Are these stocks where the highest risk resides?

Investing Education | Comments (71)

Are these stocks where the highest risk resides?

I have not discovered a method for predicting the short term direction of share prices.  Once we purchase an A1 company’s shares at a discount to intrinsic value, we cannot know what the share price will do in the short term.  We do know that provided the prospects for intrinsic value growth remain bright, the weighing machine that is the market will eventually cause share price and intrinsic value to converge.

Thats why it is so valuable to have an current and future intrinsic value estimate for every company updated daily.  Having a long term demonstrated track record of intrinsic value growth can also provide us with insights into management’s capital allocation decisions.  Knowing what the cash flow profile of a company looks like and whether the company has profitably employed capital entrusted to it by shareholders can further ensure you aren’t overstaying the party.

Soon you too will able to simply and confidently navigate the noisy distraction of the stock market to be shown those securities that deserve your time and avoid those that have a higher probability of permanently impairing your returns.  Skaffold is launching now (so keep an eye on your inbox today!)

Last week I spoke on CNBC with my old friend and peer Matthew Kidman.

You can watch the interview here: http://video.cnbc.com/gallery/?video=3000054986

Our view about the market is influenced by how many companies we can find that are both high quality and cheap.  I remember back in April this year, we had just started investing on behalf of investors in our fund but we could only find a small group of suitable companies.  That was enough to suggest that the other 2050 listed companies were either expensive and or of unsuitable quality.  A similar thing appears to be happening now.  The lower credit growth and declining iron ore prices have impacted the growth rates of future intrinsic values for banks and resource companies and these dominate our stock market index.

If you are following the Value.able-style approach to value investing, you would only be interested in high quality companies with bright prospects at substantial discounts to IV. If that fact changes as a result of the constant process of re-evaluating the prospects for the businesses in which we are interested, then one must act accordingly.

I cannot tell you whether the market is going to rise or fall in the weeks and months ahead but it does seem that value is a precious and rare commodity.  With that in mind, what are the companies that may be most at risk?

We will update this post with a table shortly but here is the short list (keep in mind the issues that have caused the companies to be in this predicament may be temporary):  Tap Oil, Neptune Marine, AACo, Somnomed, Elders, Centro and Gunns.  I will update soon with a more comprehensive list of expensive C4s and C5s soon.

The current list is not exhaustive, what I have done is taken C4 and C5 companies and sorted them by those that most recently reported cash flows that were unable to cover interest.  There are many more but these are the names that piqued my interest and I thought they might pique yours.

Posted by Roger Montgomery, Value.able author and Fund Manager, 09 November 2011.

INVEST WITH MONTGOMERY

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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71 Comments

  1. Ash Little
    :

    Hey Guys,

    Our requires return is the risk free rate of return plus a margin.

    some have a stanard margin and adjust the margin of safety…Others have a variable required return………….I don’t want to argue about this at the moment.

    My question to everyone is what do you do when the risk free rate of return is no longer risk free.

    I just can’t work this out………..can anyone help?

    • Michael
      :

      All others factors being equal if your risk free rate is no longer risk free, then your required rate of return on a ‘risky’ investment falls – it has now become less risky in a relative sense to the risk free investment.

      There is no real need to worry about this – unless you believe people such as Peter Schiff and Harry Dent. Doom and gloom sells. A book I recommend that has recently come out is ‘Markets never forget, but people do’. This is by Ken Fisher (son of Phillip Fisher). If you have been reading too much of the doom and gloom, this book may help to restore some balance into your thinking.

      • Ash Little
        :

        Thanks Michael,

        I was thinking about more sensible people like Kyle Bass who is very smart and thinks that government default ….particularly in Europe and Japan is a certainty….

        He also thinks ths USA wont default but Americans tend to be very patriotic.

        Thanks again

    • John C
      :

      When you lose faith in the banking system, some people buy gold Ash. There’s a degree of risk in everything, but the Australian big four banks are still considered one of the least risky places to park cash… for now… (not necessarily in bank shares though)… Even if your Australian recession prediction is correct, it will still be better to have cash in an interest bearing account than putting it under your mattress. An interesting point you raise though…

    • Simon
      :

      When the risk free rate of return is zero, then the margin of safety required needs to be very significant indeed! So lets assume that a gold mining company was facing significant head winds and a I.V that was no longer increasing. Then a MOS required might need to be >60%.
      So a $5.00 share has a value of $2. In this case I would start buying shares @ $1.99. However if the I.V was decreasing then I wouldn’t purchase shares at any price.

    • Vernon
      :

      Hi Ash,
      I like this question, I think the truth is no one knows, I believe it challenges core theories of finance that have been around since the 60’s. There has been 125 government defaults in the last 150 years and after QE1,2,…. I am sure the Chinese no longer view their USD Treasuries as risk free, though in theory the 30 year US T-Bill rate is still the closest thing.

      You made me go back over my notes on the topic, unfortunately though I didnt find an answer just a few points I have in my notebook:

      1st, Time horizon matters, the risk free rate in valuation models will depend upon when the cash flow is expected to occur & will vary across time.

      2nd, At the end of the day the only risk that matters is the risk you cannot diversify away.

      I know thats not the answer, but appart from taking the current risk free rate and adding on an estimate of soverign default risk I dont know. One thing is for sure though, not having a true risk free rate must put downward presure on asset prices for all risky assets, create higher volatility in prices, and increase the probablity of painful market corrections.

      One very good source of information though on this questions and many more is a blog from an NYU finance Proff by the name of Damodaran. This page is brilliant, he has given free access to his MBA valuation course with full lecture notes and podcast in addition to a host of great reading sources such as papers on the risk free rate and what if nothing is risk free. Damodaran is one of the most entertaining teachers I have ever come across and he’s a bit of a roge academic who challenges many traditional ideas and seeks alternatives to such things as betas, equity risk premiums etc.. The page is extremly cluttered but if you spend the time to sift through it you can find some great stuff.
      The page is: http://pages.stern.nyu.edu/~adamodar/

      • Roger Montgomery
        :

        Having spent the better part of the last two years re-studying valuation theory, I can vouch Aswath. Heavy going so be patient. I packed the benefits of my findings into an application that covers every stock and is updated daily?!?!?!

    • Tony Connellan
      :

      what happens when the ” risk free ” rate of return falls to 0 Two economies, Italy and USA with the “risk free” rate going in different directions.Both with sick economies.Maybe the method of deriving the rr is faulty?The idea that rr=risk free (anchor) +equity risk rate(speculative) does not work in extreme financial conditions. With the “risk free”=0, rr=0+speculative. Thus rr=speculative.What does this mean for IV?Are we not meant to be minimising speculation?Perhaps we can take a different view of rr. Perhaps we can just say we want X% for investing our money.Under present circumstances we can not quantify soverign risk.
      Tony Connellan

    • Christopher
      :

      Ash,

      I doubt there is a satisfactory answer to that question, but there are a couple of interesting points to be made I think.

      Firstly, it was never actually a risk free rate. The theoretical asteroid wiping an entire country would always have always resulted in default.

      Secondly, at least for a long time now, it hasn’t been the “most” risk free rate. Other countries with the same credit rating but a lighter debt burden and more free cash would be the rational choice as a benchmark.

      The interesting thing about this is the reliance on conventions. It was a convention that it was ever called the risk free rate to begin with, and a convention to use one (heavily indebted) country as a benchmark. Hence the saying in finance, do something twice and that’s how it’s done forever!

      While everybody has always known the points made above, it is interesting that no one seems to care until it becomes a top news story. This happens time and time again, e.g. the European debt levels, the US housing market etc. We do tend to sleepwalk into things!

      Putting aside finance’s existential crisis regarding the risk free rate, I suppose the practical answer is to demand higher margins of safety and accept that nothing is risk free…

  2. John C
    :

    G’Day Roger and the Skaffold Crew – I am thoroughly enjoying it and I can echo the sentiments below of Garry – my wife isn’t very happy with me either right now…

    Roger, I enjoyed the challenge you set in the Eureka Report to find the A2 company you described, and I did. They’ve got a pretty cool website too. I guess if I mention the company name here, that ruins the fun for those that haven’t found it yet…

    The excercise was a good way to get a handle on the filtering tools in skaffold. I also found the “Market Capitalisation View” handy to narrow down those nanocap companies to the one I was after.

    Thanks for the interesting challenge. It re-inforced to me how much more powerful and flexible Skaffold is than what I’ve had to work with previously.

    Judging by the fact that there are currently 8 buyers (but still no sellers) as at close of trading Friday 11/11/11, compared to the 3 buyers when you wrote the article, a few others have solved the riddle also, and also want in on the action.

    Cheers,
    John C.

    P.S. Is Elizabeth Montgomery (of the “Elizabeth Montgomery Super Fund A/C” 21.69% shareholding) any relation? If the founding family own c.67%, and the EMSF owns c.22%, and Mr. Ian Alexander owns another 9%, that only leaves about 2% by my reckoning. No wonder it hardly ever trades!!

    • Roger Montgomery
      :

      Great stuff John. I am delighted you have found some of the features so easily. The developers promised to make it intuitive and it sounds like they succeeded. Thanks again.

      • David martin
        :

        Roger, I have signed up and been using skaffold and it’s great-thanks.
        My question relates to using it on my iPad – when I do it refers me to a crn web site and asks me to sign in.when I do, it then tells me I am logged in on another browser and wants me to change pass word. Frustrating – is it me or is there something I am missing.

        David

  3. Stuart
    :

    Roger & Team,

    Congratulations on Skaffold. It is very impressive! The user interface is simple and very visual so it is easy to quickly get a sense of where a particular business is at. And if I am right Skaffold sources it’s data from my favourite site – one which I always thoroughly investigate as the first step in researching a business I am interested in. So I now feel even more ‘at home’ with Skaffold.

    Keep up the great work.

  5. matthew burge
    :

    Witif holdings look very interesting to me at $3.50 and are an A1 business. What does Roger think of this companies outlook?

    • Andrew
      :

      I am a big fan of wotif as a business. It appears to be a bit expensive at the moment to me. Great cash flow though. So much so I have been wondering whether Npat is the best metric to focus valuation on. Due to their revenue recognition cash flow is usually much larger than profit.

  7. Elizabeth Kitchen
    :

    Hi Roger & Team
    Just want to say thanks for Skaffold – I love it! Still not easy deciding what to buy, but easier than before (of course I do my own research!)
    Is there a separate Skaffold blog, or jsut this?
    Cheers
    Liz

  8. Andrew
    :

    It will be interesting to see the impact that ARB’s latest announcement has on price. I think there is no doubt among us that the floods in Thailand are a short term issue but at a time when the market is already jittery due to Europe, a comment about the fact that ARB’s earnings will be impacted although they have no way of knowing how much could cause a great buying opportunity if people start pressing the panic button and selling as if the company was in terminal danger.

    I am sure there are a few graduates here that would love for a panic sale of ARB to force down prices.

    • John C
      :

      Go to “Skaffold.Com” ned and fill in the “Pre-Register” fields on the left side. You’ll get mail.

  10. garry
    :

    hey Roger,
    congratulations to the team on skaffold..fantastic!!!! Joined yesterday as soon as my email arrived..haha
    I thought it would save me hours of pondering through reports and company statements.
    But yesterday as soon as I joined I logged on, and before I realised, I was into the early hours of this morning..
    The wife is not happy with my new toy????
    well done..

  11. Ron Shamgar
    :

    For an interesting risk reward, check out AZG…

    As of yesterday its trading on a PE of less than 2!

    But shhhhhh, dont tell anyone i said this.

    • John C
      :

      Thanks Ron – ComSec had AZG’s PE listed as 14,000.00, but they’re not known for their data accuracy… Skaffold (on the other hand) has them as a B2, with an IV below the current share price, and rising, but not rising “at a good clip”. Why do you like them Ron?

      • Ron shamgar
        :

        Hi John,

        I should have been more clear.

        fy12 PE is under 2 (that is if they meet forecasts).

        And I didn’t say I necessarily like them – I said “interesting risk reward”

        Therefore the emphasis should be put on the “Risk” side!

        Nothing stays on a PE of 2 for long unless it’s about to have a “liquidity” event or if not, then you’re looking at a potential 5 bagger!

        No advice. Cheers.

        Cheers.

  12. Ric
    :

    Roger. I’m sure you’re aware of this continuing bottleneck this morning when the Skaffold sign-on reaches the ‘terms & conditions’ stage, but doesn’t allow any progress beyond this. I’m heading into remote desert country for a couple of weeks this afternoon and was hoping to get signed up before this. Just checking that your team is aware of this issue. cheers.

      • John C
        :

        Yep – I’m using Firefox (which is free) – no issues at all. Very satisifed with Skaffold! My only gripe (and it’s a very small one) is the way the balls (companies) skatter (intentional spelling error) one you try to hover over them to identify them (in the arial view). Sometimes it can be hard to ID each of them when they’re tightly grouped.

        A suggestion for improvement would be further own-portfolio analysis and report printing features – an arial view of ones own portfolio would be nice for instance (to see where our past decisions fit into the Skaffold world).

        My favourite part is the skaffold line and other viewing screens within the individual company analysis – I think and remember things visually (I use visual cues to remember numbers or directions for instance), so the colourful graphical displays are perfect for me.

        I notice that some websites are struggling with DTL after their 10-for-1 share split, but I got what I needed from Skaffold.

        Congratulations to the entire Skaffold team – Thank you! Definitely worth the wait!

      • Roger Montgomery
        :

        Great feedback John. The team did monumental testing to make sure capital changes would be accurately and automatically corrected immediately. Glad you like it. Regarding the ‘gravity’ feature; just zoom in and problem solved.

      • John C
        :

        Ta Roger – yes, that did solve the issue – thanks! No reply about any links to the Elizabeth Montgomery Super Fund 21.69% holding of EMB? I don’t see the “Montgomery” name in very many “Substantial Holders” or “Top Twenty Shareholders” lists, so I reckon that the chances of this being a co-incidence must be pretty slim.

        I sometimes hear people saying things like “well, if the company was THAT good, why wouldn’t he buy as much as he could himself instead of telling everybody else about it?”, in relation to share tips. In this case, perhaps you’ve done both.

  13. Andrew
    :

    One thing i have noticed Roger is that, the only three annual reports i have looked at out of the list of companies you mention all have the word “restructure” as one of the first words mentioned.

    Also, open question, does everyone else agree with me that if a company is struggling financially than perhaps a way to reduce some costs is to stop printing glossy annual reports full of pictures and just give people a plain bit of paper with some text?

    it’s not going to suddenly make some companys profitable but it is a decent start.

    But i guess the more smoke and mirrors you put in via pretty pictures than people might actually see that you haven’t made a profit, you are struggling to pay interest while your debt levels are rising.

      • MattB
        :

        Andrew,

        One strategy I’ve seen used a bit is to fill the first few pages of the annual report with some filler about OH&S results before sneaking in the bad figures. It helps if you throw in a few pictures of employees standing around smiling for no apparent reason as well…

      • Ash Little
        :

        Hey Guys,

        I have a PDF down arrow theory,

        The more clicks it takes to get to the relevant information the more disapointed you will be.

      • Roger Montgomery
        :

        Nice Ash. Also do a keyword search for “return on equity”. I have had fun with adobe reader and IPOD prospectuses looking up the word “profit”. When adobe reader reports back “no occurrences of this word was found”. You know it’s time to move on.

      • David martin
        :

        Ash / Roger , I often refer to the inverse opulence relationship curve. At fund manager briefings and lunches we were quick to note that the thicker the smoke salmon sandwiches or the plushness of carpets invariably lead to thinner returns!

        No doubt the same with corporate reports, the use of glossy photos, etc.

        David

      • John C
        :

        Hi Andrew. JB Hi-Fi (who aren’t exactly struggling) extend their no-frills approach to their AGM as well as to their stores. From memory, instant coffee and plain biscuits was the extent of the catering. They’re AR was also very low on the gloss and photos (apart from that bright yellow cover), so it can be done. I think most shareholders appreciate the choices of companies like JBH to conserve shareholder funds. On the other hand, as Roger has just pointed out, many companies seem to be using the AR to try to market the company, rather than as a report to its owners.

      • Tony Connellan
        :

        looks like emb to me also and I have been waiting for months for a seller let alone a good margine of safety. (I want 30% using rr of 12 ) . Roll on Europe crashing!
        Regards Tony Connellan

      • Ash Little
        :

        Yep EMB,

        You are right Tony,

        I had a look at the market depth……..wow…….. all those buys and zero sells.

        Hard business to buy into that is for sure

      • John C
        :

        Hi guys – have a look at the major shareholders – there’s not much of the company left to buy. Roger said the founding family owns two thirds, so approx 67%, then there’s a 22% holding (EMSF) and a 9% holding (IPA). I’m thinking that there’s around 2 to 3% left after that lot, so it’s little wonder it trades rarely.

    • Robert P
      :

      Lots more Buyers in the Q now, at higher prices. One seller for a small parcel which is above Rogers IV.
      At the moment I won’t be able to add to my small parcel at a Suitable MOS.

  15. Andrew
    :

    I am looking at the Gunns report and understand that they have lost money but how do you determine in the report that they could not cover the interest.

    Just looking for a friendly person to point out what figures to look at?

    Thanks

    • Ash Little
      :

      Hi Andrew,

      These accounts are complicated and not a good place to start,

      Generally if the company makes a loss then interest coverage is negative but in this case they have writedowns which need to be taken into account.

      Have a look at the cashflow statement…….it will tell you much more.

      I would never invest in this company but that said specy Ash keeps saying it will be taken over at 40-50c.

      I keep telling specy Ash that that is just gambling. Hush.

      Time will tell

      • Andrew
        :

        We all have a speccy side, i can’t help but look at some companys and think that perhaps their could be one last puff in them and rationalise it by saying it is what Graham and Buffet did at one stage. However, in times of emotional confusion i turn to Charlie Munger and he sets me straight and i remember that it doesn’t matter how fancy i try to make the turds, i would still have turds.

        I also have to deal with the sentimental Andrew that despite the financials not meeting my criteria i just like the company so much that i would like to buy it. I have managed to silent this side by allowing myself to simply buy one of them and only if i have enough money to buy a decent amount and only after i get around with setting myself up an trading accountt o buy international shares amongst other things. I doubt the planets will allign to allow me to make this purchase.

        On a completley random and meaningless not, I wish i owned a TV station or production house and get Charlie Munger to do a talk show, i think it would be a ratings hit and comedy gold.

      • David King
        :

        Gunns hybrids, presently about $65, must be cashed at $100 in the event of a buyout. But if Gunns fails, and asset sales don’t cover the hybrids, too bad. And if Gunns continues to limp on, the hybrids are perpetual, ii.e. no fixed date for redemption. Had some. Sold them at a fair profit long ago. Good luck to the punters.

      • Ron shamgar
        :

        Brian, if u want a real crazy hybrid punt, check out PXUPA at $22 with $100 face value!

        Once upon a time Paperlinx was trading at $5 a share compared to 8c today!

        Lol

    • Andrew
      :

      I use x interest cover as a reasonable benchmark.

      Take the EBIT and divide it by the finance costs. The higher the better.

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