Lower prices please!

Lower prices please!

Zero.  That’s the number of blatantly obvious value investing opportunities we can find at the quality end of the spectrum at the moment.  But wait!  Before you go selling all of your shares, or cease implementing your investment strategy, you may want to read on…

As we scour the market for quality or strong consensus earnings growth, good value or unusually interesting other factors, we can find some amazing companies but they aren’t available at prices that produce the risk adjusted rates of return we are looking for.

Of course we exclude rubbish-quality businesses that need a transfusion or complete resuscitation through an opportunistic management buyout or a private equity funded takeover. Of the remainder that doesn’t require speculation on our part in order to generate a decent return, we can’t find much of great value.

Valuing businesses however is not the same as predicting their price so when we explain that the market seems to be fair value at the quality end and expensive at the rubbish end, we aren’t predicting an imminent correction.

Let’s call the possibility of a correction a ‘fat tail’. In other words, it’s an outlier with expensive consequences if it does transpire.  But it’s an outlier nevertheless.

Having scanned the market we isolated the top 100 companies that either meet our quality criteria or might be good value, have solid consensus earnings growth projections or are displaying some characteristics that we deem “interesting”.  The inputs required to receive an “interesting” rating are proprietary so please don’t ask.

When we average the margin of safety of these 100 companies, a margin of safety of negative two per cent (-2 per cent) is produced.

In other words, the average market price, for the sorts of companies we might be interested in, is about fair.  Keep in mind that intrinsic values are an estimate so a 2 per cent variation is not significant.  It’s better to be approximately right than exactly wrong.

Macmillan Shakespeare and JB Hi-Fi seem to be at the cheaper end of the rankings and Dominos Pizza and Freedom Foods are at the most expensive end. There are only 18 companies trading at a discount of greater than 20 per cent and after deeper investigation into each The Montgomery Fund has elected to own none of those.

There are 42 companies trading at an estimated 10 per cent premium or more to intrinsic value and the most expensive are at 60 per cent premiums.  For obvious reasons we aren’t buying those.

In the middle is a happy band of high quality companies that are neither too expensive nor particularly cheap but we believe many of them will retain profits and compound their intrinsic values as they redeploy profits at above rates of return on equity.

This is the area we find ourselves and indeed as I look at the portfolio of 27 companies held in The Montgomery Fund, the average margin of safety is about negative 5 per cent, in other words approximately fair value.

With 23 per cent parked safely in cash, we seem to be in a relatively good place with powder dry to take advantage of any opportunities that might arise.

Warren Buffett suggested that if you are a net buyer of stocks you actually want the market to go down. This makes perfect sense. Knowing that we are going to be buying stocks for our investors over the next six months, twelve months, two years and so on, we want cheaper stock prices not more expensive prices. With 23-odd percent in the safety of cash we are not only ready to take advantage of lower prices but hopeful of their emergence. Now, where’s that fat tail I was looking for?

MORE BY RogerINVEST 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.