings
        I bet this comment won’t even make it on your blog

      • Thanks Kevin,

        1) A5 is NOT investment grade.
        2) At no point this year have we underperformed the index. Indeed at no point this years were our returns negative.
        3) We conveniently dispose of any company that no longer meets our criteria. I sold ZGL and didn’t ever plan on covering again until some asked. I do find it a challenge to cover new ideas and revisit all the old ones all the while working in a professional capacity elsewhere. As I would like to keep the blog free, it will remain a collection of insights (of many other investors next year too) and I remain of the view that I will be under no obligation to keep my own views up to date. This is not a newsletter. Use it as you please but do your own research and seek and take personal professional advice.
        4) David is a co-contributor to a number of publications and I enjoy chatting with him when we catch up. David will plainly explain that he does not “deal” at all or ever in any of the stocks he mentions. When you say transparent in is ‘dealings’ I am not quite sure what you mean.
        5) How much did you want to bet?

        I have taken a step back and realised that investors are hurting across the board. WIth the top 50 stocks now 17% below their April highs, and the top 200 down nearly 18%, it is quite difficult to contain one’s emotions. While the current malaise could get worse, you won’t be able to invest successfully if you allow emotions to cloud your judgement. A dispassionate disposition when it comes to investing is an important temperament to have. Being able to sell out of a stock because facts change, even if you are showing a loss is a vital skill that cannot be taught. Every time a buy or sell a stock the person on the other side disagrees. Writing publicly about my thoughts also makes me a target for vitriolic disagreement and even offensive language that doesn’t get published here. When Ash and others here at the blog noted the declining cash flows of MCE many disagreed and hung on. Once the numbers were confirmed, we didn’t hang on. When I then wrote a piece about MCE earlier in the year that posed the question, ‘what is a stock worth that makes no money?’, many investors were angry, disagreed and hung on to their shares. The share price fell further. Then of course it was not their fault. Rational responses to new facts rather than emotional sentimentality will serve you best. Kevin’s anger is palpable and rather exhausting for him. Without a focused plan, written notes explaining why every decision is made and the right temperament, his and other’s emotions will rise and fall with the returns of the index.

        Every Fund manager makes mistakes and I am sure Kevin has made his own without anyone’s help here. Even Warren Buffett has – Indeed there is an entire book dedicated to all his errors. The key is to diversify so that even if one of your team is sent to the bench, the remaining players are so good, the team can still win the game. The other key is to look forward not backwards – just as the train drivers rattling past Kevin must do.

      • I think whether it was speculative or not could well depend on the time horizon you are looking at.

        I remember noting just after the recall that i think it would be fair to say that the panic price being offered after the recall is at a discount to future value, however that future value may be put back a little bit.

        I still believe this to be the case. Cochlear are a brilliant company and one that i would be happy to hold for a long time, i would be happy to look a lot further for them than i would for others due to their strong characteristics.

        Your “sell signals” are unique to your method, i don’t particularly have sell signals. I hope to find companys where selling doesn’t need to be done rapidly. This might make it easier for me to look at the move Roger made and agree with it as i can see it being seen as a great move in 4-5 years from now.

      • In a timely email, Chris sent a discussion about dividends and franking in response to an Article in Smart Investor which I post below…But the page he referred to also had a break out section written by Patrick Commins that could help many investors:

        “Losing money on an investment is never pleasant. So it’s natural to curse a decision to put money into that sinking stock. Natural, yes, but it can also be dangerous. While the final decision may have turned out to be bad, the judgement that led to it might have been perfectly sound. Tinkering with your strategy as a result may make another failure more likely rather than less. Psychologists call this common psychological pitfall “outcome bias”.

        Take medical procedures. Studies have shown individuals are more likely to be critical of the decision to pursue a particular course of treatment when the outcome was poor, even when the riskiness of the procedure was the same after the result as before. In this context, a bad result did not reflect poorly on the process that led to that decision-there’s no new information in the result that would lead you to pursue a different option if you had your time again-and yet we condemn the decision regardless.

        It’s an important bias to recognise because in a changing environment every investor needs to be perpetually evaluating their strategy. You need to make sure that you’re altering your strategy for the right reasons. And it’s clear that an outcome-biased individual is likely to fiddle excessively with strategies after unlucky failures, and fail to make the needed adjustments following a fortuitous win.

        In a paper Sticking with what (barely) worked for the US National Bureau of Economic Research, academics Lars Lefgren, Brennan Plat and Joseph Price search the evidence of outcome bias in American football coaches’ offensive strategies. In particular, they examined how a win or a loss influenced the coaches’ choice on how frequently to run or pass the ball in attack. Unsurprisingly, they found winning teams tended to stick to the winning strategies.

        But looking deeper, they found outcome bias. First, coaches were more likely to stick to their game plan after a narrow win than narrow loss, even though (the authors argue) both outcomes provide the same information about the prospect of success. Second, coaches are as likely to alter their strategies following expected wins as following unexpected wins. Third, coaches change the offensive plan in response to success or failure of the team’s defence.

        Finally, in a lesson for all investors in a turbulent market, the strongest teams “show greater persistence in their offensive strategies and less evidence of outcome bias”. Sometimes you’re game plan needs tweaking, but it’s not such a bad thing to be wrong for the right reasons.” Patrick Commins.

        And here are Chris’s comments about Dividends:

        I smile at the logic. “If Company A yields 6 per cent but is unfranked, it’s worth a lot less than Company B which also yields 6 percent but is fully franked”.

        In simple terms, yes.

        In different terms, no. If both companies yield the same, it does not take into account the share price, which may be $100 for Company A and $1 for Company B. It depends on how long you held the stock for it to get to $100, because also, you may want to sell that stock (and an equivalent number of shares in either gives very different results). Essentially, you reach a point where, if you hold a good company long enough, the dividends from the stock and the price should actually have grown enough that the dividends look after the original purchase price. Argo made that point about Macquarie, when they bought it way back in the 1980s as some other entity (before it became MBL and then MQG), and it was about $3 a share. They got more than that in dividends in 2007.

        If Company A has a better return on equity and perhaps, it does not have franking because it is based offshore and gets preferential treatment from a foreign tax shelter (thus paying little to no tax here), then maybe you don’t want it to give you a dividend ! Maybe you want them to reinvest all the profits into the company ?

        It all depends on what you intend to do with the stock later – to sell it or to keep it for the income stream. A yield can also be artificially inflated because the share price has dropped, but the dividend has not increased in real terms, it just looks like it has. It is a yield trap. TLS is a great example of such a company, where the dividend was being paid out of borrowed money. Other companies have better growth prospects for the price to go up and thus the dividend, but the yield can still be the same if they both increase lock-step with each other. Does this mean that if, five years later, company A is still paying 6% unfranked (out of pure profit) that it is worth less than Company B, which is still paying 6% (or more), but borrowing money to do so ? No, it is a nonsense.

        P.S. I also read “Greencross” was one of the featured stocks in the Christmas Fin Review Weekend edition in the Smart Money pullout. If you read the story behind it in the article, which trumpets increased revenues and profits, I had to ask the same questions re: “ABC Learning”, because the company has grown (apparently) through acquisition, not organically. How much equity have shareholders had to put in through capital raising, how much debt the company has etc. I don’t have those answers right now because I only skipped over it at breakfast this morning, but just wanted to let you know that it rang alarm bells….deja vu ? ABC also had “profits” going up and revenue increasing, but this was all being funded out of debt and capital raisings.

        Would be a great comparative case study.


      • David,

        Try not to feel sorry for those who pay 30 times earnings – that is speculative consider the average for Cochlear is 40, lowest is 14.6 and many paid 15 times ($50) and you then sold at 18 times

        What one could of thought of was what catalyst will trigger the realization from Cochlear being undervalued to being overvalued.

        This is a problem we all face is that cheap shares can stay cheap for years unless there is a catalyst (again why I prefer bonds sometimes as there are contractual interest and maturity dates!!)

        Management did say they were trying to figure out the problem asap – once fixed one would think its likely that product would come back to market place and that they would triple check that no other problems will occur. I thought perhaps next year this would happen.

        As the problem was a catalyst for the way down – fixing it would be a catalyst for the way up.

        HY results will be out shortly also another catalyst – and potentially another buying opportunity if there is some more bad news in there or could be a selling signal if abundantly positive news.

      • Nope, not rational at all. But i am thankful that people are irrational like that, it will allow me to accumulate a decent size position before the catalyst and than see the results.

        I don’t want rational competitors or the market to be efficient. It will prevent opportunities from showing up as constantly as they do.

      • Pointing out that you need to have something in mind that would cause the price to go back towards fair value.

        Not advocating trying to buy just prior to a catalysts – that is nigh impossible – always buy with a margin of safety – just have in mind what the catalyst will be.

        It can take years and years for a cheap share with no catalyst to generate a return.

        Bought COH in Sept with avg price of $50

        Keep buying the ugly or obscure securities no one else wants – that is where miss-pricing is found

      • “Mildly speculative”? If Skaffold was showing an intrinsic value in the $30’s and it was bought in the $50’s that’s throwing value investing out of the window and playing a totally different game.

  7. Roger, I was puzzled by your Sep 14th article on COH. At the time I couldn’t see how COH’s price of $51.42 was trading at a discount to intrinsic value (say using a required return of 10%). In fact even when it was at its nadir of $45.xx I estimated it was still trading above intrinsic value. At that stage even slotting in 2013’s EPS estimates only brought it to about in line with intrinsic value. Now that those dark days of Sep/Oct are behind us and you’ve made a killing from the surge in COH’s price could you possibly expand on your analysis and provide numbers that brought you to the conclusion that COH was trading at a discount? I know you generally keep your cards close to your chest however there have been occasions in the past when you have given a more detailed quantative view of a company’s valuation…. and of course it is Christmas, the time for giving!

    • Hi Mike,

      The answer is relatively easy to expand on. We looked at 1) the quality of the company (one of the highest in our market) and then 2)how close to our intrinsic value, the company’s shares had ever traded at before (not very) and 3) we estimated future intrinsic values and were confident we wouldn’t have to wait long for price to catch up. We also mentioned we didn’t ‘bet the farm’ to hedge against the possibility of lower prices (which may still transpire). Keep in mind, some questions remain: The update is positive in that the company understands the cause of failure but for current prices to be sustained we may need to see a very fast return of the Nucleus 5 back to market and because the company has allocated A$130mn-A$150mn provision to cover its responsibility with regard to explant/re-implant surgeries for failed devices this will need to be sufficient.

      • Roger, that sounds like speculation to me. Although its price was well above “intrinisc value”, you paid it on the basis that Mr Market would eventually pay even more i.e. the greater fool theory. Fair enough and you’re currently well ahead with this one (if you still own it) but it certainly isn’t value investing.

      • Overpaying for growth has its risk if growth does not come to the table but does not necessarily amount to speculation – if you have used a rational and robust investment process.

        Those of us who bought around $50 may have felt that we were prepared to risk $20 of capital and that price would not fall below our lowest estimate of value which was $30.

        Estimating the value of a business which has no contractual cash flows from now until infinity into today dollars terms is very hard (bonds are just so much easier to pin point a value!!)

        As a value investor you are not looking to precisely pin point value but simply hoping to make a purchase at a discount to even your most conservative of value estimates, but catching this falling knife (of quality) was worth it.

      • Intrinsic value is an estimate: “Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life. The calculation of intrinsic value, though, is not so simple. As our definition suggests, intrinsic value is an estimate rather than a precise figure, and it is additionally an estimate that must be changed if interest rates move or forecasts of future cash flows are revised.” Warren Buffett

      • …and when you get a chance to buy at even your most conservative of estimates – the margin of safety is huge

        Like buying at discount below net working capital which might approximate the value you would receive in a fire sale liquidation!!

        Gives me goose bumps just thinking about those times!!

  8. Hey Roger is this a good time to sell Cochlear shares or are you holding on for higher prices? Cheers

    • Hi William, We don’t provide any advice. I can only suggest you seek and take personal professional advice and don’t take your cues from short term fluctuations in price unless you are considering quality and value.

      • Hi Roger. Happy New Year. Don’t take anything personally. Most people are participating in and using this blog for its intended purpose, to educate, share ideas and insights, and it is an excellent forum that I and many others enjoy very much. Thank you for setting it up and for choosing to continue to run it when it must cross your mind often that it would be so much easier to discontinue it sometimes. You are obviously very busy and have a heck of a lot going on in your life, so your choice to continue with the insights blog IS appreciated by me and many others (probably 99%+ of contributors). Thank you!

        Personally, I follow the comments of many: Yourself and other blog contributors, Alan Kohler, Marcus Padley, Geoff Wilson, various website market reports, an endless list. On most subjects, very rarely do all agree, and I never take a comment or blog post by anybody as a cue to buy or sell a stock. In fact, I often go the opposite way. It was only after you sold out of ZGL that I started buying into them for instance. However, I glean what I can from everthing I read, and then see how it fits into or affects my own investment philosophy. Often it doesn’t have any effect at all, and other times I decide to adjust my thinking or philosophy based on the available information presented to me. At all times those are my decisions alone. Nobody is perfect; we all learn as we go, and the more I read, the more I learn. However, at no time will I ever blame my own investment decisions on anybody other than myself.

        I’ve made my share of mistakes, but I’m making less now than I was before I found your book and this site. It is helped me, and I appreciate it greatly. Thanks again. May it long continue!

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