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Investors don’t have to have astronomic IQ’s and be able to dissect the entrails of a million microcap startups to do well.  You only need to be able to avoid the disasters.

In an oft-quoted statistic, after you lose 50% of your funds, you have to make 100% return on the remaining capital just to get back to break even.  This is the simple reasoning behind Buffett’s two rules of investing.  Rule number 1 don’t lose money (a reference to permanent capital impairment) and Rule Number 2) Don’t forget rule number 1!  Its also the premise behind the reason why built Skaffold.

Avoiding those companies that will permanently impair your wealth either by a) sticking to high quality, b) avoiding low quality or c) getting out when the facts change, can help ensure your portfolio is protected.  Forget the mantra of “high yielding businesses that pay fully franked yields” – there’s no such thing.  That’s a marketing gimmic used by some managers and advisers to attract that bulging cohort of the population – the baby boomers – who are retiring en masse and seeking income.

Think about it;  How many businesses owners would speak about their business in those terms?  “Hi my name is Dave.  I own an online condiments aggregator – ‘its a high yielding business that pays a fully franked yield’.  You will NEVER hear that from a business owner.  That only comes from the stock market and from those who have never owned or run a business.

They key is not to think about stocks or talk stock jargon.  Just focus on the business.  Thats what we did when Myer floated in 2009.  And with the market value of Myer now 50% lower than the heady days of its float, it might be instructive to revisit the column I wrote back on 30 September 2009, when I reviewed the Myer Float.

And sure, you can say that the slump in retail is the reason for the slump in the share price of Myer (I am certainy one who believes that the dearth of really high quality companies means multi billion dollar fund managers are bereft of choice meaning that a recovery in the market will make all stocks rise – not because they are worth more but because fund managers have nothing else to buy). But the whole point of value investing is to make the purchase price so cheap that even if the worst case scenario transpires, you are left with an attractive return.

It would be equally instructive to review the reason why we didn’t buy the things that subsequently went well (QRN comes to mind) so we’ll leave that for a later date.

Here’s the column from September 2009:

“PORTFOLIO POINT: The enthusiasm surrounding the Myer float is good reason for a value investor to stay clear. So is the expected price.

With more than 140,000 investors registering for the IPO prospectus, everyone wants to know whether the float of the Myer department store group will be attractive. This week I want to focus exclusively on this historic offer.

At present it is suggested the stock will begin trading somewhere between $3.90 and $4.90.

The prospect of a stag profit draws a self-fulfilling crowd. But if chasing stag profits is your game, I would rather be your broker than your business partner, for history is littered with the remains of the enthusiasm surrounding popular large floats.

Popularity, you see, is not the investment bedfellow of a bargain and being interested in stocks when everyone else is does not lead to great returns. You cannot expect to buy what is popular, travel in the same direction as lemmings and generate extraordinary results. Conversely thumb-sucking produces equally unattractive returns.

Faced with these truisms, I lever my Myer One card, obtain a prospectus and open it for you.

The Myer float is one of the hottest of the year and I am not referring to the cover adorned by Jennifer Hawkins! If those 146,000 people who have apparently registered for a Myer prospectus were to invest just $20,000 at the requested price, the vendors will have their $2.8 billion plus the $100 million in float fees in the bag.

A word about the analysis: It is the same analysis I have used to buy The Reject Shop at $2.40 (today’s close $13.35), JB Hi-Fi at $8 ($19.86), Fleetwood at $3.50 ($8.75), to sell my Platinum Asset Management shares at more than $8 on the morning they listed (at $5), and to warn investors to get out of ABC Learning at $8 (they were 54¢ when ABC delisted in August 2008) and Eureka Report subscribers to get out of Wesfarmers as it acquired Coles.

I don’t list these to boast but merely to demonstrate the efficacy of the analysis; analysis that is equally applicable to existing issues and new ones.

By way of background, TPG/Newbridge and the Myer Family acquired Myer for $1.4 billion three years ago. They copped flack for paying too much, but “only” used $400 million of their own capital; the remainder was debt. Before the first anniversary, the Bourke Street, Melbourne, store was sold for $600 million and a clearance sale reduced inventory and netted $160 million. The excess cash allowed the new owners to reduce debt, pay a dividend of almost $200 million and a capital return of $360 million. Within a year the owners had recouped their capital and obtained a free ride on a business with $3 billion of revenue. Good work and smart.

But I am not being invited to pay $1.4 billion, which was 8.5 times EBIT. I am being asked to pay up to $2.9 billion, or more than 11 times forecast EBIT. And given the free “carry”, the bulk of the money raised will go to the vendors while I replace them as owners. Ownership is a very good incentive to drive the performance of individuals.

And driven they have been. In three years, $400 million has been spent on supply chain and IT improvements, eight distribution centres have been reduced to four and supply-chain costs have fallen 45%. Amid relatively stable gross profit margins, EBIT margins improvement to 7.2% and a forecast 7.8% reflect disciplined cost identification and management. Fifteen more stores are planned for the next five years and the prospectus notes that trading performance improved significantly in the second half of 2009 and into the first half of 2010. The key individuals have indeed performed impressively, but with less skin in the game they may not be incentivised as owners in future years as they have been in the past.

And what value have all these improvements created? The vendors would like to believe about $1.4 billion, and if the market is willing to pay them that price, they will have been vindicated, but price is not value and I am interested simply in buying things for less than what they are worth.

In estimating an intrinsic value for Myer, I will leave aside the fact that the balance sheet contains $350 million of purchased goodwill and $128 million of capitalised software costs. This latter item is allowed by accounting standards but results in accounts that don’t reflect economic reality. Historical pre-tax profits have thus been inflated.

I will also leave aside the fact that the 2009 numbers and 2010 forecasts have also been impacted by a number of adjustments, including the addition of sales made by concession operators “to provide a more appropriate reference when assessing profitability measures relative to sales”; the removal of the incentive payments to retain key staff – not regarded as ongoing costs to the business; costs associated with the gifting of shares to employees; and, most interestingly, the reversal of a write-off of $21 million in capitalised interest costs – all regarded as non-recurring.

Taking a net profit after tax figure for 2010 of $160 million and assuming a 75% fully franked payout, we arrive at an owners’ return on equity of about 28% on the stated equity of $738 million, equity that could have been higher after the float if $94 million in cash wasn’t also being taken out of retained profits. Using a 13% required return, I get a valuation of $2.90.

Looking at it another, albeit simplistic way, I am buying $738 million of equity that is generating 28%. If I pay the requested $2.9 billion for that equity or 3.9 times, I have to divide the return on equity by 3.9 times, which produces a simple return on “my” equity of 7.2%. For my money, it’s just not high enough for the risk of being in business.

Importantly, the return on equity – based on the simple assumptions that three stores, each generating $40 million in sales will be opened annually over the next five years and that borrowings will decline by $60 million in each of those years – should be maintained. But the end result is that the valuation only rises by 6% per year over the next five years and delivers a value in 2015 of $3.90: the price being asked today.

My piece of Myer seems a bit hot for My money.”

That was 2009.  Has anything really changed?  Has the following chart reveals.  Myer is now trading at close to Skaffold’s current estimate of its intrinsic value.  Before you get too excited (although the shortage of large listed high quality retailers means even this company’s shares may go up in a market or economy recovery) take a look at the pattern of intrinsic values in the past and the currently anticipated path of forecast intrinsic values;  Past intrinsic values have been declining (generally undesirable unless forecasts for a recovery are correct) and forecast intrinsic values are flat.

Fig.1. Skaffold Myer Intrinsic Value Line

And as the Capital History chart reveals, 2014 profits are not expected to be better than 2010. That 4 years without profit growth.  Question:  Would you buy an unlisted business (as a going concern) that was not forecasting profit growth for four years?

Fig. 2. Skaffold Myer Capital History Chart

Finally the cash flow chart reveals the company has produced what Skaffold refers to as a Funding Gap.  Its cash from operations have not been enough to cover the investments it has made in others or itself plus the dividends it has paid.  In other words for 2010 and 2011, the two financial years it has registered as a listed company, it appears from Skaffold’s data that the company has had to dip into either 1) its own bank account, or 2) borrow more money or 3) raise capital (the three sources of funds available if a funding gap is produced) to cover this “gap”.

Fig. 3. Skaffold Myer Cash Flow Chart

I’d be interested to know if you are a loyal Myer shopper or not and why?  If you don’t shop at Myer, why not?  If you do shop at Myer, what do you like about the company, its stores and the experience?  And I am particularly interested to hear from anyone who DOES NOT shop there but DOES own the stock!

Posted by Roger Montgomery, Value.able author, Skaffold Chairman and Fund Manager, 27 May 2012.

by Roger Montgomery Posted in Companies, Consumer discretionary, Value.able.

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Its hard to tell from the photo, but these are the world’s leaders – those at the centre of the current financial crisis anyway – at the weekend’s G-8 Summit at Camp David Maryland USA.

Sadly structural change, when foisted on a country, industry sector or company is often hard to discern from the usual cyclical changes.  Hopes of a near term recovery persist but are nothing but hope.

The G-8 didn’t agree on next steps to calm the euro zone debt crisis (although money printing has to be on the agenda).

As Famed hedge fund founder Ray Dalio noted at the weekend in an interview with Barrons:  “At the moment, there is a tipping toward slowing growth and a question of whether there will be a negative European shock, and that will favor low-risk assets. But to whatever extent we have negative conditions, central banks will respond by printing more money. There will be a big spurt of printing of money, and that will cause a rally and an improvement in the stock markets around the world. It’s like a shot of adrenaline: The heart starts pumping again and then it fades. Then there is another shot of adrenaline.  Everybody is asking, “Are we going to have a bull market or a bear market?” I expect we will have both with no big trend. Typically, in these up and down cycles, the upswing will last about twice as long as a down swing. We are now in the higher range of the up-cycle.”

You can read more of Ray’s interview here:

http://online.barrons.com/article/SB50001424053111904370004577390023566415282.html#articleTabs_article%3D2

Back to Camp David and the forthright language of point 31 seems sufficiently united to suggest its a topic that we may see in the headlines more because it has a tone of imminence to it…

Here’s the official statement for your ‘leggera’ reading pleasure.

Camp David Declaration

Camp David, Maryland, United States

May 18-19, 2012

Preamble

1.      We, the Leaders of the Group of Eight, met at Camp David on May 18 and 19, 2012 to address major global economic and political challenges.

The Global Economy

2.      Our imperative is to promote growth and jobs.

3.      The global economic recovery shows signs of promise, but significant headwinds persist.

4.      Against this background, we commit to take all necessary steps to strengthen and reinvigorate our economies and combat financial stresses, recognizing that the right measures are not the same for each of us.

5.      We welcome the ongoing discussion in Europe on how to generate growth, while maintaining a firm commitment to implement fiscal consolidation to be assessed on a structural basis. We agree on the importance of a strong and cohesive Eurozone for global stability and recovery, and we affirm our interest in Greece remaining in the Eurozone while respecting its commitments.  We all have an interest in the success of specific measures to strengthen the resilience of the Eurozone and growth in Europe.  We support Euro Area Leaders’ resolve to address the strains in the Eurozone in a credible and timely manner and in a manner that fosters confidence, stability and growth.

6.      We agree that all of our governments need to take actions to boost confidence and nurture recovery including reforms to raise productivity, growth and demand within a sustainable, credible and non-inflationary macroeconomic framework. We commit to fiscal responsibility and, in this context, we support sound and sustainable fiscal consolidation policies that take into account countries’ evolving economic conditions and underpin confidence and economic recovery.

7.      To raise productivity and growth potential in our economies, we support structural reforms, and investments in education and in modern infrastructure, as appropriate. Investment initiatives can be financed using a range of mechanisms, including leveraging the private sector.  Sound financial measures, to which we are committed, should build stronger systems over time while not choking off near-term credit growth.  We commit to promote investment to underpin demand, including support for small businesses and public-private partnerships.

8.      Robust international trade, investment and market integration are key drivers of strong sustainable and balanced growth.  We underscore the importance of open markets and a fair, strong, rules-based trading system. We will honor our commitment to refrain from protectionist measures, protect investments and pursue bilateral, plurilateral, and multilateral efforts, consistent with and supportive of the WTO framework, to reduce barriers to trade and investment and maintain open markets.  We call on the broader international community to do likewise.  Recognizing that unnecessary differences and overly burdensome regulatory standards serve as significant barriers to trade, we support efforts towards regulatory coherence and better alignment of standards to further promote trade and growth.

9.      Given the importance of intellectual property rights (IPR) to stimulating job and economic growth, we affirm the significance of high standards for IPR protection and enforcement, including through international legal instruments and mutual assistance agreements, as well as through government procurement processes, private-sector voluntary codes of best practices, and enhanced customs cooperation, while promoting the free flow of information. To protect public health and consumer safety, we also commit to exchange information on rogue internet pharmacy sites in accordance with national law and share best practices on combating counterfeit medical products.

Energy and Climate Change

10.  As our economies grow, we recognize the importance of meeting our energy needs from a wide variety of sources ranging from traditional fuels to renewables to other clean technologies.  As we each implement our own individual energy strategies, we embrace the pursuit of an appropriate mix from all of the above in an environmentally safe, sustainable, secure, and affordable manner. We also recognize the importance of pursuing and promoting sustainable energy and low carbon policies in order to tackle the global challenge of climate change.  To facilitate the trade of energy around the world, we commit to take further steps to remove obstacles to the evolution of global energy infrastructure; to reduce barriers and refrain from discriminatory measures that impede market access; and to pursue universal access to cleaner, safer, and more affordable energy.  We remain committed to the principles on global energy security adopted by the G-8 in St. Petersburg.

11.  As we pursue energy security, we will do so with renewed focus on safety and sustainability.   We are committed to establishing and sharing best practices on energy production, including exploration in frontier areas and the use of technologies such as deep water drilling and hydraulic fracturing, where allowed, to allow for the safe development of energy sources, taking into account environmental concerns over the life of a field.  In light of the nuclear accident triggered by the tsunami in Japan, we continue to strongly support initiatives to carry out comprehensive risk and safety assessments of existing nuclear installations and to strengthen the implementation of relevant conventions to aim for high levels of nuclear safety.

12.  We recognize that increasing energy efficiency and reliance on renewables and other clean energy technologies can contribute significantly to energy security and savings, while also addressing climate change and promoting sustainable economic growth and innovation.  We welcome sustained, cost-effective policies to support reliable renewable energy sources and their market integration.  We commit to advance appliance and equipment efficiency, including through comparable and transparent testing procedures, and to promote industrial and building efficiency through energy management systems.

13.  We agree to continue our efforts to address climate change and recognize the need for increased mitigation ambition in the period to 2020, with a view to doing our part to limit effectively the increase in global temperature below 2ºC above pre-industrial levels, consistent with science.  We strongly support the outcome of the 17th Conference of the Parties to the U.N. Framework Convention on Climate Change (UNFCCC) in Durban to implement the Cancun agreements and the launch of the Durban Platform, which we welcome as a significant breakthrough toward the adoption by 2015 of a protocol, another legal instrument or an agreed outcome with legal force applicable to all Parties, developed and developing countries alike. We agree to continue to work together in the UNFCCC and other fora, including through the Major Economies Forum, toward a positive outcome at Doha.

14.  Recognizing the impact of short-lived climate pollutants on near-term climate change, agricultural productivity, and human health, we support, as a means of promoting increased ambition and complementary to other CO2 and GHG emission reduction efforts, comprehensive actions to reduce these pollutants, which, according to UNEP and others, account for over thirty percent of near-term global warming as well as 2 million premature deaths a year.  Therefore, we agree to join the Climate and Clean Air Coalition to Reduce Short-lived Climate Pollutants.

15.  In addition, we strongly support efforts to rationalize and phase-out over the medium term inefficient fossil fuel subsidies that encourage wasteful consumption, and to continue voluntary reporting on progress.

Food Security and Nutrition

16.  For over a decade, the G-8 has engaged with African partners to address the challenges and opportunities afforded by Africa’s quest for inclusive and sustainable development.  Our progress has been measurable, and together we have changed the lives of hundreds of millions of people.  International assistance alone, however, cannot fulfill our shared objectives.  As we move forward, and even as we recommit to working together to reduce poverty, we recognize that our task is also to foster the change that can end it, by investing in Africa’s growth, its expanding role in the global economy, and its success.  As part of that effort, we commit to fulfill outstanding L’Aquila financial pledges, seek to maintain strong support to address current and future global food security challenges, including through bilateral and multilateral assistance, and agree to take new steps to accelerate  progress towards food security and nutrition in Africa and globally, on a complementary basis.

17.  Since the L’Aquila Summit, we have seen an increased level of commitment to global food security, realignment of assistance in support of country-led plans, and new investments and greater collaboration in agricultural research.  We commend our African partners for the progress made since L’Aquila, consistent with the Maputo Declaration, to increase public investments in agriculture and to adopt the governance and policy reforms necessary to accelerate sustainable agricultural productivity growth, attain greater gains in nutrition, and unlock sustainable and inclusive country-led growth.  The leadership of the African Union and the role of its Comprehensive Africa Agriculture Development Program (CAADP) have been essential.

18.  Building on this progress, and working with our African and other international partners, today we commit to launch a New Alliance for Food Security and Nutrition to accelerate the flow of private capital to African agriculture, take to scale new technologies and other innovations that can increase sustainable agricultural productivity, and reduce the risk borne by vulnerable economies and communities.  This New Alliance will lift 50 million people out of poverty over the next decade, and be guided by a collective commitment to invest in credible, comprehensive and country-owned plans, develop new tools to mobilize private capital, spur and scale innovation, and manage risk; and engage and leverage the capacity of private sector partners – from women and smallholder farmers, entrepreneurs to domestic and international companies.

19.  The G-8 reaffirms its commitment to the world’s poorest and most vulnerable people, and recognizes the vital role of official development assistance in poverty alleviation and achieving the Millennium Development Goals.  As such, we welcome and endorse the Camp David Accountability Report which records the important progress that the G-8 has made on food security consistent with commitments made at the L’Aquila Summit, and in meeting our commitments on global health, including the Muskoka initiative on maternal, newborn and child health.  We remain strongly committed to reporting transparently and consistently on the implementation of these commitments.  We look forward to a comprehensive report under the UK Presidency in 2013.

Afghanistan’s Economic Transition

20.  We reaffirm our commitment to a sovereign, peaceful, and stable Afghanistan, with full ownership of its own security, governance and development and free of terrorism, extremist violence, and illicit drug production and trafficking.  We will continue to support the transition process with close coordination of our security, political and economic strategies.

21.  With an emphasis on mutual accountability and improved governance, building on the Kabul Process and Bonn Conference outcomes, our countries will take steps to mitigate the economic impact of the transition period and support the development of a sustainable Afghan economy by enhancing Afghan capacity to increase fiscal revenues and improve spending management, as well as mobilizing non-security assistance into the transformation decade.

22.  We will support the growth of Afghan civil society and will mobilize private sector support by strengthening the enabling environment and expanding business opportunities in key sectors, as well as promote regional economic cooperation to enhance connectivity.

23.  We will also continue to support the Government of the Islamic Republic of Afghanistan in its efforts to meet its obligation to protect and promote human rights and fundamental freedoms, including in the rights of women and girls and the freedom to practice religion.

24.  We look forward to the upcoming Tokyo Conference in July, as it generates further long-term support for civilian assistance to Afghanistan from G-8 members and other donors into the transformation decade; agrees to a strategy for Afghanistan’s sustainable economic development, with mutual commitments and benchmarks between Afghanistan and the international community; and provides a mechanism for biennial reviews of progress being made against those benchmarks through the transformation decade.

The Transitions in the Middle East and North Africa

25.  A year after the historic events across the Middle East and North Africa began to unfold, the aspirations of people of the region for freedom, human rights, democracy, job opportunities, empowerment and dignity are undiminished. We recognize important progress in a number of countries to respond to these aspirations and urge continued progress to implement promised reforms.  Strong and inclusive economic growth, with a thriving private sector to provide jobs, is an essential foundation for democratic and participatory government based on the rule of law and respect for basic freedoms, including respect for the rights of women and girls and the right to practice religious faith in safety and security.

26.  We renew our commitment to the Deauville Partnership with Arab Countries in Transition, launched at the G-8 Summit last May. We welcome the steps already taken, in partnership with others in the region, to support economic reform, open government, and trade, investment and integration.

27.  We note in particular the steps being taken to expand the mandate of the European Bank for Reconstruction and Development to bring its expertise in transition economies and financing support for private sector growth to this region; the platform established by international financial institutions to enhance coordination and identify opportunities to work together to support the transition country reform efforts; progress in conjunction with regional partners toward establishing a new transition fund to support country-owned policy reforms complementary to existing mechanisms; increased financial commitments to reforming countries from international and regional financial institutions, the G-8 and regional partners; strategies to increase access to capital  markets to help boost private investment; and commitments from our countries and others to support small and medium-sized enterprises, provide needed training and technical assistance and facilitate international exchanges and training programs for key constituencies in transition countries.

28.  Responding to the call from partner countries, we endorse an asset recovery action plan to promote the return of stolen assets and welcome, and commit to support the action plans developed through the Partnership to promote open government, reduce corruption, strengthen accountability and improve the regulatory environment, particularly for the growth of small- and medium-sized enterprises.  These governance reforms will foster the inclusive economic growth, rule of law and job creation needed for the success of democratic transition. We are working with Partnership countries to build deeper trade and investment ties, across the region and with members of the G-8, which are critical to support growth and job creation.  In this context, we welcome Partnership countries’ statement on openness to international investment.

29.  G-8 members are committed to an enduring and productive partnership that supports the historic transformation underway in the region.  We commit to further work during the rest of 2012 to support private sector engagement, asset recovery, closer trade ties and provision of needed expertise as well as assistance, including through a transition fund.  We call for a meeting in September of Foreign Ministers to review progress being made under the Partnership.

Political and Security Issues

30.  We remain appalled by the loss of life, humanitarian crisis, and serious and widespread human rights abuses in Syria.  The Syrian government and all parties must immediately and fully adhere to commitments to implement the six-point plan of UN and Arab League Joint Special Envoy (JSE) Kofi Annan, including immediately ceasing all violence so as to enable a Syrian-led, inclusive political transition leading to a democratic, plural political system.  We support the efforts of JSE Annan and look forward to seeing his evaluation, during his forthcoming report to the UN Security Council, of the prospects for beginning this political transition process in the near-term.  Use of force endangering the lives of civilians must cease.  We call on the Syrian government to grant safe and unhindered access of humanitarian personnel to populations in need of assistance in accordance with international law.  We welcome the deployment of the UN Supervision Mission in Syria, and urge all parties, in particular the Syrian government, to fully cooperate with the mission.  We strongly condemn recent terrorist attacks in Syria. We remain deeply concerned about the threat to regional peace and security and humanitarian despair caused by the crisis and remain resolved to consider further UN measures as appropriate.

31.  We remain united in our grave concern over Iran’s nuclear program. We call on Iran to comply with all of its obligations under relevant UNSC resolutions and requirements of the International Atomic Energy Agency’s (IAEA) Board of Governors. We also call on Iran to continuously comply with its obligations under the Nuclear Non-Proliferation Treaty, including its safeguards obligations.  We also call on Iran to address without delay all outstanding issues related to its nuclear program, including questions concerning possible military dimensions.  We desire a peaceful and negotiated solution to concerns over Iran’s nuclear program, and therefore remain committed to a dual-track approach.   We welcome the resumption of talks between Iran and the E3+3 (China, France, Germany, Russia, the United Kingdom, the United States, and the European Union High Representative).  We call on Iran to seize the opportunity that began in Istanbul, and sustain this opening in Baghdad by engaging in detailed discussions about near-term, concrete steps that can, through a step-by-step approach based on reciprocity, lead towards a comprehensive negotiated solution which restores international confidence that Iran’s nuclear program is exclusively peaceful.  We urge Iran to also comply with international obligations to uphold human rights and fundamental freedoms, including freedom of religion, and end interference with the media, arbitrary executions, torture, and other restrictions placed on rights and freedoms.

32.  We continue to have deep concerns about provocative actions of the Democratic People’s Republic of Korea (DPRK) that threaten regional stability.  We remain concerned about the DPRK’s nuclear program, including its uranium enrichment program.  We condemn the April 13, 2012, launch that used ballistic missile technology in direct violation of UNSC resolution. We urge the DPRK to comply with its international obligations and abandon all nuclear and ballistic missile programs in a complete, verifiable, and irreversible manner.  We call on all UN member states to join the G-8 in fully implementing the UNSC resolutions in this regard.  We affirm our will to call on the UN Security Council to take action, in response to additional DPRK acts, including ballistic missile launches and nuclear tests.  We remain concerned about human rights violations in the DPRK, including the situation of political prisoners and the abductions issue.

33.  We recognize that according women full and equal rights and opportunities is crucial for all countries’ political stability, democratic governance, and economic growth.  We reaffirm our commitment to advance human rights of and opportunities for women, leading to more development, poverty reduction, conflict prevention and resolution, and improved maternal health and reduced child mortality.  We also commit to supporting the right of all people, including women, to freedom of religion in safety and security. We are concerned about the reduction of women’s political participation and the placing at risk of their human rights and fundamental freedoms, including in Middle East and North Africa countries emerging from conflict or undergoing political transitions.  We condemn and avow to stop violence directed against, including the trafficking of, women and girls.  We call upon all states to protect human rights of women and to promote women’s roles in economic development and in strengthening international peace and security.

34.  We pay tribute to the remarkable efforts of President Thein Sein, Daw Aung San Suu Kyi, and many other citizens of Burma/Myanmar to deliver democratic reform in their country over the past year.  We recognize the need to secure lasting and irreversible reform, and pledge our support to existing initiatives, particularly those which focus on peace in ethnic area, national reconciliation, and entrenching democracy.  We also stress the need to cooperate to further enhance aid coordination among international development partners of Burma/Myanmar and conduct investment in a manner beneficial to the people of Burma/Myanmar.

35.  We recognize the particular sacrifices made by the Libyan people in their transition to create a peaceful, democratic, and stable Libya.  The international community remains committed to actively support the consolidation of the new Libyan institutions.

36.  We condemn transnational organized crime and terrorism in all forms and manifestations.  We pledge to enhance our cooperation to combat threats of terrorism and terrorist groups, including al-Qa’ida, its affiliates and adherents, and transnational organized crime, including individuals and groups engaged in illicit drug trafficking and production.  We stress that it is critical to strengthen efforts to curb illicit trafficking in arms in the Sahel area, in particular to eliminate the Man-Portable Air Defense Systems proliferated across the region; to counter financing of terrorism, including kidnapping for ransom; and to eliminate support for terrorist organizations and criminal networks. We urge states to develop necessary capacities including in governance, education, and criminal justice systems, to address, reduce and undercut terrorist and criminal threats, including “lone wolf” terrorists and violent extremism, while safeguarding human rights and upholding the rule of law. We underscore the central role of the United Nations and welcome the Global Counterterrorism Forum (GCTF) and efforts of the Roma-Lyon Group in countering terrorism.  We reaffirm the need to strengthen the implementation of the UN Al-Qaida sanctions regime, and the integrity and implementation of the UN conventions on drug control and transnational organized crime.

37.  We reaffirm that nonproliferation and disarmament issues are among our top priorities. We remain committed to fulfill all of our obligations under the Nuclear Nonproliferation Treaty and, concerned about the severe proliferation challenges, call on all parties to support and promote global nonproliferation and disarmament efforts.

38.  We welcome and fully endorse the G-8 Foreign Ministers Meeting Chair’s Statement with accompanying annex.

Conclusion

39.   We look forward to meeting under the presidency of the United Kingdom in 2013.

Indeed!

Posted by Roger Montgomery, Value.ableauthor, SkaffoldChairman and Fund Manager, 20 May 2012.

by Roger Montgomery Posted in Economics.

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Harley takes his pen to My Net Fone and impresses even the company’s management with his results.

Take a look at any of the financial media channels or websites and you will likely notice the prevalence of brokers, advisors and commentators claiming that Australian stocks are currently cheap when viewed on a P/E basis. There is no denying that at the present time investors in the Australian stock market are willing to pay considerably less for the earnings of a company than they were just a few years ago. There are a number of possible explanations for this from the risk of external shocks to the increased demand for fixed income securities but there is no doubt that one of the main drivers of the lower market multiple is that investors are pricing in an expectation of lower growth rates in the majority of industries. The earnings of companies in retail, mining, property and construction just to name a few are all expected to experience low to moderate growth, if not stagnation, in the foreseeable future.

In an environment where opportunities for growth are sparse, when a true opportunity presents itself investors have demonstrated their willingness to pay up. There is no better example of this than the substantially higher industry average P/E in the telecommunications sector, where internet growth and new technological developments are driving rates of growth unrivaled elsewhere in the market. As a result investors have their eyes set on discovering the next rising star in the telecommunications world. My Net Fone Ltd may be about to have its turn in the limelight.

My Net Fone (ASX:MNF)

In the words of the company:

“My Net Fone Limited, (ASX:MNF) is Australia’s leading provider of hosted voice and data communications services for residential, business and enterprise users. My Net Fone was first founded in 2004, was listed on the ASX in mid 2006, has 52.5 million shares on issue, has operated profitably since 2009 and has paid dividends to its shareholders every six months since September 2010.

The company has a reputation for quality, value and innovation, having won numerous awards including the Deloitte Technology Fast 50 (2008, 2009, and 2010), PC User Product of the Year (2005), Money Magazine Product of the Year (2007) and many others.

My Net Fone’s wholly owned subsidiary, Symbio, owns and operates Australia’s largest VoIP network, providing wholesale carrier services to the Australian industry, including number porting, cloud‐based hosted PBX services, call termination, call origination and many other infrastructure enabled services. The Symbio network carries over 1.5 Billion minutes of voice per annum.”

What is VoIP? A Look At The Industry

Before looking closer at MNF, it is helpful to have a sound understanding of the industry in which the company operates. Indeed one should first gain a complete and comprehensive understanding of the injdustry and the competitive landscape.

VoIP, or Voice Over Internet Protocol, in its simplest form refers to the group of services that use the internet as a means for communication rather than the standard phone line. A phone call via VoIP involves the call conversation being split into data packets, transmitted over the internet and then reassembled at the other end. The primary benefit as a result is that there is no need for line rental, which provides significant savings to consumers and businesses alike. While cost reduction is generally seen as the most attractive feature of VoIP services the benefits are not limited solely to reduced expenses with a range of other products and services offered by MNF including Virtual PBX, number porting, SIP trunking and hosted services. While their terms may sound complicated they all fit under the catch all term of ‘VoIP.’

The VoIP market is highly competitive and the battle is generally fought over price. For a retail customer, the main reason you would choose VoIP over your traditional provider would of course be the cost savings that occur as a result. But for small and medium businesses, while cost is also of primary importance, other factors come into consideration including product offering, service quality and the ability of the provider to continually innovate and develop new products and services.

VoIP is not new nor is it only just now gaining popularity. If you have ever used Skype or a similar service, you have used VoIP (in fact Skype is a client of MNF’s wholesale division). But there are different VoIP service types and the kind you use when you Skype your family while away on holiday is very different to the kind you would install in your small to medium sized business of 50 full time employees. The two do not directly compete with each other. Sure, businesses may use Skype for video conferencing, but they will still need a communications system, multiple phone numbers, 1300 numbers, fax over IP, remote access to their VoIP number and a host of other services provided by MNF and their competitors. Customers of MNF have reported cost savings on phone bills of up to 50% and in the current business environment it seems likely that businesses will continue to look at ways to reduce costs while still maintaining or even increasing productivity. VoIP services have much to offer small to medium businesses in this regard.

In the early years of VoIP the main restriction was (and at times still is) the issue of low quality broadband. If the broadband connection was weak then the quality of the VoIP service would follow suit, thus making the adoption of VoIP unworthy of the investment for anyone without the highest quality broadband connection. It is no surprise then that in the case of Europe those countries with a high rate of strong broadband connection to homes and businesses (eg France) saw a higher uptake of VoIP than European countries with lower rates of high quality broadband access.

As broadband speeds improve, so too will the quality and available range of VoIP services in Australia. The roll out of the NBN will provide significant opportunities for MNF across all divisions of their business. As more people have access to fast, high quality broadband the potential market for MNF will grow. In the transition period there is likely to be a strong push for new customer acquisition by service providers as retail and business customers alike consider changing from their service type and/or service provider (See MNF’s current marketing program offering significant savings for customers to sign up prior to the roll out of the NBN). While this could result in greater competition in the business and retail markets, as we will see the wholesale division is well positioned to benefit from more service providers setting up shop creating higher demand for wholesale services.

Historic Performance – A Demonstrated Track Record Of Growth

Many investors require a demonstrated track record, which is seen as a way to further reduce the risk one takes in any given investment. As a result there are those who will take one look at the financial reports of MNF, notice the accumulated losses and be frightened away, preferring to wait until MNF has had a few years of strong returns, improving margins and profit growth under its belt. For some, turnaround stories are no go zones.

There is nothing wrong with this method of investing, in fact it can be incredibly successful (witness one W.E. Buffett) but in the case of MNF it is important to understand why the company experienced losses in its early years and why the profits are about to start rolling in.

First of all, MNF does possess a proven track record in regards to consistent revenue growth. MNF was started from scratch and has since grown to become a company that currently has 95000 subscribers. Any business owner will know that in the early years of operation profits can take time to come to fruition and a period of investment and cash outflows inevitably precedes growth in scale and subsequent cash inflows. In the case of MNF the company was operating in a brand new industry where the majority of individuals and businesses were still becoming aware of the potential for VoIP services, not to mention the fact that only the tech savvy had the necessary high speed broadband connection to make VoIP worthy of investment in the first place. In 2006, a year that VoIP uptake experienced rapid growth, 19 percent of small to medium businesses in Australia used VoIP services. But of those that didn’t, 35% were completely unaware it existed and another 7% did not understand how it could be implemented into their business.

Having said that the growth in revenues (shown in the table below) since MNF listed as a public company is very impressive.

^Provides general summary; figures are not broken down into individual or small to medium business customers

*Minus the contribution of the newly acquired Symbio Networks

Similarly impressive is the year on year growth in MNF’s total customer base, as shown both in the table above and below in a graphic from the company’s website.

Today consumer awareness regarding VoIP is strong and growing. The uptake amongst small and medium businesses is gaining considerable traction due to the significant cost savings and continually developing services on offer. While MNF’s subscriber growth rate is declining from its dizzying heights the company now has access to the potentially lucrative wholesale market through their acquisition of Symbio Networks. And to top things off the government is about to gift MNF with a once in a lifetime opportunity.

NBN – Opportunities Abound For MNF

As previously mentioned, in the past one of the restrictions holding back individuals and businesses from subscribing to VoIP based services was the lack of access to high quality broadband. While broadband penetration in Australia is not particularly low (we were ranked 21st out of OECD countries for fixed broadband penetration and 8th for wireless broadband penetration as at 30 June 2011) the roll out of the National Broadband Network (NBN) will only serve to increase the equality of access to high speed broadband across Australia. What this means is that MNF’s potential market will grow as the NBN roll out progresses.

The capability of MNF’s services are enhanced by any increase in computer power, software/hardware development or internet speeds. Furthermore since product innovation is a demonstrated strength of the company, as technology progresses the range of potential product and service offerings that MNF can deliver to their market will increase. Product and service innovation is a vital differentiating factor in any highly competitive market.

The NBN, in the company’s own words is “a once in a lifetime opportunity” for new customer acquisition as their is a mass transition from the current copper fibre network to the NBN. If the NBN achieves its objectives 93% of Australian households, schools and businesses will have access to broadband services. This will increase the up take potential for residential and SMB VoIP services significantly, and while MNF will likely have to deal with the arrival of many, many new competitors as a result of the expanding market, their wholesale division is likely to benefit from general growth of the VoIP market regardless of which service providers win market share.

(on the flip side, note the higher costs to all competitors/participants after the NBN rolls out and consider the implications of the NBN possibly becoming fibre to the node if Labour loses the next election)

The Importance Of Scale and Differentiation

As an investor it is certainly advantageous to focus on industries experiencing rapid growth. As they say, ‘A rising tide lifts all boats’ and to an extent this will be seen in the performance of internet and VoIP service providers for years to come as the tremendous growth rates are forecast to continue into the foreseeable future. But a market experiencing rapid growth breeds intense competition and if a company cannot differentiate itself from the pack it will be left to fight solely on the basis of being the lowest cost provider, which very rarely ends well for those involved.

There are two things that can separate a company from the pack and ensure it achieves financial performance above the industry average. The first is the presence of scale. MNF’s margins have historically been quite tight, but as revenue grows the margins will naturally improve. The VoIP service industry, while intensely competitive, is such that those who are able to achieve economies of scale have the potential to experience strong margin expansion as each incremental dollar of revenue generates a higher proportion of value to the bottom line. Symbio Networks, the wholesale division of MNF, currently operates at 50% utilisation leaving significant room for margins to be increased at little incremental cost to the company. So while revenue growth will likely taper off to more sustainable growth rates it is highly likely that NPAT growth will outpace revenue growth over the next few years.

In order to reach and sustain a level where economies of scale begin to benefit the bottom line, a company like MNF needs to be able to differentiate itself from competitors. There needs to be a reason why individuals and businesses will choose MNF over other VoIP providers if we, as investors, can be confident that the current high rates of return being generated by the company can be sustained.

The first differentiating factor relates to the vision of MNF management and their focus since the founding of the company. Unlike some of their larger competitors who are being forced to make the transition from older technologies and offer VoIP in addition to their current services, MNF is coming off a lower cost base and with sole focus on New Generation Networks and innovation within the VoIP market. Since the founding of MNF the goal has been “to be the leading VoIP provider in Australia.” The acquisition of the owner of the largest supplier of VoIP wholesale and managed services in Australia also helps separate MNF from the pack.

A quick read through MNF’s past annual reports will give you an idea of the demonstrated ability of the company to come up with new and innovative product offerings. In the past this has no doubt served to enhance the ability of MNF to grab market share, and is reflected in their many industry awards for exceptional products and services. As an investor your job is to determine whether or not MNF will be able to sustain the current high rates of return well in to the future. Start by researching the company’s product offering, read testimonials and compare it with those of MNF’s competitors. Sometimes the best way to form a view over the future of a company is not to approach things as an investor, but to view the business from the perspective of a potential customer.

Perhaps the most attractive feature of MNF’s business model and that which most effectively differentiates MNF from its competitors is the fact that the company is not simply a reseller of VoIP services. A large proportion of VoIP providers are in the business of buying from a wholesaler and reselling the product to the end consumer. Prior to the acquisition of Symbio, this is what it appeared as though MNF was doing when Symbio Networks was external but in actual fact the company was creating these voice services using Symbio’s VoIP technology, adding value through internally developed software and delivering a unique product offering to their customers. The company places a great deal of importance on the development of software and intellectual property to ensure they add value to the services they sell to customers. In the words of the CEO, Rene Sugo, “Today our advantage is largely technical – in terms of scalability, quality, reliability and innovative intellectual property. That is what has driven our growth, and will continue to do so in the medium term.”

Ultimately there is no negating the fact that for a company like MNF (where product development and technological advancement happens faster than most of us can fathom) we are heavily reliant on the competence of management.

The Founders – Interests aligned with shareholders

The two founders, Andy Fung and Rene Sugo, own just over 50% of the company between them. In the first quarter of this year Andy Fung retired from his position as CEO and Rene Sugo took his place. Fung is staying on as a non-executive director and retains his significant holding in the company. Both have strong backgrounds in the telecommunications industry, as well as experience and in depth knowledge in the area of Next Generation Networks. In the ever developing industry of VoIP service providers, experienced and business savvy management is integral to a company’s success.

There is more than just their significant shareholdings in the company that indicates management’s strong desire for MNF to succeed. In the early stages the directors performed services for the company at no or low cost and salaries were kept artificially low as the company dealt with the low capital base nature of a start up business. Similarly, the company was “supported by the low cost provision of services, technology and business support from Symbio Networks Pty Ltd during the start up and early growth phase of the business.” Andy Fung and Rene Sugo were the founders of Symbio Networks, and the company is now wholly owned by My Net Fone after the (related party?) acquisition was finalised earlier this year.

When MNF listed in 2006 they raised $2.5m. Unlike so many of the companies that list on the ASX these funds were not used to repay loans to related parties or to line the pockets of directors, but to fund an expanded marketing program and increase sales and support staff, which was no doubt a raging success evidenced by the growth in total customer numbers of those early years.

Management have also shown their ability to innovate and stay one step ahead of the market. They were the first to remove the pay-for-time model of pricing on international calls and pioneered the move to the now prevalent flat charge for international VoIP calls. The development of ‘On-the-Go’ services which allowed customers to access VoIP services on their mobile in 2007, ‘Meet-Me Conferencing’ in 2010 and the regularly introduced new service plans available to customers are all examples of MNF’s commitment to continually innovating their product offering.

In the process of conducting your research on MNF, do as Roger has suggested frequently here and read each financial report from the prospectus through to the most recent half yearly report. No doubt you will notice the trend of management promising something one year and delivering the next. This is, I believe, exactly what you should be looking for in the management of companies you choose to invest in. In the announcements regarding the Symbio acquisition, and in related articles, the CEO of MNF regularly described the increase in growth that he believed the company was about to experience. On the 23rd of April the company delivered yet again with a profit upgrade that they attributed to the “outstanding performance across the group,” particularly in the March quarter.

The interests of management appear strongly aligned with those of shareholders and as investors our money seems in more than capable hands. Do take the time to read the past annual reports of MNF. Not only will you better understand the growth path that management have in mind for the company but you will most certainly notice the way in which management come across as genuinely interested in the future of the company, its customers and its shareholders, something which is unfortunately rare in many ASX listed companies.

Symbio Networks – A Game Changer For My Net Fone

In September of last year MNF announced they were acquiring Symbio Networks for a maximum consideration of $6m. Symbio Networks is Australia’s largest supplier of VoIP wholesale and managed services. The company was founded by Andy Fung and Rene Sugo, the same founders of My Net Fone. The acquisition of Symbio significantly changes the dynamics of MNF as it means the company is now positioned to benefit from the entry of more VoIP providers.

Management plans to run Symbio as a wholly owned subsidiary, separate to the day to day business of My Net Fone. This is important as some of Symbio’s customers are direct competitors with the retail and business division of MNF. Symbio is actually larger than My Net Fone when comparing on the basis of revenues, with $25m of MNF’s FY12 revenue expected to come from Symbio.

The wholesale operations Symbio brings with it is a game changer for MNF. It means that the company is effectively diversified from the inevitable increase in competition that is sure to arise if and when VoIP uptake continues to grow. While the business and retail division benefits only if customers choose MNF over its competitors, Symbio, as the owner and operator of Australia’s largest VoIP network, is positioned to benefit from any overall increase in competition.

Because Symbio has clients across the Asia Pacific the company will not only benefit from the NBN in Australia, but are also positioned to do well from any further increase in broadband penetration or VoIP uptake in Singapore, New Zealand and Malaysia. As such the growth potential for Symbio, and thus MNF, is not limited solely to the Australian market.

The story of both Symbio Networks and My Net Fone are evidence of in my opinion, the visionary skills of the founders of both companies, Andy Fung and Rene Sugo. What we are seeing in the market today with increased uptake of VoIP, new VoIP related products and services being developed and the beginnings of the transition of VoIP to mobile applications, were all envisioned by Fung and Sugo as early as 2002. Today, Rene Sugo is the CEO of the merged entity and Andy Fung will remain as an advisor, consultant and significant shareholder. If their current views on the potential growth in the wholesale, retail and business divisions of their company is half as accurate as their views from ten years ago then it appears MNF is well positioned for the future.

Key Risks (may not be exhaustive)

While the prospects for MNF appear very attractive, like any investment there are risks one needs to consider:

• The NBN: While the NBN is expected to be a fantastic opportunity for MNF there are risks that surround its ultimate effect on the company. These risks include potential increases in costs that favour the larger ISPs, the possibility of substantial changes to the NBN between now and final rollout and of course the fact that the opposition intends to scrap the plan altogether. The first of these risks is reduced by the merger of My Net Fone and Symbio and the fact that MNF’s customer base, while not among the largest, is substantial at around 100,000 customers. The risk of any changes to the details of the NBN that may negatively impact MNF is negated somewhat by management’s active and ongoing correspondence with government and the fact that as the largest VoIP network operator in Australia MNF does indeed have some say in negotiations. And finally if the NBN were to be scrapped, business would go on as usual and if the recent past is anything to go by MNF will continue to grow both revenues and subscribers.

• With the acquisition of Symbio, MNF is liable to pay up to $6m depending on the performance of the now wholly owned subsidiary. The risk here is that if cash flows are impaired for whatever reason the company may need to reduce its dividend payment to fulfill its obligations. With current strong operating cash flows, growing profits and no debt this risk appears minimal.

• External shocks. While MNF is not immune to financial crises occurring in Europe, China or even here in Australia, to some degree their business is defensive in nature. The worse the economic environment becomes the more likely businesses and consumers will decide to cut costs. MNF’s services offer cost reductions in conjunction with improved efficiency and so will benefit from more Australian businesses looking to reduce their overheads.

• VoIP failing to grow and/or the introduction of a new disruptive technology. VoIP itself is a disruptive technology and one that old generation service providers are now finding themselves forced to deal with. But that does not mean a new, more efficient technology won’t come along and steal some of VoIP’s market share, so this risk is certainly one to keep in mind.

• Some other risks may be covered by watching for director’s selling of stock

The Financials

As outlined earlier MNF have grown revenues consistently since listing on the ASX. This year they are forecast to generate $41m in revenue, with $25m coming from the recently acquired Symbio Networks. In their recent earnings upgrade management forecast FY12 NPAT to come in between $2.75m and $3m, with FY13 NPAT guidance for $4m (Note: as a result of past losses the company has tax assets of $930k). If we assume the lower end of guidance then on a fully diluted basis MNF will earn around 5c per share in FY12. In the past the company has paid a dividend around half of the total earnings and with operating cash flows remaining strong there seems no reason why that will stop any time soon. Under these assumptions the company is currently trading on a PE of 7.5 and is paying a respectable dividend. What multiple should the market attribute to a company undergoing strong growth in earnings, paying a healthy dividend and operating in the rapidly expanding internet industry? That is anyone’s guess but there are numerous examples of similar companies currently trading on the ASX that the market has priced on a P/E multiple in the mid-teens, and there is no reason why MNF will not or should not be priced accordingly.

While the company appears to be cheap on a P/E multiple basis the most attractive feature of MNF’s financial performance for me, is its ability to continue to generate fantastic returns on incremental capital for many years to come. The current returns on equity are unsustainably stratospheric – a result of the accumulated losses on the balanced sheet. But even if we calculate return on equity with total contributed capital from shareholders, ignoring the reduction in equity that has resulted from accumulated losses, the company will still generate a return on equity in excess of 50% for FY12 and FY13. The nature of this business is such that provided success continues, high returns on equity can be sustained.

I believe the market is yet to factor in that MNF is now a significant player in the wholesale VoIP market and while its business and retail division will continue to face growing competition, the company has demonstrated its ability to differentiate itself from its competitors. With what seems like highly competent management, bright industry prospects and the ability to sustain current high rates of return My Net Fone currently appears to tick all of my value investing boxes.

Let Harley know what you think of his work and share your own insights.  Please note the views of the author are his own and may not represent those of the publisher.  It is a must that you conduct your own research and seek and take personal professional advice before undertaking any security transactions.  The sources of data Harley relied upon to produce this post may or may not be accurate so readers must investigate and satisfy themselves that are are completely aware of and accept all risks before undertaking any securities transactions they conduct after they have sought advice from a licence adviser familiar with their needs and circumstances.

Authored by Harley and posted by Roger Montgomery, Value.able author, SkaffoldChairman and Fund Manager, 29 April 2012

by Roger Montgomery Posted in Insightful Insights, Technology & Telecommunications.

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For new readers to the blog, welcome. Here at Roger’s blog we are conducting an ongoing study comparing the performance of investment portfolios recommended by major broking houses verses a loose selection of A1 and A2 stocks bought as a big a discount to IV as possible.

(Its Roger here:  Its important to understand this is a hypothetical investment portfolio based on one of the Twin’s consistent approaches to stock selection.  In that regard it is not a collection of small high risk bets whose returns could be easily ramped.  I will be very surprised if you see high double digit returns from such an approach for that reason.  At Montgomery, managing +$200 million simply precludes us from investing in the small companies that would produce higher returns on relatively insignificant $5000 sums – irrespective of whether or not the returns can be boosted by disingenuous marketing by social media marketing experts or worse, even ramping.  Its easy to make 50% per annum on $100,000.  Much harder on $1billion.  Even personally our individual speculative selections may have a couple of hundred thousand dollars allocated to them and so we are also precluded from employing capital where liquidity may be boosted only by the participation of a small group of invisible Facebook friends.  Worse, our experience tells us that such anonymous groups can be a manic depressive bunch and when they’re told that a holding has been sold, the illiquid volumes of the companies they are toying with will produce the very opposite result of that which they aspired to achieved.)

We have been following twin brothers and their investment decisions and performances since December 2010.

The twins each inherited $100,000 and sought differing advice how to invest it, the quarterly reports of their investments can be found here:

http://rogermontgomery.com/will-david-beat-goliath/
http://rogermontgomery.com/how-are-the-a1-twins-performing/
http://rogermontgomery.com/which-a1-twin-is-outperforming/

By the end of 2011 our first twin, the regional Queensland accountant was still head down, trying to help hundreds of clients recover from all the natural disasters of the previous 12 months, government help was available but so was the paperwork. As these tasks drew to a close, Queensland entered a bitter and hard fought state election, so comprehensive was the coverage, it was hard to watch anything else. There had been a lot on, and checking on the performance of his portfolio had really been at the bottom of the list.

Our NSW based public servant had pretty much had the same six months, but for very different reasons. Being in the Foreign Affairs office of the federal public service, he was now getting used to the third minister in 2 years, much changed, often needlessly and nobody had any time for anything other than redeploying resources and priorities.

As March ended and the weather cooled, both brothers had a chance for a bit of R&R and to catch up on personal business. Neither were particularly thrilled with the performance of their portfolio; Our public servant , who had always invested through Goldman Sachs had performed exactly in line with the broader market, his portfolio was down 8.6% over the 15 months, and had lost nearly $9 000. He felt he could do better, and had been thinking about getting other advice for quiet a while now, and decided to act. He now only had $91 000 left and decided to switch brokers and became a client of the giant international broking firm UBS, who provided him with their Australian Equity Core Portfolio. Here is an image of the advice from UBS and how his $91 000 was divided amongst the 10 stocks listed.

Source:  March 2012 ASX Investor Hour.  www.asx.com.au

Our Queensland accountant had faired significantly better, by investing in A1 and A2 stocks he had outperformed the market by 13.2% over the 15 months. However, he acknowledged that a couple of his investment decisions had performed poorly and wanted to rebalance his portfolio, he too decided to act. With over $104 000 available to invest he decided to round down his investable sum back to $100 000 and spend the surplus on a short Gold Coast holiday with his family and the balance on a membership to Skaffold. Skaffold is the research tool that would help him scour the every listed company to find quality stocks that may be selling at a price that offered a discount to estimated intrinsic value. Skaffold would also save him the time of sorting through ten years of annual reports for every listed company. Armed with ability to narrow down the choice of stocks, he would able to focus on the few that met his criteria and do further research on them before investing.

Here are the twin’s portfolios side-by-side:

The varying quality ratings of the 2 portfolios makes for interesting reading. On the basis of quality, the UBS portfolio doesn’t look very disciplined yet the portfolio chosen with the help of Skaffold looks pretty consistent. Except for 1 stock that is an A4. Our Skaffold user feels this cash flow positive producer may be about to be rerated by the market and A4 is as speculative as he could bring himself to be.

We will revisit our investing twins just after June 30 to see which portfolio is performing better, many thanks to Roger for putting the stocks to the test and actively encouraging this ongoing project.

All the Best
Scott T

Keep in mind this is a hypothetical and educational exercise only and not a recommendation of any kind.

Authored by Scott and posted by Roger Montgomery, Value.able author, SkaffoldChairman and Fund Manager, 19 April 2012.

by Roger Montgomery Posted in Investing Education, Skaffold.

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RISK: Successful investing is all about managing risk and, as luck would have it, this is one of the things that we, as a species are not particularly good at.

It is demonstrably true that humans are terrible at evaluating the complex risks associated with modern environments. This is not new information and there are plenty of oft referred examples which you can probably bring to mind; how we assess the actual probability of death from road vehicles vs. the perceived risk of death from spiders, snakes, sharks and aircraft (1,414 deaths vs. 32 in Australia 2009), the detrimental health risks of nuclear power vs. the dangers of fossil fuels (for every nuclear power linked death, there are an estimated 4,000 coal related deaths. Both candles and wind power are linked to more deaths than nuclear energy), or the real risk of bacterial infection vs. swine flu or mad cow disease (septicaemia alone was responsible for 993 Australian deaths in 2009).

Even if we acknowledge this shortcoming and integrate this knowledge to inform our everyday decisions, humans are hardwired to act on perceived risk, and are thus influenced to varying degrees by emotion. This is an evolutionary thing, and was suitable during the times that most of our transition to the dominant species occurred, but far less so now. The data necessary to evaluate complex risk often requires computers to calculate, and gut feel just won’t cut it anymore. To make it worse, we (as an aggregated faceless mass of humanity) are more inclined to trust information that reinforces existing beliefs (a well established phenomena known as confirmation bias). In a world where prominent politicians (and others) oppose the use of vaccines responsible for the eradication of polio and smallpox, in direct contradiction of peer reviewed science, finding someone who will tell us that we are right about pretty much anything is not challenging.

In summary, our natural instinct is to assess risk using our perception rather than facts, our perception is very often wrong, and even if we go looking for facts, we are inclined to assign more validity to data that supports our predisposition rather than to conduct an objective assessment.

You want more? In an apparent contradiction, this inability to overestimate our abilities may even confer an evolutionary advantage. Unfortunately, this would work at a species level, rather than for the wealth of the individual, and is a complex topic for another day (more about it here van Veelen,M. and Nowak,M.A. (2011) Evolution: Selection for positive illusions. Nature, 477, 282-283)

So, why is this important, and how is it relevant to investment?

Investment, as we all know, is about accurately assessing risk, and requiring an appropriate return to compensate for these risks to our capital. The more accurately we can assess risk in our investments AND act accordingly, the more likely we are to maximize returns. Knowing that investment is about managing risk however, is VERY different, and a lot easier than doing the work that this understanding requires.

Risk is managed using facts and knowledge. There is no place for gut feel. The more relevant facts we have about an investment, and the more knowledge we have about how to integrate this mass of data, the more accurately we can ascertain risk. As investors, we are looking for opportunities where professionals, with millions of dollars allocated to data collection, and which have analysts with years of experience, have mispriced this risk.

It could be argued that this is not necessarily so, that we could accept the average rate of return, such as with an index ETF. In this case we are accepting the risk premium applied by the market, and the inferred risk premium is out of our control. Historically, the 10 year compound annual rate of return for the ASX is 2.4% (excluding dividends), and for 5 years -3.1%. Even going back 22 years to 1990 only gets you just over 4%. In my opinion, the reward over any of these time frames is clearly inadequate, even allowing for dividends. These returns are comparable or worse than much lower risk investments including cash (not accounting for tax).

This leaves us competing against experienced, well resourced professionals and, more dangerously, many not-so-great investors as we try to outperform the market. In this context a quick look at P/E ratios is unlikely to yield the stocks that will lead to suitable returns. We need to be able to value businesses, find those that are mispriced and, most importantly, identify and assess the risks inherent in our calculations.

There are many tools for valuing businesses, such as the intrinsic value method described by James E Walter and explained much more accessibly in Valu.able, and even some for assessing risk (such as the Macquarie Quality Rating). The research necessary to even partially determine such metrics for all of the companies on the ASX (let alone internationally) with any accuracy is far beyond that available to the average retail investor, so historically we have had to only work on a handful of stocks recommended by professional researchers or investment publications, or use our gut as a first pass.

Like so many other things, the information age has turned this on its head. These days, a single service can value, and assess the quality of, the entire ASX, identifying companies worthy of further, thorough analysis. And this is exactly what products like Skaffold are useful for, and why they always come with a disclaimer.

When you make an investment, it is your cash, and your decision. You will reap the rewards if you get the risks right and pay the price if you do not. Tools like Skaffold (as an implementation of the MQR and intrinsic method) simply remove the noise, and allow you to find gold without having to pan too much gravel. When I first came across the MQR, both Forge Group and JB Hi-Fi were A1 and trading at a discount to estimated I.V. The decision to invest in the former and not the latter was not a function of luck, but an exercise in risk management.

The reason I invested in Forge was, that I know the industry, because I worked in it. I know the way high ROE is achieved in construction and mining services, the kind of businesses that can maintain it, and how such businesses generally grow. After carefully considering all of the available data and quantifying what I did not, or could not know, I felt I really did understand the risk and the potential reward, and as such made the investment.

In contrast, I did not understand how JB Hi-Fi would continue its level of growth, even in the medium term. I also work in the technology industry, and the threat to margins from online retailers was obvious, even two years ago. (This threat and the maturing nature of JBH was written about by Roger Montgomery some years ago) The discount to I.V was there, but the risk that ROE could not be maintained was too high for me. This is not a comment on the quality of JB Hi-Fi as a company, but on its valuation as a growth stock using historical ROE.

Generally, the more we know about managing businesses, the industries in which they operate and the products they are selling, the better we are at identifying and managing risks associated with these activities. If we were running the business we would be assessing strengths, weaknesses, opportunities and threats, barriers to entry, competitive advantage, brand awareness, and R&D just for starters. If we are considering about buying even a small part of a company, we should be doing the same.

In my opinion, I would rather have large investments in a smaller number of companies where I have control of the risk than rely on the brute force of diversification where I accept the risk premium of the market in general. I miss out on a lot of really good stories as a result (I don’t invest in mining exploration stocks for example) but at least I sleep well at night. My capital has been the result of far too much work for me to treat it cheaply.

There will be times when you can’t accurately assess risk, and times when no high quality stocks whose risks you understand are trading at a discount to their intrinsic value. It is times like this that it is hardest to hold your nerve. Remember, you don’t have to invest in the stock market, you can assess other asset classes, or alternatively you can follow Arnold Rothstein’s advice to Nucky Thompson (Boardwalk Empire – I recommend it if you haven’t seen it) for when the path forward isn’t immediately clear or the risks too great.

Do nothing.

Postscript:

1. What is more common in Australia, suicide or homicide
2. Motor vehicles are the most common cause of deaths attributable to “external causes”, what are the next 3 most likely
3. What is the more common cancer in Australian women? Respiratory, digestive or breast?

Answers

1. Suicide represents 24% of all deaths by “external causes” compare to 2.4% for deaths attributable to assault. While this probably didn’t surprise you suicide is also far more common in the USA.
2. In order; Suicide, Falls and Accidental Poisoning (Snakes, spiders, jellyfish and crocs hardly rate a mention. There were not deaths attributable to snakes on a plane).
3. In order; Digestive (4,917), Respiratory (3,080) and Breast (2,722)

Data from ABS census 2009

http://abs.gov.au/AUSSTATS/abs@.nsf/mf/3303.0/

1. van Veelen,M. and Nowak,M.A. (2011) Evolution: Selection for positive illusions. Nature, 477, 282-283, 10.1038/477282a. Available at: http://www.ncbi.nlm.nih.gov/pubmed/21921904 [Accessed September 15, 2011].

“Dividend policies and common stock prices” James E Walter

Author: Dennis Gascoigne is, or has at some time been; a Civil Engineer, Application Developer, Molecular Biologist, Management Executive and Professional Musician. He has held senior management roles in international Australian construction companies, has founded successful businesses in both civil engineering and information technology, and more importantly, played at the Big Day Out. These days he splits his time between genome research, and working on his cattle farm at Tenterfield in the NSW tablelands.

by Roger Montgomery Posted in Insightful Insights.

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Many of us grew up with a diet of the brilliant work of Walt Disney. As children we laughed and cried along with the characters of Donald Duck and Mickey Mouse, Cinderella and Bambi.  More recently, boosted by the purchase of Steve’s Job’s Pixar business, Disney continues to build its library and draw many more generations into the fold with the characters of Finding Nemo, Toy Story, Monsters Inc and Cars.  The company dominates with its ‘share-of-mind’ competitive advantage. In this Guest Post Andrew takes the scalpel to the company and dissects its major components.

What does your company REALLY do?
A nuts and bolts look inside the happiest company on earth

The ability to make assumptions about the future prospects of a business is fundamentally linked to how we understand that business. Without a good understanding you will be more than likely flying blind and your perceptions and reality could be in very different places and therefore throwing a great deal of uncertainty into any estimate of intrinsic value (which is linked more to the future prospects than anything).

A company that I am very fond of and one that I am sure almost everyone here has heard of is the Walt Disney Company (NYSE:DIS). I thought this would make a great case study in understanding the business.

So what does Walt Disney do? The first thing that comes to mind is the feature cartoons that it made its name on and its theme parks. These are the most iconic images that are attached to this famous company and more than likely where we were first knowingly exposed to the brand whether it be entering Disneyland for the first time and looking up Main Street towards the castle or watching movies like Snow White, Dumbo, Pinocchio.

What may surprise some people however is that most of the revenue and net income for the company comes from television.

Take a look at the below table:

Figure 1-Yearly breakdown of DIS segment revenue and net income (net income is before non-controlling interests taken out and are reported in US$ Millions)
As you can see in Fig.1, every year from 2001 to 2011, the largest contributor to revenue and profit (except 2002) was the Media Networks segment of the business. Over this period the company has on average brought in around 41.5% of the groups revenue and 55% of the net income as shown by fig 2.

Figure 2- Average % of total group figures
This technique of looking at the individual segment results and comparing them to the overall group is a technique I like to use to really understand the nuts and bolts of the business. Looking at these figures I can see that even though DIS made its name by animating feature cartoons and opening gigantic theme parks, it is the TV channels they own that make up the most crucial element of the business as it is today. There for if you were interested in investing in DIS you would be very wise to focus particular attention on understanding how the media Networks business derives its revenue and what risks are associated with this segment. Luckily the DIS annual report defines this in quite good detail but back to this later. One thing to realise though is that this type of analysis is greatly influenced by scale of operations. The biggest divisions will or at least should, bring in the bulk of the revenue and profits. It may be helpful to see on a relative basis at where the magic happens.

To do this, you might like to use profit margins of each segment. It is not uncommon for a diversified businesses smallest division to have the highest profit margin as in Qantas with their frequent flyer division. Disney is no different. It can change from year to year as shown in figure 3 however. Once again as you can see, lately it has been about the media networks. Looking at this however, you can gain a clearer picture of the profitability of each division in a relative manner. Despite being one of the smallest divisions, the consumer products segment is right up there in regards to profitability.

Figure 3- Net margins by division and overall group
So now, simply by looking at the financials we can get a clearer picture as to what DIS is really all about. We can see that the media networks business is arguably the most important. I can also see that the parks and resorts division is a pretty predictable segment with revenue and profit growth pretty consistent throughout the years and whose margins remain quite stable.

So where to next? Well you want to understand the risks associated with each segment so that you can be better placed to understand them and be able to make informed decisions and assumptions on the future. As mentioned earlier, the DIS annual Report actually goes into detail about the specific risks of each segment as well as detail as to how they derive their revenue. All annual reports will have a description of what the principal activities of the business are as well and if the management is shareholder orientated than it may include some very handy bits of information about the companies past, present and future. This is the next step, read all the information you can about that company whether it be through annual reports or newspaper articles, also read about the industry and read industry specific media to see what the insiders are doing and saying about the future. Knowledge is indeed power.

These are the simple steps to understanding a business and is aimed at the beginning investor although I think everyone can benefit from thinking more about how to understand a business they want to invest in.

Have you got any examples of businesses where the core operation may differ from what people may perceive? What gems can be found in the nuts and bolts of existing businesses? What techniques do you use to understand a new business? Feel free to post any thoughts below.

What do I think of Disney? Their return on equity has been increasing but is still below my required return so my valuation would still be at around or lower than their reported book value but I would love to own them personally. They are one of the biggest brands in the world and when they get it right, they create products that will last generations.

Guest Author: Andrew Leggett. Posted by Roger Montgomery, Value.able author, Skaffold Chairman and Fund Manager, 18 April 2012.

by Roger Montgomery Posted in Companies, Investing Education.

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I spent Easter at the beach, getting away with my family and we enjoyed the company of a bunch of friends. The smallest children all like to build sand castles at the very edge of the dry sand where it becomes moist and pliable. Of course as the tide comes in they are constantly being forced back lest they find their monuments suffer from each mini-tsunami. Investors build their portfolios well back from the high tide mark and the relatively safety gives them the ability to gain perspective and see the tides for what the are.

In this Guest Post, Scott Green explores the merit of sitting further back and doing nothing.

Doing nothing whilst doing something

A value investing strategy requires discipline and patience over a long period of time to work succesfully. You can’t just be a value investor one week then jump to speculative investments the next and expect that the preservation and growth of capital over the long term will be adequate. Patience and discipline are linked inexorably and will take work to develop.

If you are anything like me you struggle with the urge to do ‘something’ in the market even when there is no real value to be found. As the days stretch in to weeks, the itch can become very tough to control and sometimes you just have to do something to alleviate the pressure. This is especially prevalent in markets that seem to be continually rising. You can think you are missing out even though your investment rules and/or Skaffold tell you that nothing is value. You can eventually ‘snap’ and relax your rules and trade, justifying your decision to yourself in any number of ways. Conquering this itch is an important step to becoming a succesful long term investor.

Doing Nothing

One of the key aspects of value investing that Roger has mentioned many times is switching off the stockmarket and focusing on businesses and investigating promising businesses for potential investment. However, in todays 24hr news cycle with information flying at you from every different angle it can be hard to completely switch off. Below I have detailed some steps that I have taken in my personal investment journey to reduce my exposure to the news cycle and also modify the way I do view items when I interact with them. Maybe they can assist you in your in you investment journey.

1) Keep your ‘value goggles’ on – When you do read a business article or watch an investment show, view it all through the prism of what you have learned in Value.able or elsewhere. You will be amazed at how simple it can become to quickly identify whether or not the relevant piece is helpful to you or of no value. You can save a lot of time reading the financial news if you avoid all the articles that involve speculation rather than investing. A healthy dose of skepticism probably goes hand in hand with the ‘value goggles’.

2) Avoid living on the business channels, websites and newspapers – Reading or viewing articles on the many available sources of business news is not itself unhealthy but, like fast food, living on it probably is. The popular image of the ‘investor’ is the man (or woman) in their office, big screen showing stockmarket prices and a fast paced business channel, a copy of some financial paper and a website screening the market for the latest breaking news and trends. As investors, we should use the media as a source of information but not allow it to dictate to us what we should or should not be doing. Of course, if Roger or a trusted value investor (Buffet, Klarman, Whitman etc.) is appearing on a show or writing an article that should be required viewing/reading.

3) Do not constantly check the stockmarket – Some people (I used to be one of them) know where the stockmarket is sitting at any given time throughout the day. They also know where their own portfolio sits in relation to this. They live and die every hour of the day depending on whether they are ‘up’ or ‘down’. As longer term focused investors, day to day fluctuations should be of no concern to us. You will find yourself a much more relaxed person if you track your portfolio once a month instead of once a day. To aid in this, avoid using the many free portfolio tracking services available on the web. Perhaps the biggest step is deleting the apps off your smart phone that will happily tell you how much you are worth every second of every day from anywhere on the planet. I found this the best thing I ever did in regards to switching off the stockmarket and controlling the ‘itch’.

Doing Something

This does not mean that we sit around in a vacuum waiting for ideas to just come to us, trade and then return to the void of nothingness. Instead, we replace the actions that hinder us with the actions that will assist us in our investment journey. These are some of the things that I do which progress my investment journey without inducing the urge to act.

1) Read good books on value investing – Many of us got our start in value investing through Value.able but there is a world of other great value investment books out there that can enhance your knowledge. The grand daddy of them all is, of course, Security Analysis by Benjamin Graham along with its easier to read brother The Intelligent Investor. Others I would recommend are Margin of Safety by Seth Klarman (if you can find it or afford it!), The Agressive Conservative Investor by Marty Whitman and You Can Be a Stockmarket Genius by Joel Greenblatt (Terrible title but the last word on special situations value investing). You should also read some of the books that detail specific situations, usually ‘investments’ that went wrong! Examples include When Genius Failed by Roger Lowenstein about the rise and fall of Long-Term Capital Managment, a hedge fund that collapsed spectacularly in 1998, and Liars Poker by Michael Lewis about the authors experience as a bond salesman at Salomon Brothers in the late 1980’s.

2) Read investor letters by trusted value investors – The annual shareholder letters of Warren Buffet are considered required reading by all in the invesment community but there are many others that are valueable sources of learning and, sometimes, ideas to pirate away and research some more. These can commonly be found on the websites of the respective investment funds, though there are other websites that collate the information. Also, they can sometimes get there hands on the more hard to find letters from the more private funds. The ones I like are Marty Whitman from Third Avenue Management, Seth Klarman of the Baupost Group and David Einhorn from Greenlight Capital.

3) Research companies – Probably the most important something you should be doing. Using Skaffold or other sources to generate ideas leads in to researching thses ideas to see if they are worth investing in. Indeed, most of my own ‘investment time’ is taken up reading company reports and balance sheets. some can be quickly dismissed as unsuitable whilst others will, after suitable research be deemed acceptable and join our portfolio. The research of companies is the heart of value investing and the only way to ensure that investments are made below intrinsic value and with a margin of safety.

Hopefully, the above ideas will assist you in your investment journey as the have assisted me. THey have helped me become a better, more disciplined, more patient and much more relaxed, investor. A soothing balm over the itch if you like.

Guest Post Author: Scott Green.  Posted by Roger Montgomery, Value.able author, Skaffold Chairman and Fund Manager, 18 April 2012.

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Do New Hope Corporation (NHC), Northern Star Resources (NST), Mt Gibson Iron (MGX), Navarre Minerals (NMC), Allmine Group (AZG), Credit Corp Group (CCP), Matrix composites (MCE), Coffey International (COF), Data #3 (DTL), Breville Group (BRG), UGL (UGL), QR National (QRN) and Seymour Whyte (SWL) make Roger’s coveted A1 grade?  Watch this edition of  Sky Business’ Your Money Your Call broadcast 14 April 2012 to find out, and also learn Roger’s current insights into the Mining Services sector. Watch here.

by Roger Montgomery Posted in Companies, Energy / Resources, Intrinsic Value, Investing Education, TV Appearances, Value.able.

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Do Thorn Group (TGA), Maverick Drilling (MAD), Campbell Brothers (CPB) and Galaxy Resources (GXY) achieve Roger’s coveted A1 grade? Watch Part 1 of Sky Business’ Your Money Your Call 10 April 2012 program now to find.  Watch here.

by Roger Montgomery Posted in Companies, Investing Education, TV Appearances.

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PORTFOLIO POINT: Coal mining services provider Mastermyne is attractive if you consider its work in hand, revenue and earnings prospects. Cash flow, however, must be watched closely and value has recently taken flight.

Investors can be an irrational lot. When share prices are low, investors are reluctant to buy, preferring first a rise in prices to confirm their beliefs. Yet when those beliefs are confirmed and after share prices rise, the reluctance to buy remains; now the investor waits for lower prices to provide a more attractive entry point.

Mastermyne (ASX:MYE) has enjoyed a recent surge in its share price. Even though the rise has pushed its share price above a rational estimate of intrinsic value, it should not dissuade an investigation of MYE as conventional wisdom suggests favourable industry dynamics bode well for its earnings prospects over FY2012 and beyond. For now, turn the stockmarket off and focus on the business.

Mastermyne, established in 1996, is Queensland’s “leading” provider of specialist underground coal mining services. The company’s operations are primarily in the Bowen Basin, but the company also enjoys a growing presence in NSW’s Illawara. The company counts BHP, Rio, Vale and Anglo Coal among its Tier 1 customers. Demand for the company’s services is tied to coal production volumes and the short and medium-term outlook for coal production is positive, thanks to demand from emerging economies.

Bright prospects do assume the following: a benign environment for union action against coal miners (union action is currently underway for the BHP-Mitsubishi JV); no impact from litigation by the “Stopping the Coal Export Boom” movement that has also carefully planned and funded litigation action to delay development of port and rail infrastructure; and the spread of new production in Queensland’s Galilee Basin and NSW’s Hunter Valley.

Mastermyne’s three business segments are:

Mastermyne Underground (Mining Services) (>90% group revenue) (underground conveyor installation, extension and maintenance; underground roadway development; underground ventilation device installation).

Electrical and Mechanical Services (>1% of group revenue) (above ground electrical and mechanical services, including construction, maintenance and overhaul of draglines, wash plants, materials handling systems and other surface infrastructure).

Engineering and Fabrication (designs and fabricates attachments for underground equipment; general engineering and fabrication; supply of consumables for underground coal mines).

Since listing in May 2010 and under the direction of Tony Caruso (CEO since 2005, MD since 2008 – pictured above at far left during Mackay’s best business 2010 gala awards), MYE is off to a good start as a listed company. Importantly, investors should note that of the $40 million raised in the float, not a dollar went into the business. About $2.3 million went to the deal’s brokers and vendors received $37.7 million. Equally importantly, the company didn’t say in its prospectus that the proceeds had been used as ‘working capital’. I have seen plenty of companies that did, even though not a cent went in.

Supported by a strong order book, MYE exceeded its prospectus forecast revenue and earnings for 2010 by circa 4%, and earnings for 2011 by 10%.

Citing limited ‘through-the-cycle’ performance transparency, many investors get nervous about a company that is either new or newly listed. There is no escaping the argument in this case. Not only that, but the fact remains these types of mining contractors typically have high operating leverage and feast can quickly turn to famine, especially where barriers to entry are low (such as in this case) and competitors are willing to price irrationally when pickings get slim.  However, between FY2007 and FY2010, MYE achieved compound annualised growth of 17% in earnings before interest, tax and amortisation. Encouragingly, the company grew operating earnings during the GFC and, in a more recent six-month period to August last year, grew its FY2012 contracted order book by 30% – this on top of the previously mentioned prospectus-exceeding growth for FY2011 and second-half 2011 operating earnings growth of 22%.

During MYE’s annual general meeting (AGM) late last year, a very strong start to the current financial year was also cited. Growth in the two smaller divisions is being targeted (expect strong growth off a low base) and the company is positioning to engage in larger projects that are coming online over the next three to four years. Specifically, Mastermyne said that demand for its services remains strong and is increasing.

While several analysts have cited MYE’s strong employee growth as evidence of its statements about pipeline growth, it also serves as a reminder of the operating leverage that engineering contractors typically display. A leading position is essential in the event that industry-wide revenue ever turns south.

Watch the cash

On a work-in-hand, revenue and earnings basis, this is a company with bright prospects. The one caveat, however, is cash flow. Ultimately, it is by cash flow that a company lives and dies. A company waiting for its customers to pay while growing fast must manage its cash flow very carefully.

As is typical in a capital-intensive business (note: reason to moderate any plans for grand portfolio allocations), growth requires significant capital expenditure, as well as more typical variable expense increases. For 2011, net operating cash flows declined from $15.1 million to $9.4 million (take a look at the $20 million jump in receivables for a partial explanation). However, after subtracting $2.6 million for capex, the company was still able to pay its borrowings down by $6.7 million (the apparent increase in ‘borrowings’ is due to finance leases – another cost associated with expansion). Finally, a dividend of $2.6 million arguably caused the bank balance to decline by $2.2 million in 2011.

Using my method to estimate business cash flow, an $8.7 million business cash outflow can be offset by an $11 million increase in property plant and equipment, but the company really needs some of those 1200 additional staff it has taken on to be working in the receivables management part of the back office.

I suspected the accrual accounting used to record revenue would be based on effort expended, and indeed, the annual report confirms this:

“Revenue from services rendered is recognised in profit or loss in proportion to the stage of completion of the transaction at the reporting date…”

However, clients like BHP, Rio, Anglo Coal and Vale, while making a great looking CV, will also ensure Mastermyne won’t be dictating cash payment terms. The impact of this should not be underestimated, because Mastermyne will require cash to maintain and expand its equipment fleet, as well as maintain dividends (forecasts for per share dividends can be seen in the graph below).

Source: www.Skaffold.com

Only once you are comfortable with an understanding of how the cash flows through the company, its quality and its prospects do you move to analysing its intrinsic value.

Intrinsic value is a function of a company’s equity and the profitability of that equity, as well as a conservative required return.

The make-up of Mastermyne’s equity is therefore important and an examination of the balance sheet reveals that a not-insubstantial portion of the owner’s equity is comprised of intangibles, namely goodwill. The payment to the vendors of around $40 million was well in excess of the book value of net tangible assets, and so the accountants created a common control reserve to ensure the balance sheet balanced. The upshot is this would be a problem if the company were required to borrow meaningful funding. The combination of operating leverage and higher debt (if it were to grow) is itself less than perfect, and debt backed by goodwill leaves shareholders with precious little to support share prices if revenue or operating margins were to turn down.

That appears unlikely in the near term and so we move to the other element of the intrinsic value equation, which is return on equity. For the next two to three years, these returns are expected to remain high and stable at around 31%.

Based on these expectations, and turning the stockmarket back on, Mastermyne is trading at a premium to its current value. A pullback to $1.80, if it were to transpire and all else being equal, should be a trigger to pull the file out and conduct some due diligence on the company’s prospects at that time.

*Mastermyne (ASX:MYE, Score B1) is a small Montgomery [Private] Fund holding.

Posted by Roger Montgomery, Value.able author, Skaffold Chairman and Fund Manager, 26 March 2012.

by Roger Montgomery Posted in Energy / Resources, Insightful Insights, Manufacturing, Skaffold.

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On 1 March, Harley sent me an email.  Right in the guts of reporting season with up to 93 companies reporting in a single day, I have to confess to prioritising our work for the fund.  But Harley put a lot of thought into his letter to me about Allmine Group and I would hate to see it not receive some feedback from the wider community.  The price hasn’t changed so one suspects the arguments he puts forward remain unchanged also.  Here’s Harley’s letter(s) in full.  Remember Harley is not providing any advice nor are we.  For those interested in researching the company and referring it to their advisor, you can find Allmine’s latest investor briefing Allmine March2012 Investor Presentation.

Hi Roger,

I have followed the blog virtually since inception and have written to you a few times (about NST when it was 42c and ZGL when it was 32c – Emails are below as proof. Just thought I’d point that out! :P)

I’ve said it before but thanks again for how open you are with what you practice and for being willing to teach those that are willing to learn. It is much appreciated and has made a significant impact on my own development both as an investor and in what I aim to do as a career.

In this email I just wanted to point out an interesting little stock. I have done a lot of homework on this one (and I promise it isn’t a stock ramp!) but I thought it was worth letting you know about it and writing my view, even though it is likely you are already aware of the company.

The company is called Allmine Group, (ASX:AZG), and is composed of three divisions: Arccon which is in mining services, Construction Industries Australia and Allmine maintenance. I apologise if this email becomes too long but the company has a very interesting story and I believe it is incredibly cheap.

Firstly, just looking at the numbers, the company reaffirmed its 2012 profit numbers of around $16.5m which puts it on a fully diluted EPS of around 5.5c. The SP is currently sitting at 15c. On my numbers, the per share value of Net Receivables, Net Cash and tangible assets for FY12 is 14c. The company is most certainly cheap on a number of metrics, and when using the formula from Value.able it becomes even more attractive.

The issue the market had with the company, and one that I believe is being resolved, is cashflow. The Sep quarter 4C showed OCF was negative and the company appeared to be relying on the banks to keep running. The obvious assumption was that a capital raising was on its way, something I didn’t agree with but believed still needed to be considered. Around that time I actually gave the company a call and spoke to Scott Walkem, CEO, about their CF situation. He basically said that the company was “essentially cash flow positive” and that short term negative CF was a result of the huge step change in the business, which I’ll expand upon in a moment.

I tried to gauge when he saw CF turning positive and his exact words were “I see no reason why we won’t be in a net cash position by June 2012.” While encouraged by this I didn’t want to act solely upon his words and so have waited until recently to take a position in the company (and am looking to buy more after the company reports). More encouraging was the fact that weeks after I spoke to Walkem he purchased $50k in shares, adding more skin in the game.

What I find most important is the fact that in the latest 4C the company was OCF positive. They were also able to establish a number of new contracts across all divisions and secured a new bank facility last December. So while I am not overly bullish on mining services as a whole in the short term, I am of the view that the value in AZG is enough to warrant an interest.

Even more interesting is the qualitative side of AZG. AZG acquired Arccon, a company founded by Robert Wilde and John McGowan, two highly successful and well respected men in the industry. Arccon was the brain child of these two men, and Construction Industries Australia (CIA) was born out of Arccon and these two companies have significant relationships with two of the Chinese giants in mining – MCC and China Non Ferrous Metals.

Basically what happened was that Robert Wilde went to MCC and told them he could promise substantial savings on their Sino Iron project. He ended up saving them $100m+ (according to Scott Walkem) and out of this CIA was born. As a result the two companies have strong relationships with MCC and its sister company China Non Ferrous Metals. As a result of this relationship Arccon and CIA are able to not only have access to some of the projects MCC and China Non Ferrous are working on (evident in recent contract announcements), but also have access to cheap project financing via the Chinese banks. In the meantime the Allmine maintenance division announced a new contract with Downer EDI worth $10m p.a. which is a substantial amount based on the $30m odd revenue of the previous year.

Since following the blog I have learnt so much and been given so many investment opportunities and ideas, that if possible, hopefully I can return the favour! AZG in my view is worth a look. It appears to me to be very cheap, has only recently become OCF positive and I believe there is minimal risk of a capital raising. Obviously one must consider some of the risks: slowdown in China, weakness in the Chinese banks impairing the relationship with MCC and NFC, commodity prices falling. In my view in an ironic way, thanks to the relationship with MCC and NFC Allmine is less exposed to a slowdown in China than other mining services companies. The Chinese desire for resources is not a short term play and without further lengthening this email I do not see Chinese exploration/acquisitions of resource projects slowing in the event of a commodity price fall, in fact I expect the opposite as they see cheap assets as an opportunity.

In terms of catalysts for SP appreciation if Allmine can reconfirm a $16.5m profit this month and put it on a PE of 3 I think that will be a shock to the market. The latest report will reveal a substantially different company to that shown in the previous report with the 100% acqusitions of both Arccon and CIA now being fully accounted for, and Skaffold will likely rerate the company too if I am correct!

Thanks again Roger.

Regards,

Harley

…Seperately Harley also wrote the following about the company…

Overview

Allmine Group provides a life of mine service to its clients via three divisions: engineering, construction and fixed and mobile maintenance services. The company is comprised of Allmine Maintenance, Arccon and Construction Industries Australia (CIA). But there is much more to Allmine Group than meets the eye. At first glance it is just another mining services company, but the story behind this company is an exciting one and one that completely changes your view of the company when you begin to understand it.

When AZG listed in March of 2011 they were entirely a maintenance services company. I remember looking at the prospectus when they listed at 20c and thinking it was an ok company but nothing outstanding. Since that time Allmine have made two significant acquisitions that have substantially changed the nature, growth profile and outlook of the group.

Firstly, Allmine bought Arccon Mining Services, an EPC/EPCM contractor for a maximum consideration of $22.8. The acquisition will be paid for in two tranches. The first tranche has been paid and involved an equity deal of 75 million shares at 20c/share, a total consideration of $15 million. The second tranche is performance and loyalty based, whereby Arccon must achieve NPAT of $5.55m in 2012. If the target is achieved another $7.8m worth of shares will be issued at the 5 day VWAP at June 30 2012. For the Arccon shareholders to receive this payment they will have to hold 75% of the shares issued to them in Allmine.

The second acquisition was for Allmine to purchase the remainder of Construction Industries Australia (CIA), which was 50% owned by Arccon and 50% by the original founders. The total consideration paid was $3m paid in shares at 20c strike price. In 2011 CIA achieved $10.5m NPAT. Yes, you read that correctly.

Now at first glance it seems impossible that such acquisitions could be made so cheaply, to good to be true in fact. The truth is that the initial payments being made do not fully reflect the price that will ultimately be paid for these companies. Instead, the rest of these payments will come through in the performance incentives program which provides for substantial benefits for management and original Arccon shareholders should they achieve key objectives. The details of the performance incentive plan are quite complex and are explored in depth later in this report.

Background

I took a closer look at this company around September last year. At the time it was very cheap based on its forecast earnings, but its operating cashflow (OCF) was negative. There was fear of an imminent capital raising as it appeared upon looking at the financial statements that the company was relying on the banks for survival. But that wasn’t the case.

What the market was missing was the company was essentially cash flow positive, but that cash flow timing issues were causing OCF to come out negative. I looked into the company and thought it’s story (which I will get into in a moment) was one of a company with incredible opportunity and its current share price was ridiculously cheap. So I got in contact with the company and, luckily enough, was able to speak to the CEO, Scott Walkem, over the phone. Much of the story that follows is direct from the CEO himself.

Allmine Group’s Story: Not Your Everyday Mining Services Company

When AZG bought Arccon and CIA they substantially changed the makeup of the company. Arccon and CIA have two significant competitive advantages: access to cheap project financing from Chinese banks and management with a proven track record.

Arccon was founded in 2003 by Robert Wilde and John McCowan, the two founders of the hugely successful Minproc Engineers which was taken over by AMEC plc., the UK mining services giant. These guys have a proven track record in growing a successful company, and they have significant ownership in AZG as well as performance related incentives. And shareholders can be more or less assured that they will remain at the company for at least the next three years, as the details of the acquisition state they must do so to receive their performance and loyalty bonuses.

It is their experience, as well as their connections to the Chinese companies China Metallurgical Group Corporation (MCC) and China Non-Ferrous Metal Industry’s Foreign Engineering Construction Co. Ltd (NFC), and as a result their access to cheap project financing from the Chinese banks, that presents a fantastic opportunity.

The story goes like this. Robert Wilde, then working at Arccon, got in contact with MCC and told them he could help them achieve sizable savings on the Sino Iron Ore project in the Pilbara (which MCC owns 20% and which AZG works on to this day). They agreed and in the end Arccon was able to save MCC $100m USD on the project. From this demonstration of ability CIA was born, and the company was introduced to MCC’s sister company, NFC.

MCC and NFC are big companies. They work on big projects around the world with Tier 2 (or below) mining companies. They are able anywhere between 70-100% of the project requirements through the Chinese banks at relatively cheap rates. Arccon now has a “significant pipeline of work across next the 1-4 year time horizon” (most recent Half Yearly Report) as a result of this relationship, while CIA is currently undertaking projects on a lump sum and cost recovery basis with MCC. Many of these big contracts involve financing arrangements through Chinese banks, something no other Western mining services company can offer their clients.

Allmine Group now has two clear competitive advantages:

1) Management with a proven track record.

2) Key relationships with MCC and NFC allowing large projects to be financed via the Chinese banks.

These two factors, particularly the latter, in my mind represent something the market may just latch onto when it realises how significant these competitive advantages are. I encourage you during the process of researching this company to look closely at some of the projects AZG has lined up as a result of these arrangements as they are indeed quite large and begin coming through in Q4 of this year.

Of course the maintenance division, while not as attractive as Arccon and CIA, is still a strong business. It is experiencing labour shortages, as Walkem said “the business could be twice as large tomorrow if we could find the people.” The company announced it had initiated an in-house training program to help alleviate this issue and that first signs were encouraging.

CIA is in the process of diversifying its client base away from MCC to reduce the reliance on the Chinese company, with positive news coming from its contract win with UGL. At the moment CIA is heavily dependent on contracts at the Sino Iron Ore Project, which as many of you will know has had its fair share of negative press, so any diversification can only be positive.

The Allmine Advantage

The main difference between Allmine and competitors is indeed the connection to the Chinese companies and through them the cheap financing of the Chinese banks. Firstly, mining companies will be attracted to the prospect of cheap financing on offer from MCC and NFC. In the past, and in recent news, Australian companies have not been satisfied with the performance of MCC, as was made clear when CITIC Pacific complained about the cost blow-outs on the Sino Iron Ore Project. It is therefore in the interests of MCC and NFC to have Arccon (and CIA) covering some of their contract requirements in Australia, as projects need to be completed to Australian standards. If MCC were to lose their relation with Arccon they would greatly reduce their chance of future contract wins (and therefore opportunities to secure resources) in Australia. The Chinese company relationship is very important to Allmine Group, but don’t think it’s a one way street as MCC and NFC benefit too.

From a client’s perspective working with MCC/NFC and Allmine Group offers project financing, access to cheaper Chinese materials and work completed according to Australian standards. To demonstrate this competitive advantage in action, read the following from an announcement by Reed Resources:

“The involvement of both NFC and Arccon in the EPC consortium enables Reed to access the cost benefits of a Chinese contractor, whilst retaining appropriate Australian expertise and experience, to ensure Australian standards and work practices are adhered to and construction of the Project can be executed smoothly.” (Nov 11 2010)

As has been demonstrated the management of Allmine clearly have a few things to show the big Chinese engineering companies when it comes to efficiency and cost management. For a small to mid tier company looking to go from explorer to producer, in an environment like today where the future of potential project financing seems uncertain (whether true or not), this is an attractive option.

It is also important to note that the projects Arccon tenders for via their relationship with MCC and NFC are not limited to Australia. In fact some of their biggest projects are overseas with two examples being the Yandera project in Papua New Guinea and the Citronen project in Greenland.

The goal of the Chinese is to eventually source half its imports of iron ore from owned or co-owned mines by 2015. They want to diversify away from their reliance on BHP, RIO and Vale, for obvious reasons. For this to occur the Chinese will need to continue to invest money into iron ore and other commodity projects worldwide, and to do so by buying/financing projects. If this is to occur, as I expect it will since the Chinese have made it a priority, then Allmine is well positioned to benefit from increased Chinese investment into iron ore and related commodity projects. Remember the Chinese will need more than just iron ore. Zinc, vanadium, copper, molybdenum, all are resources the Chinese need to secure. I expect to see more stories along the lines of small-medium sized Australian companies partnering up with companies like MCC to secure project financing while MCC (or other Chinese companies) take large stakes in the projects/companies themselves.

Then of course you have the proven track record of Wilde and McCowan, which should translate into further contract wins for Arccon and CIA outside of MCC and NFC. Continued diversification is a positive and it seems a focus of Allmine management.

The maintenance division, while smaller, should not be forgotten. If labour issues can be kept under control the business should stay relatively profitable. On top of this the synergies will only increase as the volume of work for Arccon and CIA picks up.

Cashflow Turnaround

Cash flow is key for this business. As it stands the balance sheet is not strong enough to withstand a significant shock should something unexpected occur. When OCF was negative last year, Scott Walkem insisted there was no need for a capital raising saying the company is essentially cash flow positive and backing it up by purchasing shares for his own account. He said that the company was undergoing a step change in growth and the changes in working capital were temporary and beneficial long term.

In the latest 4C he was proven right when OCF was reported as positive, albeit by only $2m. At December 31 2011 AZG had $2.5m cash at bank but had drawn down their bank overdraft to the tune of $7.7m. While they have plenty of room to draw down this facility under normal operating circumstances, should something unforeseen occur then the company will have little room to move.

Negating these risks somewhat are three key factors. The first is that the CEO is purchasing shares. He purchased $50k last year and another $100k earlier this year. Insider buying is always a good sign. The second is that the potential for cash flow to turn around, and to do so quickly, is certainly there. Around $36m in cash is coming in each quarter, and that is expected to increase in future. In the most recent quarters the company experienced significant growth, increasing total engineers from 5 to 50 as well as a significant jump in total employees.

And finally, the company has forecast for working capital needs to normalize in the fourth quarter of FY12 and for cash to start building up on the balance sheet. They still maintain their forecast of $17m cash by the end of FY12.

Is There An Issue With Dilution?

If you are going to invest in Allmine you need to be aware of the almost inevitable increase in total shares on issue. It is true that the total share count will likely increase substantially. What is not correct is the idea that this is a net negative for shareholder value.

While a number of new shares will likely be issued it will not cause a significant reduction in the value of this company so long as current performance is maintained. Today there are 280m shares on issue. There are 40m options at 20c, 2.5m at 25c and 2.5m at 30c. Each represents a price that is above current equity per share! Thus if these options were to be exercised it would actually be value accretive! As I write this the 20c options are at the money while the rest are out of the money and thus are unlikely to be exercised before a substantial share price rise.

One must keep in mind that if options were to be exercised it would inject over $8m into the company, which would entirely remove the negative cash flow position of the company. Options being exercised is actually a net benefit to the value of the shares!

The next issue of possible dilution relates to the second tranche of payment for the Arccon acquisition. Should Arccon achieve NPAT of $5.55m in FY 2012 $7.8m of shares will be issued at the 5 day VWAP as at 30/6/12. It is difficult to determine how many new shares will be issued because it depends on what the share price is at the time the VWAP is calculated. If the company can continue its strong performance it is entirely possible that the share price is substantially higher by June than it is today. But at the same time it could be cut in half tomorrow! It really is anyone’s guess. So for now let us assume the 5 day VWAP at 30/6/12 is near enough the current share price, or 20c. At 20c 39m shares will be issued, taking the fully diluted share count to 360m. Remember the total number of shares to be issued in this second tranche payment for the Arccon acquisition is highly sensitive to the share price in the 5 trading days prior to 30/6/12.

The final source of dilution relates to the performance incentives to be paid out to management and the CEO. In a moment we will look more closely at this, but for now take it that the maximum number of shares on issue for FY12 will be 400m. Provided the $16.5m NPAT is achieved, EPS will come to 4.1c and the current share price represents a PE of 4.8.

Performance Incentives For Key Management

On face value the total considerations paid for Arccon and CIA are ridiculously low, especially considering the calibre of management. The truth is that these acquisitions will be paid for over time and provided Robert Wilde and John McCowan achieve key objectives for the company. Personally I prefer this approach to simply overpaying upfront for a company, as at least this way any shareholder dilution is a trade off for increased performance.

The CEO, Scott Walkem, has his incentives tied to total market cap. According to the plan he receives no performance incentive if market cap is below $60m, $1.8m between $60 and $80m, $2.4 between $80m and $100m. If market cap is over $100m Walkem receives $3m plus 1% of the total market cap up to $200m. Again the payment is made in shares at the 5 day VWAP as of June 30 2012. Currently the market cap sits at $56m, but it I would not be surprised if options were exercised if the market cap does not break the $60m mark between now and then.

Robert Wilde is rewarded according to the NPAT achieved by Arccon in FY12. He receives $2.474m if NPAT is between $7m and $12m; and $4.2m if NPAT if it is above $12m. Again it is tied to the 5 day VWAP at 30/6/12. Unlike the shares to be issued upon exercise of options these shares will not result in any cash being injected into the company.

So let’s now calculate the maximum total of shares to be issued. We will assume the 5 day VWAP at the relevant time is equal to the current share price, or 20c.

45m shares can be issued through exercise of options, 39m shares will be issued for the second tranche payment for Arccon, the maximum realistic payout to Scott Walkem is 9m shares (since the CEO is rewarded based on market cap his bonus relies on the share price increasing, which would ultimately increase the VWAP used and thus reduce the total new shares to be issued.) and the maximum payout to Robert Wilde is 21m. This brings the maximum realistic total to 394m shares.

It is difficult to forecast the total shares to be issued, simply because no one can forecast the share price. But even assuming 394m shares are on issue by the end of this year, it would mean profit came in near guidance, or around $16.5m, which still puts the company on a PE in the 4’s. There are risks to this company but provided the profit numbers are hit dilution is not one of them.

Risks

As with any company there are some key risks one should consider. They are as follows:

Cashflow: This risk has been covered above. Some may avoid this company as cash flow in the recent past has been weak, which admittedly makes them vulnerable to key project risk. If this is you, consider waiting for the next few cash flow reports before investing.

Key Project Risk: This is in my view the biggest risk for Allmine. They are strengthening their balance sheet but are not in a solid enough position to withstand a number of key projects being delayed or cancelled. They have had one major project delayed due to weak vanadium prices already, which is something to keep an eye on. (In regards to this project the company is still in informal negotiations with Arccon and the project will likely go ahead. In what form will be revealed in April.) Because the big key projects don’t start coming through until FY13 the FY12 profit number is still uncertain and reliant on timing of projects. It is my view that this risk is negated by those big projects in the pipeline, but it does not prevent the possibility of a project delay causing the FY12 profit forecast to be missed.

Chinese Connection: While a significant strength, the risk of losing the relationship with MCC and NFC is indeed a risk and would damage the billions of dollars worth of projects in the pipeline. However, it is important to remember that the benefits are mutual, and MCC/NFC do indeed benefit from working with Arccon and CIA.

Profit Guidance Being Missed: As with any company the risk exists that profit falls short of guidance. This is true with Allmine. However, the margin of safety on offer reduces this risk. The company made clear they expect the second half of FY12 to be stronger than the first. If we consider the possibility that this doesn’t occur, and instead profit continues at the same pace as the first half then NPAT will come in around the $12-$13m mark, the increase in the second half being due to the profits from CIA having a full 6 months to come through, unlike in the first half. In this case, and assuming the maximum possible share dilution occurs EPS will come in at around 3.2c and if you were to purchase today you would still be paying a PE of only 6, which isn’t too bad for a downside scenario.

The Financials And A Valuation

Ok, here is where it gets really interesting. When I first noticed this company it had announced earnings guidance of $16.5m. As I have made clear if this were to be achieved the company is currently very cheap, which reflects its doubling in price since then.

In the latest half yearly report AZG reported NPAT around $5m in the half, but the key to the report was the reaffirmed earnings guidance. They stuck with the original $150m revenue and$16.5m NPAT but separated the guidance into two key parts. The company announced $13m from construction and maintenance services, with an additional $4-$8m in ‘at risk’ income due to uncertainty regarding timing of contracts. $13m NPAT for 2012 would represent a continued rate of performance over the first half, as the acquisition of CIA comes through to the bottom line. And there is now potential for upside as according to the company there is the possibility that NPAT comes in as high as $21m.

Forecasting profit for an EPC/EPCM services company is very difficult, and for the sake of company valuation I would rather be conservative and right than optimistic and wrong. So when valuing this company I have decided to assume NPAT of $15m, which would mean falling short of guidance by 10%. For me this takes into account the recent project delay as well as any other unforeseen risks. It also assumes $150m revenue comes through but that margins fall from historical levels, which is not impossible considering the labour issues currently present in the industry. The numbers that follow are in my opinion quite conservative. Suffice to say that if the upside of profit is achieved this company is ridiculously cheap, so in using conservative numbers I hope to demonstrate that even in such a case the company still presents value.

So assuming $15m NPAT let’s forecast equity per share. Equity was $54.4m at December 2011. Since no dividend will be paid retained earnings would increase by $9.8m. We will assume that the 40m options at 20c are converted, which is likely if the share price rallies going into reporting season. If this were to occur it would inject $8m into equity. Equity would now be equal to $73.6m and equity per share on a fully diluted basis (394m shares) would come to 18.6c. This means that if $15m NPAT is achieved (which would mean they are short on guidance, upside exists) that on a fully diluted basis the book value of the company is near the current share price. Average ROE would come to 23.4% and would be likely to remain stable or increase in future years as the larger projects with MCC and NFC start to come online. EPS will be 3.8c putting the current share price on a PE of 5.25.

So what does this mean for the value of the company?

Using these numbers and based on an average of three valuation models, I value Allmine Group at 40c.

Thanks Harley …As always be sure to conduct your own research and do not engage in any securities transactions of any description without seeking and taking personal professional advice.

by Roger Montgomery Posted in Energy / Resources, Investing Education, Skaffold, Value.able.

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Week after week our email inbox is filled with investor’s questions: A reasonably frequent one is about the performance of a portfolio of stocks that I wrote about last year filled with companies whose revenues had a large recurring component to them. If you know anything about the recurring patterns in fractal geometry, you know how beautiful the recurring theme can be.

The lift in the market over recent months has heightened anticipation. Today I will outline the performance of the six stocks I chose at the start of October last year.

But first: do you remember what we wrote about back then? The market was down 20% and radio news programs led with stories of large losses overnight in foreign markets. Shortly afterwards the market officially entered a “bear” market.

And then it promptly bounced. I remember this period because it was when we started a new Sub-Portfolio with six stocks that had one thing in common: a high percentage of recurring revenue. We called it the Recurring Value.able Portfolio.

As I wrote back then: “All the companies selected enjoy high rates of return on equity; they all have manageable, little or no debt; and they all enjoy the benefits of low levels of capital intensity, helping to generate copious cash.

“But what really marks these companies: Hansen, Iress, REA, Reckon and M2 Communications as a little special is the significant levels of recurring revenue. Iress (ASX: IRE, MQR: A1), enjoys close to 80% recurring revenue through the supply of its information and trading platforms; Hansen (HSN, A1) close to 70% through the supply of billing platforms and software; Reckon (RKN, A1) close to 60% through its provision of online accounting, personal finance and practice management software; and M2 Telecommunications (MTU, A1) close to 67% through telecommunications and internet access plans.

“Think of the advantages of running a business that begins each year with a material amount of its revenue locked in for the next 12 months. It is these recurring revenue streams that help derisk a company through strengthening balance sheets. The solid financial position then enables a business to comfortably expand current operations and take maximum advantage of other opportunities as they arise.”

A year ago I wrote that a portfolio constructed from high recurring revenue businesses and purchased at prices representing a margin of safety, should outperform the index. It was on that basis that I created a second Value.able portfolio called the Recurring Value.able Portfolio. Sitting within the Value.able portfolio its purpose is simply to demonstrate to you the relative performance of these holdings compared to the market.

You may recall I also overweighted the stocks that were trading at the largest discounts to my then estimate of intrinsic value and said: “I don’t believe the level of recurring revenue will change materially if Greece defaults and even if equity risk premiums increase because of more frequent recessions in the US” …adding “these holdings should perform as true defensives”.

Since I penned those thoughts, what has been the performance of each of the six companies’ shares? Hansen, Thorn Group and M2 were all trading at discounts to our then estimate of intrinsic value and M2 at the largest, while Iress, Reckon, and REA Group, were all at premiums to intrinsic value. The following table shows the share price increases and decreases for each of the six.

What I have done, is grouped those same companies by premium or discount to intrinsic value.

Those that were cheap are in the top half of the table, and produced a simple average return of 11.01%. Those that were expensive produced an average simple return of 7.63%. In other words, those with a high level of recurring income that were also cheap outperformed the All Ordinaries index; while those with a high level of recurring income but were expensive, on average, underperformed the All Ords.

Now, if you’ve been reading my column here long enough, you’ll know that a short period is not long enough to measure relative or absolute performance and neither is a small sample, but nevertheless, we have to start somewhere and the reality is we have plenty of experience to support the notion that quality and value combined leads to outperformance over the long run.

As an update to our October piece on this subject, find following the Skaffold intrinsic value line charts for each of the six companies. They describe where the current price is compared to Skaffold’s estimate of intrinsic value and whether, based on current forecast earnings, intrinsic value is expected to rise materially in coming years.

What are your favourite recurring revenue companies?  By thinking laterally you may discover a couple of companies that wouldn’t normally be thought of as enjoying recurring revenues.  To leave a comment click on the link below and enjoy reading the two further new posts below.

Posted by Roger Montgomery, Value.able author, Skaffold Chairman and Fund Manager, 15 March 2012.

by Roger Montgomery Posted in Companies, Investing Education.

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By Praveen J on 9th January 2012 and updated Feb 20 2012

This year I have been given an opportunity to write about my experiences in applying what I have learnt as a Value.able graduate and Skaffold member. At the moment I am looking to invest in stocks with a market capitalisation under $2 billion (small to micro caps). Key MINIMUM criteria for me include: Return on Equity > 15%, Net Debt/Equity < 50%, and forecast change in Intrinsic Value > 5%. I will also be focussing on investment grade companies across ALL Industry Sectors/Groups that have Skaffold Quality Scores between A1 to A3, and B1 to B3. This will encompass my “investment universe” of stocks on the ASX. I will of course require a decent margin of safety, but I will be watching stocks that are trading close to their Intrinsic Value or at a small premium, in the event of a decline in price over the next 3 to 6 months. Initial screening using Skaffold reveals over 100 stocks, a more aggressive filter would reduce this number even further. Amongst the results are 10 stocks in the Basic Materials Sector and Gold & Silver Group, 6 of which are predominantly involved in gold exploration, development and production:

• Ramelius Resources (ASX:RMS)
• Medusa Mining Limited (ASX:MML)
• Silver Lake Resources (ASX:SLR)
• Dragon Mining (ASX:DRA)
• CGA Mining (ASX:CGX)
• Regis Resources Limited (ASX:RRL)

Table 1. Stocks listed by safety margin (highest to lowest, 9th January 2012) (Source: Skaffold):

Although Ramelius Resources (RMS) meets my initial screening criteria and is an A1 company, it has a NEGATIVE forecast EPS growth. So in this blog post I will be discussing and comparing Medusa Mining Limited (MML) and Silver Lake Resources (SLR). Here we have two companies that have commenced production of gold (they are making money), they are fundamentally healthy, they have good prospects for Intrinsic Value appreciation, AND are both trading at a discount to their Intrinsic Value. Being commodity businesses, the question I have to ask is whether either really have any competitive advantage. I will discuss this later.

Now in the context of the European sovereign debt crisis, anaemic growth in the US, and concerns of a slowdown in the Chinese economy, I am wary about investing directly in a small cap Australian mining company. However, in this case we are dealing with a commodity that may benefit in this time of uncertainty, with gold long being regarded as a “safe-haven”. Having said that, the future price of gold is still a significant element of risk. At the time of writing the price had dropped down to around US$1600/ounce, after a peak of close to US$1900/ounce in September 2011. Below are some charts of historical gold prices, I’m not going to try and analyse them, but they may serve as a point of discussion. Certainly investing in gold equities requires a bullish stance on the future price of gold in the medium to long term.

Figure 1. Spot gold price chart last 1 year:

Figure 2. Spot gold price chart long-term:

GOLD PRIMER:

Annual reports and AGM presentations for gold and other mining companies assume a level of pre-existing knowledge. Without this, they really make no sense at all. So let me start with some bare basics before I discuss each stock in detail:

What is an Element? An element is a pure chemical substance. You may have heard of something called the periodic table (maybe in your high school science class), this is actually a list of all chemical elements. Examples of elements include carbon, oxygen, aluminum, iron, copper, lead, and of course gold.

What is a Mineral? A mineral is a naturally occurring solid chemical substance that is a combination of elements.

What is an Ore? An Ore is a type of rock that contains minerals. Most individual elements are found in the form of a mineral, though there are some elements that can be found in their elemental state, gold is one of them. Gold is also found in combination with silver and occasionally copper.

What is an Ore Deposit? This is an accumulation of Ore.

JORC? This is the Joint Ore Reserves Committee. The Code for Reporting of Mineral Resources and Ore Reserves (the JORC Code) is widely accepted as a standard for professional reporting purposes.

What is a Mineral “Resource” and what is an Ore “Reserve”? These terms are often incorrectly used interchangeably, the exact JORC definitions are below:

Figure 3. Resources versus Reserves (Source: JORC):

RESOURCE; “A CONCENTRATION OR OCCURRENCE OF MATERIAL OF INTRINSIC ECONOMIC INTEREST IN OR ON THE EARTH’S CRUST IN SUCH FORM, QUALITY AND QUANTITY THAT THERE ARE REASONABLE PROSPECTS FOR EVENTUAL ECONOMIC EXTRACTION. THE LOCATION, QUANTITY, GRADE, GEOLOGICAL CHARACTERISTICS AND CONTINUITY OF A MINERAL RESOURCE ARE KNOWN, ESTIMATED OR INTERPRETED FROM SPECIFIC GEOLOGICAL EVIDENCE AND KNOWLEDGE. MINERAL RESOURCES ARE SUB-DIVIDED, IN ORDER OF INCREASING GEOLOGICAL CONFIDENCE, INTO INFERRED, INDICATED AND MEASURED CATEGORIES.”
RESERVE; “THE ECONOMICALLY MINEABLE PART OF A MEASURED AND/OR INDICATED MINERAL RESOURCE. IT INCLUDES DILUTING MATERIALS AND ALLOWANCES FOR LOSSES, WHICH MAY OCCUR WHEN THE MATERIAL IS MINED. APPROPRIATE ASSESSMENTS AND STUDIES HAVE BEEN CARRIED OUT, AND INCLUDE CONSIDERATION OF AND MODIFICATION BY REALISTICALLY ASSUMED MINING, METALLURGICAL, ECONOMIC, MARKETING, LEGAL, ENVIRONMENTAL, SOCIAL AND GOVERNMENTAL FACTORS. THESE ASSESSMENTS DEMONSTRATE AT THE TIME OF REPORTING THAT EXTRACTION COULD REASONABLY BE JUSTIFIED. ORE RESERVES ARE SUB-DIVIDED IN ORDER OF INCREASING CONFIDENCE INTO PROBABLE ORE RESERVES AND PROVED ORE RESERVES.”

What is the difference between high and low-grade gold Resource? There aren’t any fixed definitions that I could find, but generally < 4.0 grams/tonne is low-grade, >8.0 grams/tonne is high-grade, and everything in between is about average. A large amount of low-grade gold could be just as profitable as having high-grade gold, as it could be cheaper and easier to mine the low-grade gold (for example low-grades in “open pit” or near surface mines, versus high-grades in “narrow vein” or deep underground mines).

Stages of mining: exploration, development, or production? Exploration involves primarily drilling activity in order to discover ore deposits and then define the Resource and Reserve levels, as well as feasibility studies, development involves primarily engineering / construction work, and production involves the mining, processing at the mill, and selling of the commodity.

Junior, mid-tier, or senior gold producers? Junior gold producers are generally considered as those producing under 200,000 ounces per annum of gold, seniors over 1,000,000 ounces, and the mid-tier producers in between.

What is a mining tenement? This is basically a license/permit granted by the Government to undertake exploration, development, and/or mining activities in a specific area.

What are royalties? Royalties are an expense that needs to be paid to the State Government in Australia for any minerals that are mined. In Western Australia for example, royalties are 2.5% of the value of gold produced.

What are cash costs? This is the operating cost required to produce one ounce of gold. Average worldwide cash costs are around US$620/ounce. Cash costs do not include capital expenditure. TOTAL cash costs include royalties.

What is hedging? Agreeing on the sale price of a certain volume of gold ahead of producing it, it is done to protect the company from the short-term volatility of the market gold price, but will reduce return when the price is rising.

Quick comparison of gold producing companies… First of all, make sure you compare similar companies, i.e. a junior producer with another junior producer, not a junior with a senior. Look at the total amount of resources they have, quoted in ounces, look at the cash costs, and look at how much ounces they have produced per year, and what level is expected in the future. Look for companies that are actively drilling to expand their resource base and find new ore deposits. A company may have one site producing gold, another being developed, and several others under exploration. This ensures that when Resources deplete at one site, there are other potential mines in the wings.

ANALYSIS: MEDUSA MINING LIMITED (ASX:MML)

MML is an un-hedged gold producer listed on the ASX and LSX and is currently operating in the Philippines.

Figure 4. MML’s Skaffold Line (Source: Skaffold 6th January 2012):

Looking at the figure above we can see that the share price has been on the climb since early 2009. The ACTUAL Intrinsic Value (which is based on analyst forecasts) has also followed suit since then, and has generally remained above market price. Market price reached a peak of $8.35 in September 2011 but has since been on a downward slope. More importantly though, the ACTUAL Intrinsic Value is expected to continue rising. In this instance however, the AVERAGE Intrinsic Value (a more conservative estimate), which is based on past performance with an emphasis on the last 3 years, is not expected to rise as strongly. As this value does not necessarily take into account all possible future events, what I need to find out is what future prospects the company has that could have contributed to the analyst’s forecasts. Another important thing to consider is why has the market price dropped almost 50% in just a few months? I’ll come back to this last point later…

Currently MML’s production is focussed on the Co-O mine in the Mindanoa Island area. A second potential gold production centre is under exploration at the Bananghilig deposit. MML currently have JORC code compliant mineral Resource of 21.3 million tonnes, at a grade of 9.6 grams/tonne (g/t) at Co-O and 1.3 g/t at Bananghilig, for a total of 2.6 million ounces (mOz). The company aims to keep Resource and Reserve levels at the Co-O mine stable year to year (by replacing whatever is used up each year), and in doing so avoid spending too much money on expanding this base to levels that will not get mined for several years. Exploration budget for 2012FY is US$27 million. Gold production for 2011FY was 101,474 ounces. Total cash costs for 2011FY were an extraordinarily low US$189/ounce (includes royalties). This could be due to the fact that mining is done predominantly via hand-held equipment, and labour costs are low. The site is also adjacent to a highway with close access to the port, and has grid power via hydropower.

Production for 2012FY was expected to be around 90,000 to 100,000 ounces. This will be ramped up to 200,000 ounces per annum by 2014FY after completion of the Co-O mine expansion. Exploration continues at Bananghilig, MML are targeting production of 200,000 per annum at this site by 2016FY. Near future expansion related capital expenditure will be funded from existing cash rather than through capital raisings and debt facilities, which is great and not surprising given their huge operating margins. Having said that, with regards to Bananghilig, no announcement has been made yet regarding whether feasibility studies are to take place, and whether this deposit will go into production phase at all. Further to this, based on current Reserves at Co-O, its mine life is only about 5 years. The risk here is if they are unable to continue replenishing the Resource and Reserve base over the coming years to extend the mine life further. However published analyst research reports are suggesting a possible mine life of over 25 years, indeed a similar mine south of Co-O (Diwalwal) has been mining for 20 years. There is also the risk of political/social instability in this country. MML is targeting 400,000 ounces per annum of production of gold by 2016FY.

Figure 5. Production timetable in ounces (Source: MML AGM Presentation November 2011):

ANALYSIS: SILVER LAKE RESOURCES (ASX:SLR)

SLR is also an un-hedged gold producer that currently operates in 2 key regions of Mount Monger and Murchison in Western Australia, approximately 50km south east of Kalgoorlie.

Figure 6. SLR’s Skaffold Line (Source: Skaffold 6th January 2012):

From the figure above what I can see is that the market price has generally been above the ACTUAL Intrinsic Value, although it appears that a great opportunity to buy would have been at the start of 2011. The ACTUAL Intrinsic Value has increased significantly since then, and looks like rising quite rapidly over the coming few years. Market price reached a peak of $3.87 in December 2011, and in fact SLR was one of the best performing stocks on the ASX for the year, significantly outperforming the S&P ASX 200 Index. However, the market price has since dipped down, and a buying opportunity has once again presented itself! The AVERAGE Intrinsic Value is also rising, but as with MML, the growth here is more conservative. Note that as these two lines become closer together, our confidence in the Intrinsic Value estimate is increased.

SLR currently has 24.1 million tonnes of JORC Resource at grades of 8.9 (g/t) at Mount Monger and 2.8 g/t at Murchison for a total of 3.3 mOz as at June 2011. The company is aiming to build the Resource base for 2012FY to 5 mOz. In the last 2 financial years, they have increased this Resource base by 1 mOz each year. This has been via an extensive drilling programme each year that is part of their long-term exploration budget ($18 million per annum). Total production of gold for 2011FY was 63,425 ounces. Total cash costs for 2011FY were US$674/ounce (includes royalties). The Mount Monger operations are targeting production of 100,000 to 110,000 ounces for 2012FY. The company expects to ramp up production here to 200,000 ounces per annum by 2014, with an expected mine life > 10 years. The Murchison operations will start production in Q3 2013FY, and is expected to produce 100,000 ounces per annum (from 2014FY) with an 8-10 year mine life. Mining at these locations is predominantly underground. Open pit productions have recently commenced at their Wombola Dam site. SLR has also recently reported high-grade copper discoveries at their Hollandaire site within the Eelya Complex that could provide added value. SLR is targeting 300,000 ounces per annum of production of gold by 2014FY.

Figure 7. Production timetable in ounces (Source: SLR AGM Presentation November 2011):

REVENUE, NET PROFIT, CASH FLOW, RETURN ON EQUITY:

Figures 8 & 9. Comparison of Annual Revenue & Reported Net Profit:

Revenue levels for both companies look excellent, but we can clearly see that MML’s net profit figures are significantly larger than SLR’s, and is a reflection of their low operating costs. But as with any business, we need to delve deeper and look at their overall cash flow. With an impending “credit crunch” in 2012, and a degree of caution in the market with equity investing, a healthy cash flow could be essential in order for junior companies to be able to confidently fund their exploration and development activities.

Figure 10. MML Skaffold Cash Flow (Source: Skaffold 30th December 2011):

Figure 11. SLR Skaffold Cash Flow (Source: Skaffold 30th December 2011):

Both companies have rising levels of cash flow from operations (blue line). MML has an overall funding surplus (green line) that is increasing, and has also managed to pay dividends for 2011FY. Whilst at SLR the overall funding surplus is decreasing, to the point that there is now a funding GAP. This suggests that they have used up more cash in investments and financing than they have received directly from their operations. According to Skaffold, money to account for this spending has come from shareholder equity raisings and increased debt or a reduction in the cash at bank (if there is any). Looking at the Skaffold Data Table sheds more light on recent cash movements for each company…

MML generated a net cash flow of $90 million from its operating activities for 2011FY. However, it also spent a net cash flow of $49 million on investment activities, as well as $18 million for dividend payments (un-franked, low payout ratio). Investment activities were predominantly capital expenditure related to exploration, evaluation, and development activities. Despite the large amount of cash flow invested outside operating activities, after taking into account foreign exchange effects and equity capital movements (add ~ $5 million total), the company was able to increase it’s Bank Account balance by $28 million dollars. This left a 2011FY balance of $58 million (UP from $30 million 2010FY). SLR generated a net cash flow of $33 million from its operating activities for 2011FY. It also spent a net cash flow of $46 million on investment activities, clearly more than it’s operating cash flow. This is once again predominantly capital expenditure related to exploration, evaluation, and development activities. Consequently, despite a rise in revenue, net profit, and operating cash flow, the company actually had a net decrease in its Bank Account balance of $13 million, which left the 2011FY balance at $16million (DOWN from $29 million 2010FY).

MML’s last capital raising was in February 2009 for $20 million, about 3 years ago now. SLR’s last capital raising was as recently as November 2011 for $70 million, this was to help develop their Murchison project and accelerate copper exploration activities. Prior to this it had conducted capital raisings of $19 million during 2010FY and $30 million during 2008FY. Although neither company has significant debt, I think this reiterates that MML is in a better cash flow position at this stage. It appears that continued capital raisings have been required by SLR to help meet ongoing investment demands, unfortunately this could dilute shareholder ownership. Even if capital raisings were issued at a price above equity per share, I would prefer if they were able to fund their investments predominantly from existing cash flow.

A LITTLE ABOUT CAPITAL EXPENDITURE:

As I learnt with these examples, gold mining companies spend a great deal of their retained earnings and cash flow on exploring for gold and developing new mines. These expenses do not go immediately into the Income Statement, instead you will see the total expenditure in the Balance Sheet, as an Asset! These companies may have exploration happening at multiple different sites at any one time, if drilling results prove unsatisfactory, or mining is deemed not technically or financially feasible, part of these expenses will be written-down, and will affect future reported Net Profit. Similarly, cumulative exploration and development expenses will become incurred or amortised only once the mine goes into production. All this capital expenditure is not yet generating any profit, yet it adds to the equity. So unless the company is generating sufficiently higher profits each year from the mines that are in production (e.g. by producing more ounces of gold, at a higher average price, or doing it more efficiently), the Return on Equity will decline. From looking at the annual reports, I noted that MML had listed capital expenditure of US$116 million for 2011FY, and SLR A$76 million. Cleary these are highly capital-intensive businesses, though at the very least it gives their competition a high barrier to entry.

RETURN ON EQUITY:

Figure 12. MML Skaffold Capital History (Source: Skaffold 6th January 2012):

Figure 13. SLR Skaffold Capital History (Source: Skaffold 6th January 2012):

The Skaffold Capital History for MML tells me that although its Net Profits (green line) are forecast to rise over from the next few years, the shareholder equity is expected to rise even more, and thus Return on Equity (blue line) is forecast to decline from 45% 2011FY to 33% in 2014FY. Although a Return on Equity of 33% is still excellent. On the other hand, SLR’s Return on Equity is forecast to rise from 19% 2011FY, and remain stable at around 36% until 2014FY. I suspect that a stable Return on Equity is difficult to achieve in this industry given that there are often several projects on the go at different stages, some generating profits and others not, but at the very least the overall returns must always be high.

FINAL COMMENTS:

What attracts me to MML are its high margins and excellent cash flow that should insulate it against any significant changes in the gold price. A number of things may have contributed to the fall in market price, macroeconomic factors aside. Certainly the market price plunge happened not long after a mining fatality in October 2011. This, along with increased development to prepare the Co-O mine for higher production has resulted in lower production guidance for 2012FY. There was also some weather damage from a tropical storm to parts of their mill in December 2011, the scope of the effect on production will be available in the December 2011 Quarterly. Regardless, these are abnormal once-off events that should not impact on the long-term prospects of the company. For me the key is whether the Bananghalig deposit has a large enough Resource base, and whether it will be mined, as this will determine whether MML can grow from a junior to a mid-tier producer.

The advantage that SLR offers is that it already has a second mine that has progressed further in the development phase, and will commence production earlier. Though there are two things that concern me at this stage. The first being the relatively high operating costs that make SLR far more sensitive to gold price volatility. And the second is the company’s cash flow, and in particular its requirement for capital raisings to fund exploration and development activities. Having said that, forecast EPS Growth is 217%, and I expect that this should improve cash flow over the coming few years. Further to this, as with MML, the management team appears to have significant experience behind it, and in SLR’s case I noted that all the Directors hold significant shareholdings in the company, each owning over 4 million fully paid ordinary shares each.

But is either of these companies truly extraordinary? What does this mean? Well Chapter 5 in Value.able tells me that in an extraordinary business I must find the following factors; Bright long-term prospects, high Return on Equity driven by sustainable competitive advantage, solid cash flow, little or no debt, and first-class management. I think that MML comes closest to meeting all these factors, but others might disagree. The key factor for me is having a sustainable competitive advantage. In the Co-O mine they are sitting on a Resource that could last over 25 years, is extraordinarily low in operating cost, and could generate an enormous amount of cash that could easily fund future expansions, and perhaps even acquisitions. In a business that can be highly capital-intensive, the ability to fund exploration and development with cash flow rather than capital raisings and debt is a great advantage. The question mark of course is how sustainable this will be. And of course, I am no Geologist! What I do know is that this is a fundamentally healthy and profitable business, and despite this, the market is significantly undervaluing it. If I were to invest in this business, I would need to accept that there is level of risk involved, but by buying it at a significant margin of safety, and allocating such an investment in a reasonable manner within my portfolio, I think this risk could be significantly reduced.

POD’s (points of discussion):

1. Has gold’s bull run come to an end, or will it rise to new highs?
2. In your opinion, do MML or SLR have any sustainable competitive advantage?
3. What are the benefits/risks of mining in the Philippines versus Australia?

Since writing this post there have been a number of key announcements made by each company. Their share price’s and safety margins have also changed. Most notably, MML has now downgraded its 2012FY production guidance to 75,000 ounces, citing delays due to effects of tropical storms and torrential rain in December 2011 and January 2012. Also, SLR has announced a the acquisition of Phillips River Mining.

LINKS:

Skaffold
www.skaffold.com

World Gold Council
www.gold.org

JORC
www.jorc.org

DISCLOSURE:

I do not hold any shares in any of the companies mentioned in this blog post.

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

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Do BHP Billiton (BHP), Fortescue Metals (FMG), Seek (SEK), Bluescope Steel (BSL), GR Engineering (GNG), CSL (CSL), Peak Resources (PEK), Harvey Norman, (HNN), Buru Energy (BRU), The Reject Shop (TRS), ASG Group (ASZ), Tatts Group (TTS) and  Webject (WEB) make Roger’s coveted A1 grade?  Watch this edition of  Sky Business’ Your Money Your Call broadcast 29 February 2012 to find out.  Watch here.

by Roger Montgomery Posted in Companies, Energy / Resources, Investing Education, TV Appearances, Value.able.

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We are pleased to make the following Announcement. Chris Mackay, Hamish Douglass and I worked patiently to bring this together. I am delighted to see it announced. By way of background, in addition to their roles at Magellan Financial Group, Hamish Douglass is a member of the Foreign Investment Review Board and a member of the Takeovers Panel.  Chris Mackay sits on the Financial Sector Advisory Council that is one of the main conduits of industry insights to the Treasurer and is on the board of James Packer’s Consolidated Media. Thank you.

Posted by Roger Montgomery, Value.able author, Skaffold Chairman and Fund Manager, 29 February 2012.

by Roger Montgomery Posted in Value.able.

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Their is something prescient in the name John Deason and Richard Oates gave to their 1869 gold nugget the ‘Welcome Stranger’ and the one Kevin Hillier gave to his 875 troy ounce find ‘The Hand of Faith’.  Today’s gold price is indeed very welcome to gold bugs and there is plenty of faith needed that prices will rise even further.  But gold bugs have received a terse warning from none other than Warren Buffett who has just released Berkshire’s 2011 letter.  For those of you who believe gold (A.K.A. the barbarous relic) is the best investment you won’t find any more support from Warren this year than any other (with the exception of his 1999 dalliance into silver) . You can find his complete letter here: Berkshire 2011 Annual Report.

Here’s the section on gold:

“The second major category of investments involves assets that will never produce anything, but that are purchased in the buyer’s hope that someone else – who also knows that the assets will be forever unproductive – will pay more for them in the future. Tulips, of all things, briefly became a favorite of such buyers in the 17th century.

This type of investment requires an expanding pool of buyers, who, in turn, are enticed because they believe the buying pool will expand still further. Owners are not inspired by what the asset itself can produce – it will remain lifeless forever – but rather by the belief that others will desire it even more avidly in the future.

The major asset in this category is gold, currently a huge favorite of investors who fear almost all other assets, especially paper money (of whose value, as noted, they are right to be fearful). Gold, however, has two significant shortcomings, being neither of much use nor procreative. True, gold has some industrial and decorative utility, but the demand for these purposes is both limited and incapable of soaking up new production. Meanwhile, if you own one ounce of gold for an eternity, you will still own one ounce at its end.

What motivates most gold purchasers is their belief that the ranks of the fearful will grow. During the past decade that belief has proved correct. Beyond that, the rising price has on its own generated additional buying enthusiasm, attracting purchasers who see the rise as validating an investment thesis.

As “bandwagon” investors join any party, they create their own truth – for a while. Over the past 15 years, both Internet stocks and houses have demonstrated the extraordinary excesses that can be created by combining an initially sensible thesis with well-publicized rising prices. In these bubbles, an army of originally skeptical investors succumbed to the “proof” delivered by the market, and the pool of buyers – for a time – expanded sufficiently to keep the bandwagon rolling. But bubbles blown large enough inevitably pop. And then the old proverb is confirmed once again: “What the wise man does in the beginning, the fool does in the end.”

Today the world’s gold stock is about 170,000 metric tons. If all of this gold were melded together, it would form a cube of about 68 feet per side. (Picture it fitting comfortably within a baseball infield.) At $1,750 per ounce – gold’s price as I write this – its value would be $9.6 trillion. Call this cube pile A. Let’s now create a pile B costing an equal amount. For that, we could buy all U.S. cropland (400 million acres with output of about $200 billion annually), plus 16 Exxon Mobils (the world’s most profitable company, one earning more than $40 billion annually). After these purchases, we would have about $1 trillion left over for walking-around money (no sense feeling strapped after this buying binge).

Can you imagine an investor with $9.6 trillion selecting pile A over pile B? Beyond the staggering valuation given the existing stock of gold, current prices make today’s annual production of gold command about $160 billion. Buyers – whether jewelry and industrial users, frightened individuals, or speculators – must continually absorb this additional supply to merely maintain an equilibrium at present prices.

A century from now the 400 million acres of farmland will have produced staggering amounts of corn, wheat, cotton, and other crops – and will continue to produce that valuable bounty, whatever the currency may be. Exxon Mobil will probably have delivered trillions of dollars in dividends to its owners and will also hold assets worth many more trillions (and, remember, you get 16 Exxons). The 170,000 tons of gold will be unchanged in size and still incapable of producing anything. You can fondle the cube, but it will not respond.

Admittedly, when people a century from now are fearful, it’s likely many will still rush to gold. I’m confident, however, that the $9.6 trillion current valuation of pile A will compound over the century at a rate far inferior to that achieved by pile B.”

Before simply believing Warren WILL be right…There’s this in the annual report as well: “Last year, I told you that “a housing recovery will probably begin within a year or so.” I was dead wrong”

A much older quote that summarizes Buffett’s long-held view is this one “It gets dug out in Africa or some place. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head.”

In my earlier post on this subject HERE, I note; “But I trust you can see the irony in claiming gold is ‘useless’ and yet it can buy [all the agricultural land in the United States, sixteen companies as valuable as Exxon and a trillion dollars in walking-around money].

For those of you who are interested in two alternative perspectives, (assuming the debasing of fiat money across the globe is not enough to encourage you), I thought you might find some of what you need in the following points, and also Warren Buffett’s father’s views. (Note: we only own three or four gold stocks all of which have rising production profiles and do not require ever increasing gold prices to support the returns on equity that justify much higher valuations.  So we aren’t quite in the ‘carried-away’ camp even though some have doubled in price.  This latter development delights us in this market).

And now a short commercial break…

Here are two Skaffold screenshots, each gold stocks we currently own.  If you are a member of Skaffold, you should be able to pick them right away.  If you aren’t a member, what are you waiting for?  Head over to www.skaffold.com and become a member today.

And now back to our regular programming…

From gold’s mouth itself;

Let’s start with the basics of my enduring characteristics. I have some characteristics that no other matter on Earth has…

I cannot be:

Printed (ask a miner how long it takes to find me and dig me up)
Counterfeited (you can try, but a scale will catch it every time)
Inflated (I can’t be reproduced)

I cannot be destroyed by;

Fire (it takes heat at least 1945.4° F. to melt me)
Water (I don’t rust or tarnish)
Time (my coins remain recognizable after a thousand years)

I don’t need:

Feeding (like cattle)
Fertilizer (like corn)
Maintenance (like printing presses)

I have no:

Time limit (most metal is still in existence)
Counterparty risk (remember MF Global?)
Shelf life (I never expire)

As a metal, I am uniquely:

Malleable (I spread without cracking)
Ductile (I stretch without breaking)
Beautiful (just ask an Indian bride)

As money, I am:

Liquid (easily convertible to cash)
Portable (you can conveniently hold $50,000 in one hand)
Divisible (you can use me in tiny fractions)
Consistent (I am the same in any quantity, at any place)
Private (no one has to know you own me)

From an entirely different perspective on gold it may be worth reading the Hon. Howard Buffett.  Congressman Buffett argues that without a redeemable currency, an individual’s freedoms both financial and more broadly is dependent on politicians. He goes on to observe that fiat (paper) money systems tend to collapse eventually, producing economic chaos. His argument that the US should return to the gold standard was not adopted.

Human Freedom Rests of Gold Redeemable Money
Posted Thursday, May 6, 1948

By HON. HOWARD BUFFETT

U. S. Congressman from Nebraska
Reprinted from The Commercial and Financial Chronicle 5/6/48

Is there a connection between Human Freedom and A Gold Redeemable Money? At first glance it would seem that money belongs to the world of economics and human freedom to the political sphere.

But when you recall that one of the first moves by Lenin, Mussolini and Hitler was to outlaw individual ownership of gold, you begin to sense that there may be some connection between money, redeemable in gold, and the rare prize known as human liberty.

Also, when you find that Lenin declared and demonstrated that a sure way to overturn the existing social order and bring about communism was by printing press paper money, then again you are impressed with the possibility of a relationship between a gold-backed money and human freedom.

In that case then certainly you and I as Americans should know the connection. We must find it even if money is a difficult and tricky subject. I suppose that if most people were asked for their views on money the almost universal answer would be that they didn’t have enough of it.

In a free country the monetary unit rests upon a fixed foundation of gold or gold and silver independent of the ruling politicians. Our dollar was that kind of money before 1933. Under that system paper currency is redeemable for a certain weight of gold, at the free option and choice of the holder of paper money.

Redemption Right Insures Stability
That redemption right gives money a large degree of stability. The owner of such gold redeemable currency has economic independence. He can move around either within or without his country because his money holdings have accepted value anywhere.

For example, I hold here what is called a $20 gold piece. Before 1933, if you possessed paper money you could exchange it at your option for gold coin. This gold coin had a recognizable and definite value all over the world. It does so today. In most countries of the world this gold piece, if you have enough of them, will give you much independence. But today the ownership of such gold pieces as money in this country, Russia, and all divers other places is outlawed.

The subject of a Hitler or a Stalin is a serf by the mere fact that his money can be called in and depreciated at the whim of his rulers. That actually happened in Russia a few months ago, when the Russian people, holding cash, had to turn it in — 10 old rubles and receive back one new ruble.

I hold here a small packet of this second kind of money – printing press paper money — technically known as fiat money because its value is arbitrarily fixed by rulers or statute. The amount of this money in numerals is very large. This little packet amounts to CNC $680,000. It cost me $5 at regular exchange rates. I understand I got clipped on the deal. I could have gotten $2½ million if I had purchased in the black market. But you can readily see that this Chinese money, which is a fine grade of paper money, gives the individual who owns it no independence, because it has no redemptive value.

Under such conditions the individual citizen is deprived of freedom of movement. He is prevented from laying away purchasing power for the future. He becomes dependent upon the goodwill of the politicians for his daily bread. Unless he lives on land that will sustain him, freedom for him does not exist.
You have heard a lot of oratory on inflation from politicians in both parties. Actually that oratory and the inflation maneuvering around here are mostly sly efforts designed to lay the blame on the other party’s doorstep. All our politicians regularly announce their intention to stop inflation. I believe I can show that until they move to restore your right to own gold that talk is hogwash.

Paper Systems End in Collapse
But first let me clear away a bit of underbrush. I will not take time to review the history of paper money experiments. So far as I can discover, paper money systems have always wound up with collapse and economic chaos.
Here somebody might like to interrupt and ask if we are not now on the gold standard. That is true, internationally, but not domestically. Even though there is a lot of gold buried down at Fort Knox, that gold is not subject to demand by American citizens. It could all be shipped out of this country without the people having any chance to prevent it. That is not probable in the near future, for a small trickle of gold is still coming in. But it can happen in the future. This gold is temporarily and theoretically partial security for our paper currency. But in reality it is not.

Also, currently, we are enjoying a large surplus in tax revenues, but this happy condition is only a phenomenon of postwar inflation and our global WPA. It cannot be relied upon as an accurate gauge of our financial condition. So we should disregard the current flush treasury in considering this problem.

From 1930-1946 your government went into the red every year and the debt steadily mounted. Various plans have been proposed to reverse this spiral of debt. One is that a fixed amount of tax revenue each year would go for debt reduction. Another is that Congress be prohibited by statute from appropriating more than anticipated revenues in peacetime. Still another is that 10% of the taxes be set aside each year for debt reduction.
All of these proposals look good. But they are unrealistic under our paper money system. They will not stand against postwar spending pressures. The accuracy of this conclusion has already been demonstrated.

The Budget and Paper Money
Under the streamlining Act passed by Congress in 1946, the Senate and the House were required to fix a maximum budget each year. In 1947 the Senate and the House could not reach an agreement on this maximum budget so that the law was ignored.

On March 4 this year the House and Senate agreed on a budget of $37½ billion. Appropriations already passed or on the docket will most certainly take expenditures past the $40 billion mark. The statute providing for a maximum budget has fallen by the wayside even in the first two years it has been operating and in a period of prosperity.

There is only one way that these spending pressures can be halted, and that is to restore the final decision on public spending to the producers of the nation. The producers of wealth — taxpayers — must regain their right to obtain gold in exchange for the fruits of their labor. This restoration would give the people the final say-so on governmental spending, and would enable wealth producers to control the issuance of paper money and bonds.

I do not ask you to accept this contention outright. But if you look at the political facts of life, I think you will agree that this action is the only genuine cure. There is a parallel between business and politics which quickly illustrates the weakness in political control of money.

Each of you is in business to make profits. If your firm does not make profits, it goes out of business. If I were to bring a product to you and say, this item is splendid for your customers, but you would have to sell it without profit, or even at a loss that would put you out of business. — well, I would get thrown out of your office, perhaps politely, but certainly quickly. Your business must have profits.

In politics votes have a similar vital importance to an elected official. That situation is not ideal, but it exists, probably because generally no one gives up power willingly.

Perhaps you are right now saying to yourself: “That’s just what I have always thought. The politicians are thinking of votes when they ought to think about the future of the country. What we need is a Congress with some ‘guts.’ If we elected a Congress with intestinal fortitude, it would stop the spending all right!”

I went to Washington with exactly that hope and belief. But I have had to discard it as unrealistic. Why? Because an economy Congressman under our printingpress money system is in the position of a fireman running into a burning building with a hose that is not connected with the water plug. His courage may be commendable, but he is not hooked up right at the other end of the line. So it is now with a Congressman working for economy. There is no sustained hookup with the taxpayers to give him strength.

When the people’s right to restrain public spending by demanding gold coin was taken from them, the automatic flow of strength from the grass-roots to enforce economy in Washington was disconnected. I’ll come back to this later.

In January you heard the President’s message to Congress or at least you heard about it. It made Harry Hopkins, in memory, look like Old Scrooge himself.
Truman’s State of the Union message was “pie-in-the-sky” for everybody except business. These promises were to be expected under our paper currency system. Why? Because his continuance in office depends upon pleasing a majority of the pressure groups.

Before you judge him too harshly for that performance, let us speculate on his thinking. Certainly he can persuade himself that the Republicans would do the same thing if they were In power. Already he has characterized our talk of economy as “just conversation.” To date we have been proving him right. Neither the President nor the Republican Congress is under real compulsion to cut Federal spending. And so neither one does so, and the people are largely helpless.

But it was not always this way.
Before 1933 the people themselves had an effective way to demand economy. Before 1933, whenever the people became disturbed over Federal spending, they could go to the banks, redeem their paper currency in gold, and wait for common sense to return to Washington.

Raids on Treasury
That happened on various occasions and conditions sometimes became strained, but nothing occurred like the ultimate consequences of paper money inflation.
Today Congress is constantly besieged by minority groups seeking benefits from the public treasury. Often these groups. control enough votes in many Congressional districts to change the outcome of elections. And so Congressmen find it difficult to persuade themselves not to give in to pressure groups. With no bad immediate consequence it becomes expedient to accede to a spending demand. The Treasury is seemingly inexhaustible. Besides the unorganized taxpayers back home may not notice this particular expenditure — and so it goes.

Let’s take a quick look at just the payroll pressure elements. On June 30, 1932, there were 2,196,151 people receiving regular monthly checks from the Federal Treasury. On June 30, 1947, this number had risen to the fantastic total of 14,416,393 persons.

This 14½ million figure does not include about 2 million receiving either unemployment benefits of soil conservation checks. However, it includes about 2 million GI’s getting schooling or on-the-job-training. Excluding them, the total is about 12½ million or 500% more than in 1932. If each beneficiary accounted for four votes (and only half exhibited this payroll allegiance response) this group would account for 25 million votes, almost by itself enough votes to win any national election.

Besides these direct payroll voters, there are a large number of State, county and local employees whose compensation in part comes from Federal subsidies and grants-in-aid.

Then there are many other kinds of pressure groups. There are businesses that are being enriched by national defense spending and foreign handouts. These firms, because of the money they can spend on propaganda, may be the most dangerous of all.

If the Marshall Plan meant $100 million worth of profitable business for your firm, wouldn’t you Invest a few thousands or so to successfully propagandize for the Marshall Plan? And if you were a foreign government, getting billions, perhaps you could persuade your prospective suppliers here to lend a hand in putting that deal through Congress.

Taxpayer the Forgotten Man
Far away from Congress is the real forgotten man, the taxpayer who foots the bill. He is in a different spot from the tax-eater or the business that makes millions from spending schemes. He cannot afford to spend his time trying to oppose Federal expenditures. He has to earn his own living and carry the burden of taxes as well.

But for most beneficiaries a Federal paycheck soon becomes vital in his life. He usually will spend his full energies if necessary to hang onto this income.
The taxpayer is completely outmatched in such an unequal contest. Always heretofore he possessed an equalizer. If government finances weren’t run according to his idea of soundness he had an individual right to protect himself by obtaining gold.

With a restoration of the gold standard, Congress would have to again resist handouts. That would work this way. If Congress seemed receptive to reckless spending schemes, depositors’ demands over the country for gold would soon become serious. That alarm in turn would quickly be reflected in the halls of Congress. The legislators would learn from the banks back home and from the Treasury officials that confidence in the Treasury was endangered.

Congress would be forced to confront spending demands with firmness. The gold standard acted as a silent watchdog to prevent unlimited public spending.

I have only briefly outlined the inability of Congress to resist spending pressures during periods of prosperity. What Congress would do when a depression comes is a question I leave to your imagination. I have not time to portray the end of the road of all paper money experiments.

It is worse than just the high prices that you have heard about. Monetary chaos was followed in Germany by a Hitler; in Russia by all-out Bolshevism; and in other nations by more or less tyranny. It can take a nation to communism without external influences. Suppose the frugal savings of the humble people of America continue to deteriorate in the next 10 years as they have in the past 10 years? Some day the people will almost certainly flock to “a man on horseback” who says he will stop inflation by price-fixing, wage-fixing, and rationing. When currency loses its exchange value the processes of production and distribution are demoralized.

For example, we still have rent-fixing and rental housing remains a desperate situation.

For a long time shrewd people have been quietly hoarding tangibles in one way or another. Eventually, this individual movement into tangibles will become a general stampede unless corrective action comes soon.

Is Time Propitious
Most opponents of free coinage of gold admit that that restoration is essential, but claim the time is not propitious. Some argue that there would be a scramble for gold and our enormous gold reserves would soon be exhausted.

Actually this argument simply points up the case. If there is so little confidence in our currency that restoration of gold coin would cause our gold stocks to disappear, then we must act promptly.

The danger was recently highlighted by Mr. Allan Sproul, President of the Federal Reserve Bank of New York, who said:
“Without our support (the Federal Reserve System), under present conditions, almost any sale of government bonds, undertaken for whatever purpose, laudable or otherwise, would be likely to find an almost bottomless market on the first day support was withdrawn.”

Our finances will never be brought into order until Congress is compelled to do so. Making our money redeemable in gold will create this compulsion.
The paper money disease has been a pleasant habit thus far and will not he dropped voluntarily any more than a dope user will without a struggle give up narcotics. But in each case the end of the road is not a desirable prospect.

I can find no evidence to support a hope that our fiat paper money venture will fare better ultimately than such experiments in other lands. Because of our economic strength the paper money disease here may take many years to run its course.

But we can be approaching the critical stage. When that day arrives, our political rulers will probably find that foreign war and ruthless regimentation is the cunning alternative to domestic strife. That was the way out for the paper-money economy of Hitler and others.

In these remarks I have only touched the high points of this problem. I hope that I have given you enough information to challenge you to make a serious study of it.

I warn you that politicians of both parties will oppose the restoration of gold, although they may outwardly seemingly favor it. Also those elements here and abroad who are getting rich from the continued American inflation will oppose a return to sound money. You must be prepared to meet their opposition intelligently and vigorously. They have had 15 years of unbroken victory.
But, unless you are willing to surrender your children and your country to galloping inflation, war and slavery, then this cause demands your support. For if human liberty is to survive in America, we must win the battle to restore honest money.

There is no more important challenge facing us than this issue — the restoration of your freedom to secure gold in exchange for the fruits of your labors.
I am internationally accepted, last for thousands of years, and probably most important, you can’t make any more of me.”

Posted by Roger Montgomery, Value.able author, Skaffold Chairman and Fund Manager, 26 February 2012.

by Roger Montgomery Posted in Energy / Resources, Insightful Insights, Skaffold, Value.able.

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We all know retail businesses are swimming against the tide. We have written about that subject here at the blog on many occasions and below is a brief list of more recent posts:

We are not investors in momentum or sentiment however this blog allows me to share our thoughts with you and we are noticing a shift in investor sentiment now. The stock market indices with exposure to resources are underperforming the indices without. The industrial indices are rising at a faster rate and falling at a slower rate than their resource-rich bretheren.  Today is a classic example, This tells us that a shift is afoot. If you have been reading this blog regularly, you will know that we are also not enthusiastic about Iron Ore prices and believe prices of $100 per tonne or less are possible in coming years.  On air, I have explained that is our reason for not purchasing BHP despite optimistic earnings forecasts by analysts.

I think the lower-iron-ore price story is catching on and quietly but surely investors are reducing their relative weighting to resource heavyweights.

With that in mind, it could be that most down-in-the-dumps retail sector that now holds a few gems. Next week we’ll explore the results of the reporting season but for today I thought we should revisit The Reject SHop following its half year results.

Here’s the list of recent posts covering retail stocks and the retail sector.

http://rogermontgomery.com/invest-in-kfc-or-just-eat-it/
http://rogermontgomery.com/is-it-just-harvey-norman-or-bricks-mortar-retailing-generally/
http://rogermontgomery.com/are-bargains-available-at-woolworths/
http://rogermontgomery.com/now-waving-drowning/
http://rogermontgomery.com/not-so-high-at-jb-hi-fi/
http://rogermontgomery.com/dumped-by-the-wave-of-fashion/

Way back in September 2009, I published my reason for selling 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.”

Like many value investors, I was a little premature and the price first rallied to more than $17.00.  Since then the price has steadily declined to $11.80 after hitting a low of $9.12.

More recently – in December – I wrote:

“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.”

Value investors are often early to buy and early to sell but over the long run, being certain of a good return is safer than being hopeful of an exceptional one and so, when it comes to buying decisions a demonstrated record is often essential.

In TRS’s FY12 earnings guidance, the company noted “Significant expenditure on increasing brand awareness”.  This is a real shame because at the time the company float The Reject Shop enjoyed 90% brand recognition and thats why its store roll out was working so well – shoppers knew the company, the store and the offer even though they had never been into a store in their area.

The company has provided earnings guidance for the full year 2012 of $20.5 to $22 million and while some smart analysts will note this is a 53 week year – we don’t care about such arbitrary lines in the sand.  Our approach to investing is involves treating any purchase and ownership as if we owned the whole company.  In that light and over the long term it doesn’t matter whether there are 52 weeks in a year or 52.5 or 53.

Thirteen analysts cover the stock and this week, eight have upgraded (only one downgraded) their forecasts for 2012 (remember the downgrade could be an error on the part of teh analyst rather than the company disappointing) .  I still believe the business will mature but there could be some value in the turnaround and a stabilisation of strong cash flows, and returns on equity over the next few years around 35%.  This is the rate of return on equity the company generated on $21 million of equity in 2005 (its intrinsic value then was around $4.00).  Today the company is expected to return to 35% returns on equity but on 3 times the equity.  You should be able to estimate the intrinsic value from those metrics.

There have been terrific results amongst our fund holdings such as Credit Corp, Seek, Breville Group, ARB, Decmil and Maca.  Have you been encouraged by any of the results?  Start a discussion by clicking on the Comments button below.

Posted by Roger Montgomery, Value.able author, Skaffold Chairman and Fund Manager, 24 February 2012.

by Roger Montgomery Posted in Companies, Consumer discretionary, Value.able.

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Bloomberg:

Biography: While Walter Schloss’s name is not nearly as ubiquitous as Warren Buffett, Schloss was arguably one of the best investors ever. Like Buffett, Schloss was a student of Ben Graham, worked at Graham’s firm with Buffett , and is one of ” Super Investors” mentioned by Buffett in his famous essay The Super Investors of Graham-And-Doddsville.

Here’s a table of Schloss’s returns to 1984.

Walter Schloss was born in 1916. At 18 years old he worked as a Wall Street runner for on Wall Street. While he didn’t attend college he enrolled in several classes given by legendary investor Benjamin Graham. Schloss eventually went to work for the Graham-Newton Partnership. In 1955 Schloss launched his own value fund. He ran the fund until 2000.

Schloss was reportedly very frugal. In one year, legend has it that his total office expense was $11,000 while his partnership generated a net profit of $19,000,000.

Schloss stopped actively managing other people’s money in 2003 and was a treasurer for the Freedom House a non-profit group devoted to furthering democracy, and human rights.

Over the 45 years Schloss managed his fund he trounced the S&P 500 by producing returns of 15.3% versus 10% for the S&P 500. A $10,000 initial investment in Schloss’s fund would have grown to $12,344,268, compared to an initial investment of $10,000 in the S&P 500 which would have produced $1,173,909.

Farewell and Thank You.

Posted by Roger Montgomery, Value.able and Skaffoldauthor and Fund Manager, 21 February 2012.

by Roger Montgomery Posted in Investing Education.

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Following on from our comment yesterday about BHP and comments in the media explaining why we weren’t buyers of BHP or RIO (falling Iron Ore prices and a contracted customer (28% of RIO’s revenue last year) who won’t honor contracts), we are interested in the flow of information through the week.

First the RBA held off cutting rates.  Did they know that China would soon be exporting inflation (cost pressures there)?  Then the next day China reported…guess what….the biggest jump in inflation…so forget about rate cuts there to help out US and Euro exports?

And now we are hearing that over at RIO a freeze has been placed on contractors and recruitment. Read; “massive overspend / cost inflation”.

Today Bloomberg quoted an analyst on China:  “Domestic demand was genuinely weak in January, while exports remained on a gradual downward trend,” said Yao Wei, a Hong Kong-based economist for Societe Generale SA.  And “Tom Albanese, chief executive officer of Rio Tinto Group, said yesterday he remains confident of a so-called soft landing in China…  Inflation (CNCPIYOY) accelerated last month for the first time since July as food prices climbed before the holiday that started Jan. 22, a statistics bureau report showed yesterday. An index of export orders in the agency’s survey of manufacturing purchasing managers released last week showed a contraction for the fourth straight month.  The IMF said in a Feb. 6 report that China’s economic expansion may be cut almost in half from its 8.2 percent estimate this year if Europe’s debt crisis worsens, a scenario that would warrant “significant” fiscal stimulus from the government.(See my postscript).

17/2/2012 PostScript:  An analyst we regard highly wrote this to us today:

“On this recent visit, our wise counselor forecast China’s growth rate will be in therange of 8 to 9% in 2012—assuming no major external shocks. Inflationary pressurewill be lower this year than last, especially in the first half of the year. The inflation ratein China for the entire year will be lower than 4%. Low inflation will allow thegovernment to deregulate prices—water, natural gas, and power.Our trusted counselor believes that export markets cannot be counted on to deliver thegrowth that China needs in 2012. Likewise, domestic consumption, while on the rise as apercentage of GDP, is hard to stimulate quickly. Therefore, the only remaining option to preventChinese economic growth from slowing is for the government to use investment as a stimulus.”

Here’s a quick view from Skaffold of RIO.  To become a Skaffold member and enjoy having every stock in the Australian market quality rated and valued and all valuations and data automatically updated for every company every day CLICK HERE

Posted by Roger Montgomery, Value.able and Skaffoldauthor and Fund Manager, 10 February 2012.

by Roger Montgomery Posted in Energy / Resources, Insightful Insights, Manufacturing.

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There has been a bit of action on the IPO front over the past few months. Sixteen stocks have been added to the main board of the ASX, as set out below with their actual listing date.

I thought it might be a worthwhile task to run the ruler over them and see if any are potential investment candidates among the newcomers.

Let’s start our exercise at the more speculative end of the investment spectrum. I don’t gamble with money, so let’s eliminate those that are involved in exploration activities given their high risk/high reward dynamics. There are 12 exploration businesses among this group. I will leave these to others who are more suitably qualified in working out whether any opportunities exist here and whether they will find something before their cash runs out.

Of those remaining, well-known NZ website Trade Me and RXP Services are involved broadly in the IT space, Alliance Aviation is involved in mining services and finally Chorus, another NZ company, specialises in Telecommunications. These are the four businesses we will focus on. A brief review of these follows.

Alliance Airlines (AQZ)

I will start with a sector I know well – airlines. A capital intensive industry with lots of competition rarely makes for wonderful business economics (Qantas, Virgin) and despite Alliance operating in a niche market of fly-in, fly-out operations for the mining sector, my view remains the same: I will never invest a dollar into this sector.

Alliance has grown quickly since its formation in late 2002. From nothing, to a fleet of 20 Fokker 100 and Fokker 70LR jets as well as five Fokker 50 turboprops with established, long-term, profitable blue-chip relationships with BHP Billiton, Santos, Incitec Pivot, and Newcrest. That’s an outstanding achievement by management. A distinguishing feature is that approximately 75% of Alliance’s 2010-11 revenue was subject to medium to long-term contracts – recurring revenues.

No matter. Any airline cannot escape competition or its high level of ongoing capital requirements. And for a niche space, four other competitors (Cobham, Network aviation, Qantaslink, Skywest) appear to be a handful in terms of the prices they can charge, competition for future contracts (especially when 44% of 2010-11 revenue was from one client, BHP), ongoing operating margins and future market share gains.

A total 47.6% of Alliance’s forecast for 2011-12 EBITDA will be consumed on refurbishments, maintenance, rotables, new aircraft and property, plant and equipment. This leaves just over 50% to pay taxes, interest and for working capital requirements. And once all is paid for, only a little will be left over for future dividends, buybacks, etc. It is not surprising, therefore, that the prospectus does not forecast a dividend to be paid in 2012.

Despite a pro-forma forecast of $18.1 million NPAT, or 20.1¢ earnings per share, and the shares trading below what the business may be worth, if you ever see me buying an airline, please put me in a straitjacket.

RXP Services (RXP)

Unfortunately, this business has a very, very short history and no real track record. It was formed in October 2010, just 15 months ago, with the purpose of establishing an information & communications technology (ICT) business with a focus on medium/large enterprises and the government.

The founders have done this, but with one drawback. Rather than building a business organically, the purpose of the float was mainly to raise funds to acquire two unlisted businesses in Vanguard and Indigo Pacific. The rollup of these has seen RXP service capabilities expand overnight from nothing into a broad range of management, business and ICT consulting, delivery and support services.

With a number of already listed ICT businesses already competing for market share – SMX, CSG, OKN, many of which have had a chequered operating history as listed entities – the space appears to be a little crowded. I can’t see how RXP will differentiate a commodity product offering.

And turning to its financials, despite the consolidated accounts in the prospectus showing how the businesses may have looked had Vanguard and Indigo been owned in the past, they weren’t; what we see is what would have been a profitable little businesses. But as we have little to go on as to how they will actually function together going forward under new stewardship, we will watch this one from the sidelines for now.

Chorus (CNU)

Chorus is a spin-out from Telecom New Zealand. It is New Zealand’s largest telecommunications utility company, a technical way to describe a business that builds, maintains and repairs existing phone and broadband lines.

Following the demerger, Chorus is a business whose sole focus is on bringing fibre within reach to as many New Zealanders as possible – kind of like our own NBN Co., but not run by the government, even if it has been chosen by the Crown to build NZ’s ultra-fast broadband (UFB) network to 830,000 urban premises, as well as extend fibre further into rural New Zealand through the Rural Broadband Initiative (RBI) by the end of 2019.

Having so far deployed some 2500 kilometres of fibre optic cable, upgraded hundreds of local telephone exchanges with new broadband equipment and installed or upgraded about 3600 roadside cabinets, a target of 20,000 kilometres of fibre optic cable to deliver ultra-fast broadband will probably be met. Management’s recent experience in rolling-out ADSL2+ broadband is coming in very handy and helping to build New Zealand’s fibre future.

There are some obvious tailwinds here, with the long-term nature of this contract and ratings agency Moody’s has assigned Chorus a Baa2, stable issuer and senior unsecured rating. A rating similar to Bulgaria and Kraft foods.

Look under the hood, however, and you can see that about $NZ1.7 billion of net interest bearing debt was outstanding as at December 2011, all current. On just $NZ422 million of equity, it appears that Telecom New Zealand may have also let go of some unwanted baggage in the de-merger.

While 2011 cash flows appear to be well managed and interest payments well covered, I can’t help but be reminded of another infrastructure asset in Asiano when it was demerged from Toll holdings in 2007. It too was saddled with a large debt burden and at the end of its first trading day; Asciano had a market capitalisation of $7 billion. Today it is $4.5 billion.

Trade Me (TME)

Last but not least is the well-known NZ website Trade Me. Similar to eBay international, Trade Me is now dual-listed on both the New Zealand and Australian Stock Exchange.

While this is another spin-off, Fairfax Media Limited (ASX:FFX, SQR B3) has retained a shareholding of 66% – generally a good sign.

On one reading this might be the pick of the recent floats. The business has an  moderately geared balance sheet, produces a significant amount of free cash with low levels of ongoing capital expenditure now that the website is mature and has a history of earnings growth which any shareholder, and that includes Fairfax, would be truly happy with. On top of this, with Fairfax retaining a material level of ownership in the business, they are still highly incentivised to continue promoting the website via its vast media network.

On another reading Fairfax paid $750mill for Trade Me (TME) and have just sold 34% of it for $363.5 mill or a total ‘value’ of $1.07Bln.  This will help them justify the carrying value on their own balance sheet.  Further, since 2007 TradeMe has made net profits totalling $276mill, the bulk of which has been taken out as dividends.  So FFX have made an IRR of about 17% per annum.  Given FFX have set up the company with market cap of about $1 billion, equity of $631 mill ($721 mill goodwill and therefore negative NTA) and debt of $164 mill, the expected return on equity is just over 10 per cent means FFX have got a return that you might not.

Posted by Roger Montgomery, Value.able and Skaffold author and Fund Manager, 6 February 2012.

by Roger Montgomery Posted in Investing Education.

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