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Tatts Group’s purchase of NSW Lotteries could reduce its intrinsic value. A lottery ticket might be a better investment. Read Roger’s article at eurekareport.com.au.

by Roger Montgomery Posted in Media Room, On the Internet.

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Heading into Easter, I received an enormous pile of valuation requests and while many were little mining explorers burning through $500,000 of cash per month and with just $3 million in the bank, quite a few were solid companies that hadn’t been covered before.

And to confess, some of the requests were quite rightly keeping me accountable and making sure I post the company valuations I said I would, when I have appeared on Sky Business with either Nina May, Ricardo Goncalves and Peter Switzer.

What are they, I hear you ask? Forge Group (FGE), Grange Resources (GRR), Arrow Energy (AOE), Cabcharge (CAB), Coca Cola (CCL), Data 3 (DTL), Hutchison (HTA), Incitec Pivot (IPL), Metcash (MTS), Sedgeman (SDM) and UXC (UXC)

I am really impressed by the frequency with which I am now receiving emails containing insights I didn’t know about companies that I have covered.

As a fund manager it was not unusual for me to adopt Phil Fisher’s ‘scuttlebutt’ approach to investing. By way of background, Warren Buffett has previously described his approach to investing as 85 per cent Ben Graham and 15 per cent Phil Fisher. Fisher advocated scuttlebutt – talking to staff, to customers and to competitors.  I did the same and would often end my interview of a company’s CEO or CFO with I’d learned from reading Lynch; “if I handed you a gun with one silver bullet, which one of your competitors would you get rid of?” The answers were always revealing. Sometimes I would get; “there’s noone worth wasting a silver bullet on”, but most of the time, I would find out a lot more about the competitive landscape than I had bargained for. Occasionally, I would learn that there was another company I really should be researching.

Back to your insights, they are amazing. Now you know why I enjoy sharing my own insights and valuations with you as much as I enjoy the process of investing.

One thought for you; Many of you are sending your best work via email. I would really like to see everyone benefit from the knowledge and experiences you all have so hit reply and if you have some insights (as opposed to an opinion), just click on ‘REPLY’ at the bottom of this post and leave as much information as you would like.

So here are a few more valuations to ponder over Easter. I hope they add another dimension to your research. And before you go calling me about coal seam gas hopeful Arrow Energy, note that the valuation is a 2009 valuation based on actual results. The forecasts for Arrow for the next two years are for losses, and using my model, a company earning nothing is worth nothing. Of course Royal Dutch Shell and Petro China think its worth more and perhaps to them it is, but as a going concern its worth a lot less for some time to a passive investor.

I hope you are enjoying the Easter break and look forward to reading and replying to your insights.

Posted by Roger Montgomery, 1 April 2010

by Roger Montgomery Posted in Companies, Consumer discretionary, Health Care, Insightful Insights.

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I am guessing from the many emails I received this week about healthcare stocks that the quantity may have something to do with the sector being in the headlines (remember it is an election year)?

Government numbers show that spending on healthcare is expected to nearly double as a proportion of GDP over the next 40 years. With fewer babies being born and people living longer, it is inevitable that the population is ageing. In the next thirty years, the proportion of the population aged over 65 will double to 22% and in the next forty years, the number of Australian’s aged 85 and over is expected to increase from 1.8% of the population to 5.1%.

Government estimates show that this will exact a heavy toll on the cost of providing health and the following chart reveals where those costs for the government and opportunities for healthcare companies lie.

Using government estimates for GDP growth, the above charts suggests the government will spend $38 billion on medicare and $68 billion on the PBS in 2040. Figures such as these have provided the large community of buy-and-hold investors with a sound investment theme to pursue. But in some cases this theme has led to some extremely irrational pricing, as we will discover.

There are more than 20 healthcare stocks listed on the ASX that essentially fall into two categories.

1. The provision of care and related services. This can mean pathology companies such as Sonic Healthcare, private hospitals such as Ramsay Healthcare, and providers of specialist ancillary services, such as software provider iSoft.

2. Research and development. This can mean companies that produce generic pharmaceuticals, such as Sigma, or research into and development of cancer drugs, such as Sirtex.

Like another exploratory industry, the mining sector, the size of these companies can vary from the very small, such as Capitol Health with a market cap of just $15 million, to global blood products and plasma giant CSL, which has a market cap of about $20 billion.

The ideal combination of characteristics for a healthcare company that an investor would seek out is no different to those that should be sought more generally; a very high quality balance sheet, stable performance, a high Return on Equity, little or no debt and a discount to intrinsic value.

So what do I think are the superior businesses? Following is a table of my findings.

Using a combination of 15 financial hurdles, I note that the best quality companies, but not necessarily the cheapest in the sector, are CSL, Cochlear, Sirtex, Biota and Blackmores.

Do you see that Search box to the right, just under my photo? You will need to scroll up. Type CSL, Cochlear or Blackmores into the box and click GO to read my past insights. And if your appetite remains unsatisfied, visit my YouTube channel, youtube.com/rogerjmontgomery, and search there too (there are many videos in which I talk about CSL and Cochlear).

I should point out that each of the remaining three – Sirtex, Biota and Blackmores – are generating high Returns on Equity and has manageable or no debt.

The lowest ranked by quality are Primary Healthcare, Sigma, Australian Pharmaceuticals and Vision Group. I won’t be buying these at any price and their Returns on Equity are less than those available from a risk-free term deposit.

Alchemia, which manufactures a generic treatment for deep vein thrombosis and pulmonary embolism, Phosphagenics, with its patented transdermal insulin delivery system, and Capitol Health are also low in terms of quality and also highly speculative because they are yet to report profits. Analysts, however, are forecasting profits for all three in 2011 and 2012 and Alchemia is forecast to earn more than 30% Returns on Equity after a loss in 2010.

In between this group are companies whose quality is neither compelling nor frightening; these are businesses that if I was forced to by I might only if very large discounts to intrinsic value were presented and in some cases, only if I was happy to speculate – which generally I am not. Sonic, Ramsay (search RHC for more analysis), iSoft, Pro Medicus, Healthscope, Halcygen Pharmaceuticals, ChemGenex, Acrux and SDI fall into this band.

I have ranked all of the healthcare companies by their safety margin: a measure of their discount or premium to the current year’s intrinsic value. This reveals that some companies are trading at discounts to intrinsic value. As an investor you need to be satisfied that the companies you choose also meet your quality criteria, which should mimic your tolerance for risk.

Take a close look at Biota, for example. Its price of $2.38 is significantly lower than the estimated intrinsic value, however you will also see that the return on equity is forecast to fall from 50% to 11%. There will be a commensurate decline in intrinsic value in coming years and the apparent discount will no longer exist, meaning that unless return on equity improves considerably in a few years it will cease to be a good investment.

If my portfolio approach were to include some exposure to healthcare then my first choices would be CSL and Cochlear. These are both well managed, large-cap businesses with stable returns on equity and zero or low levels of gearing.

My next preferred exposure would be pathology and radiology operator Sonic, alternative medicine distributor Blackmores, and liver cancer treatment marketer Sirtex

Finally, if I was comfortable speculating on stocks then the companies I would seek to conduct further research on would be the two pharmaceutical minnows, Halcygen and cancer drug developer Chemgenex. Both companies are forecast to generate attractive rates of return on equity in 2011 and 2012 and have little or no debt. Halcygen is also currently trading at a discount to its estimated intrinsic value.

REMEMBER… Before making any investment decisions, my comments should only be seen as an additional opinion to the essential requirement to conduct your own research and see a qualified financial professional.

Everyone is capable of being terrific investors, you just need to remember that there is serious work to be done by YOU in the business of investing.

Posted by Roger Montgomery, 25 March 2010

by Roger Montgomery Posted in Companies, Health Care.

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The requests for valuations and insights have been coming in thick and fast, and I have to confess to being a little surprised. The vast majority of requests have been for great quality businesses, some of them even the ‘A1’ companies that I alluded to on the Sky Business Channel a few weeks ago (the highlights will be on my YouTube channel in the next week or so).

If you have sent me an email requesting my insights and valuation for a particular business, thank you. You have uncovered some really interesting stories.

Lloyd, who was kind enough to drive me to the airport following my ASX Investor Hour presentation in Perth last November, suggested one such company to me, Forge Group Limited (FGE). At the time, FGE was trading at a bit more than a dollar.

If my memory serves me correctly, Lloyd bought the stock around 30 cents. I looked at it, ran it through my models and liked it a lot. For a tiny little company it was a true A1 – very high quality on all counts. It had also doubled its profits a few times.

Today it trades at $2.82 and has received a bid for 50% from Clough Limited. They have a hide! This company is potentially worth a great deal more, but don’t take my word for it – remember that you should see my view as just one more opinion, should always conduct your own valuations and research, and if necessary, seek independent advice from someone familiar with your financial circumstances and needs.

If you asked me to value a particular business, and there have been a few requests, I would have explained that I will do my best to post a valuation up as soon as possible but those companies that received the most requests would be posted first.

So here are my insights, and valuations, for the most popular businesses, as requested by you over recent weeks and even months.

Electrical contractor, Southern Cross Electrical Engineering Ltd (SXE)

Prior to its capital raising and downgrade, SXE was expected to generate Returns on Equity in excess of 37% in 2010 and 30% in 2012. Recent events however are likely to see these numbers fall to 22% and 27% respectively. The value today is 96 cents and lower than the current price, however the value next year, if it can earn the new forecast numbers, will be higher than the current price. You need to satisfy yourself that the revised expectations are indeed achievable.

Pawn shop chain (and commercial microfinance operator), Cash Converters International (CCV)

There has been a lot of interest in Cash Converters. I have seen these stores and while I cannot see them becoming a retailing powerhouse like a JB Hi-Fi or even The Reject Shop, that may not be the company’s intention. More than 2/3rds of reported profits are generated from secured and unsecured small personal loans that are distributed by a network of 509 second hand goods stores.  CCV has the metrics of an attractive business indeed its an “A” class stock, but scale is the issue.  Just how big can they ever be?  If we remember that we want a) Big Equity and b) Big Returns on Equity, then I can see the big returns on equity but Big Equity may be someway off.

The value of CCV today however is 74 cents – about ten cents higher than the current price, and based on current estimates is worth 93 cents in a couple of years. Those valuations compare favourably to the current price and very favourably to the 32 cents the shares traded at in March 2009.  Always keep in mind that you want to buy these sorts of stories at very big discounts to intrinsic value.

Figure 1.  CCV’s historical and forecast earnings and dividends per share

On the surface here’s a company that has the quality characteristics I like and is at a discount to intrinsic value.  The only question mark is about how big they can get.  If you intend to trade shares of CCV seek independent financial advice from a qualified professional who is familiar with your needs and circumstances and do not rely on the general nature of comments posted here.

Investors must also be aware of the impact of the intention of the Consumer Credit Code Amendment Bill 2007 and the subsequent Fee, Credit and Transition Bills as they relate to the nationalisation of regulation of operators such as Cash Converters and its perceived competitors, such as City Finance.

(Postscript:  ‘Reg’s’ comment below and my response are worth reading and considering and investors should pay attention to the growth of the company’s loan book and the relationship with its new largest shareholder and try to get answers to the questions I pose about continued growth and the ongoing relationship of loan book growth to retail stores)

Online job lister, Seek Limited (SEK)

Seek is a great business. Like all of the world’s most successful internet stories, it’s a plain old list. And it has developed that competitive advantage some companies achieve when scale and popularity leads to ‘essentialness’. People search for jobs at seek.com.au because there are lots of jobs, and there are lots of jobs because lots of people look for jobs there. I haven’t worked out if reaching this point is a function of strategy or dumb luck, but by definition someone has to make it to this point and he who gets there generates a lot of money and a high Return on Equity that is protected from imitation.

Seek is no exception, and its Return on Equity is expected to exceed 30% over the next two and half years. But while ROE is good and its earnings and intrinsic value growth is heading in a smooth north easterly direction, the fact remains that its popularity, as reflected in the current price of $7.90, is well in excess of the value, which is closer to $5.00 and rising to $6.30 in a couple of years. Sorry guys! Of course it was available to buy below $5.00 as recently as August last year, but that is of little use to you now. Patience is required.

Cranes for hire company, Boom Logistics Limited (BOL)

Boom Logistics is a business I remember reviewing when it floated. I was there at the IPO briefing and even then I didn’t like it. And didn’t I look foolish not taking any stock – it shot up from its listing price of 99 cents to almost $4.00 in less than 28 months.

I can sometimes get very frustrated knowing what a business is really worth and since 2005, the value of this business has been declining, along with its Returns on Equity. In 2004 ROE was 30% and today it is expected to approach 4.5%. Because you can do better in a bank account with no risk, you should think very carefully about investing in BOL. It is trading at 33 cents, but its value is less than 10 cents.

Hospital operator, Ramsay Health Care Limited (RHC)

Ramsay Healthcare is a business whose ‘theme’ I like. The population of Australia is ageing – the number of people over 75 will double in the next decade and a half, and while that will bring much sadness, the reality is that hospitals are there to provide the care that an ageing population needs. Despite a great story, hospitals aren’t that easy to run well.

You see, unlike most other businesses, hospitals can’t simply place a price on a service based on its cost and add a mark-up. Instead, they have to deal with insurance pay scales, meaning hospitals will make more money taking care of some patients and not others, and this is often not within their control.

Generally, hospitals make more money when more things happen to patients, such as pathology tests, diagnostic and therapeutic procedures, and operations. Operations are usually reimbursed at a higher rate than a medical patient, and while length of stay counts, its usually the hospital that has more surgical patients is the one that makes more money.

Conversely, a patient who lingers in a hospital is costing them money as their ongoing care may not be justified and they are blocking that bed from receiving another, better paying patient. Ever had a baby in hospital and felt like you were being booted out before your were ready? Anyone?

This is just the tip of the iceberg, but explains why running a hospital is so much more challenging than selling DVD’s to teenagers.

Having said that, Ramsay is doing a good job, as Figure 1 testifies.

Figure 2.  RHC’s historical and forecast earnings and dividends per share

Of course, there is a bit of hockey-stick optimism in the forecasts, and you can thank my peers in the analyst community for that. More importantly however, the hospital is generating Returns on Equity of about 14% over the next three years, up from circa 10% in the last few years.

The value of the business is rising, along with the returns. In 2000 Ramsay’s intrinsic value was just 58 cents. In 2012 its forecast intrinsic value is $8.13. – that’s an increase of 25 percent per year! Exceptional, but the price has never allowed investors to buy at a discount to intrinsic value.

In April 2000 RHC shares traded as low as 74 cents, but never below the 2001 valuation of 91 cents. Since then you have had to buy the shares above intrinsic value in order to participate in the growth in intrinsic value.  But whereas in 2000 you only needed to wait a year for intrinsic value to catch up, you would be waiting much longer today. With the shares currently priced at $13.50, even a 2 -year wait won’t see the value catch up.  It looks a little pricey now.

Keep in mind that I cannot predict share prices. I can tell you what things are really worth and tell you that over time price and value catch up with each other one way or another, but that is all I can tell you. I guess I can also vouch, having managed a couple of hundred million dollars, that if you buy good businesses below intrinsic value, things tend to work out ok.

Mining laboratory operator and cleaning solution seller, Campbell Brothers Limited (CPB)

Second last on the list is Campbell Brothers. Its been generating a decent Return on Equity for a decade, and its intrinsic value has been rising every year in that time. But like Ramsay, CPB’s intrinsic value will still not have reached the current price, even in 2012. I reckon it is worth $20 in 2011, and today its trading at $29.

Finally, one that needs no introduction, ASX Limited (ASX)

I have written about the ASX in my forthcoming book, Value.able. The ASX is worth less than $21 today and intrinsic value should rise to $26 in 2012. But Returns on Equity are not a patch on other companies, averaging 13.5% over the next few years. And despite the monopoly characteristics the company evidently has, it has not been able to charge what it wants for fear of emigration to rivals applying to set up. As a result, there is some correlation to the direction of the stock market, and predicting it is like predicting the price of a commodity – difficult.

Is your hand still up?

I have deliberately left out any discussion about debt, so be sure the companies you are investing in have little or none.  There is much more on this in Value.able, including a chapter devoted to when to sell.

I hope you are getting a great deal of use from these valuations and I look forward to your comments and input.

Posted by Roger Montgomery, 19 March 2009

by Roger Montgomery Posted in Companies, Health Care, Insightful Insights.

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Qantas reported its half year profit today and the oft’ heard investor refrain “but Roger, its pays me a good dividend” was dealt a heavy blow with the company announcing no dividend would be paid for the half year.

As you all know by now, an airline profit is an accounting construct.  If the depreciation charge was replaced by “a provision for replacement cost of aircraft” (my own accounting invention), the charge would be a lot higher and no profits would exist.  Indeed, even though I have been saying this since the 90’s, it was evidenced again in Qantas’s half yearly report with $142 million of “additional depreciation”

So how are dividends ever paid?

A quick look at the debt and equity over the year reveals it is the charitable nature of banks and shareholders that keeps the planes in the air.  As I write this, the total market value of the company is less than all the money that has been injected into it and left in it over the last decade and a half.

Can you believe a private equity group wanted to pay $11.1 billion for Qantas, or $5.45 per share? Can you believe that the stock market price went as high as $6.06, valuing the business momentarily at $12.3 billion? And they say the stock market and that its participants are rational!

The world’s airlines have accumulated aggregate losses of almost $54 billion over the last decade and in 2010 will lose another collective $5.8 billion[1]

Now don’t get me wrong. I am not saying Qantas isn’t a great Australian icon. Nor am I saying that the team isn’t doing a world-class job. Indeed, Qantas is regarded as the most profitable airline in the world. But you can see yourself that it would be very painful financially to own Qantas outright. From a purely capitalist perspective, I would rather own something else. A term deposit perhaps.

Here is a link to todays ABC Radio Interview about Qantas on The World Today: ABC RADIO qantas interview

[1] International Air Transport Association (IATA) Report 2009

Posted by Roger Montgomery, 18 February 2010.

by Roger Montgomery Posted in Airlines.

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United Group may be well liked by fund managers, but not by Roger. In this appearance on Your Money Your Call Roger Montgomery also comments on the value of AMP, Tatts Group and one of his favourites, Telstra (ASX:TLS). Roger admits viewers may get sick of him saying so, but Telstra is a business going nowhere, despite its high dividend yield. Watch the interview.

by Roger Montgomery Posted in Media Room, TV Appearances.

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Since early December Paul, Squigly, Steven and Darren have requested I value Westfield. WDC is also a popular stock with viewers of Nina May’s Your Money Your Call on the Sky Business Channel (you can watch highlights at my YouTube channel, just type ‘Westfield’ into the search feature), and rightly so. It’s a company run by three of the most capable men in the world and one whose shares I have owned in the past.

Today its price, according to a number of analysts and strategists, does not appear to have responded to expectations for an improvement in economic conditions in the US. The biggest gap between inventories and orders since the mid 70’s, the decline in housing inventory, the strong turnaround in cyclical indicators and the steep yield curve all suggest an acceleration in US economic growth – by the way if this doesn’t sound like me, you are right. I am just repeating what I have been reading.

I don’t subscribe to the view that it’s the job of the investor to allow macro economic forecasts to influence micro-based investment decisions.

If however the economists are right, and the US economic recovery does gain traction, then all that remains is a recovery in consumer confidence to see Westfield benefit. Of course if the US economic strength is sustained, then one suspects the US dollar will also recover, making Westfield’s profits more valuable in Australian dollar terms.

Those things aside, lets have a quick look at the valuation and take a dispassionate view about the price irrespective of whether others believe the price has or hasn’t responded to US growth expectations. Continue…

by Roger Montgomery Posted in Companies, Consumer discretionary, Property.

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The following article first appeared in  Alan Kohler’s Eureka Report on December 9, 2009.

Stocks in aggregate are no longer cheap. They were much earlier in the year, but based on the present levels of profitability they are not cheap any more. Those buying today are doing so in a patently perfunctory manner or are simply motivated by the fear of continuing to miss out. In the short term, losses rather than profits are more likely to ensue for those buying today.
Before you go selling your holdings in a fit of panic, remember there are always at least two views about the market’s short-term direction.

In one corner are the bulls, who say that the equity market’s recent strength is the beginning of a multi-year rally that owes its ongoing support to the fact that looming inflation will deliver negative returns from cash, which, combined with the massive expansion of the monetary base, represents a free, low-doc loan from the government.

In this environment many suggest that asset class inflation is assured. Indeed, just under $20 billion a week has been creeping out of the bomb shelters and into assets such as shares and gold.

In the other corner sit the economic bears, such as Nouriel Roubini, David Rosenberg and Marc Faber, who say the same inflationary and expansionary balance sheet policies of the West have given the US dollar an intrinsic value of zero, which will bankrupt America and produce a complete horror show that makes the last downturn look like a picnic.

Yield Curves.

So who was it that said two people looking at the same set of facts could not arrive at vastly different conclusions? Listening to and reading the apologetics and protestations of these extraordinarily successful investors must make the morning chat with your broker about whether AMP is paying too much for AXA seem inane. (Postscript:  AMP was paying too much for AXA – Nab’s purchase is even more ridiculous).

Perhaps more importantly, to whom do you listen? You cannot base that decision on who is smarter because both groups have geniuses in their ranks; nor can you base your decisions on previous successes because both groups have extremely wealthy proponents.

The answer does not lie with replicating the financial and reputational bets taken by the economists, strategists and traders. Indeed, it lies in not taking a view at all but allowing an entirely different group of facts to dictate your actions.

Those facts are the book values or the equity of companies on a per-share basis, the anticipated profitability of those book values, the manner in which profits are currently retained and distributed (in others words, capital allocation by management) and a reasonable required rate of return.

On these measures most companies are no longer cheap and many are downright expensive. This has occurred for two reasons, that combined, reflect the typical short-term focus of both professional and amateur investors.

The first reason is that share prices have obviously risen. They have risen because Australia has sidestepped a recession, interest rates remain accommodative, our output is in demand and overseas markets have recovered.

The second reason is that shareholders who may have stayed on the sidelines, have pumped money into attractively priced dividend reinvestment plans, placements and rights issues as many of Australia’s largest companies collectively raised $90 billion in the 2009 financial year.

And who can blame the investor who bought shares in Wesfarmers at $29 for wanting to bring down their average price and participate in an entitlement offer to buy three more shares at $13.50 when the rest of the shares they own are trading at $16?

But while the reduction of debt, associated strengthening of balance sheets and stag profits are attractive, there is a nasty downside to all of this.

If I have a company with $100 of equity on the balance sheet and 100 shares on issue, each share is entitled to $1 of the net book value of the assets. If, however, my company’s shares are trading at 10¢ because of the global financial crisis and my bankers ask me to reduce my $100 of debt to $50, I may choose to issue 500 shares at 10¢ to raise the required $50.

The first thing that happens of course is that company equity rises by $50 but more disturbing is that there are now 600 shares on issue. Where once each shareholder owned $1 of equity for every share they held, they now own just 25¢ worth of equity.

And if you are a small shareholder from whom the company couldn’t conveniently raise money, your holding has just been diluted because the institutions got the lion’s share of the placement.

Further, the money raised went to pay down debt rather than investment, so the earnings will only increase by the post-tax interest saved. As a result, the return on equity declines as well and because the true value of a company is inextricably related to the profitability of its book value, company valuations decline.

Valuations have thus declined and yet share prices have risen. As Benjamin Graham said, in the short term the market is indeed a voting machine. And I am not talking about one tiny or obscure corner of the market. Rights issues and placements, according to Paterson’s research, now account for more than 6.5% of total market capitalization: the highest level in more than 20 years.  (Postscript:  figures compiled by trade-futures.com show that 80% of small traders are bullish – the same level as when the market peaked in November 2007).

In the current environment, many value investors will succumb to temptation and their lack of discipline and reduce their discount rates. In doing so they try and keep their valuations from looking out of touch with ever-increasing share prices but really they’re playing catch-up. And when share prices fall slightly, value apparently and suddenly appears.

But the margin of safety is illusory and with returns from stocks unlikely to sustain returns so far out of whack from everything else, real value is some distance below. Only a demonstrated track record can prove otherwise.

Posted by Roger Montgomery, 9 December 2009

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While chatting with Nina May on her Sky News program Your Money Your Call, a viewer called in to ask about Crane Group (ASX: CRG).

My curiosity was piqued because somewhere back in 2006 I owned the shares, but shortly after I changed my mind and never looked at them again. When my valuation model spat out the numbers I could immediately see why it hadn’t come up on my radar again.

Ten years ago the business was generating 10.4% returns on its equity – nothing to write home about. In 2012 it is forecast to earn the same, up from about 7.5% today.

For anyone reading my Roger Montgomery Insights blog for the first time, an ROE of 7.5% is not much better than you can get in the bank, and given the risks associated with owning a business and the fact that there are businesses we can invest in that are generating 20%, 30% even 40% and trading at small multiples of their equity (and without vast amounts of debt or accounting goodwill), it makes no sense to sell something in my portfolio that is first grade for something that is not.

CRG was worth about $6.00 ten years ago and today its worth about $5.00. If the analysts are right with their earnings forecasts, my value of the business will not rise much more than 7.5% in 30 months time to just under $5.40.

With the price today at almost $9.00, there is no incentive to buy the shares.

For new visitors to my blog, a caveat and a little background: My valuation is not a price prediction. I do not know what the price is going to do. Whilst I can tell you the value of a share with a high degree of confidence, I cannot accurately predict the future price. The price could rise or fall substantially and I simply cannot know.

My objective instead is to buy high quality businesses – those with little or no debt, high returns on equity and sustainable competitive advantages – at prices well below their intrinsic values. If, after buying the price falls and I still have confidence in my valuation, then the fall represents an opportunity rather than a reason to be fearful and sell.

For the year to June 30, the funds I founded and ran (I have since sold and resigned from these businesses) returned 3% to 11% in a year that the market fell about 21%. Since June 30, my portfolios (you can track them in Alan Kohler’s Eureka Report and Money Magazine) have risen 26% and 31% respectively, whilst the market is up 19%.

Posted by Roger Montgomery, 30 November 2009

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On Richard Goncalve’s Market Moves show on the Sky Business Channel last week I mentioned I would estimate a value for Fortescue Metals Group (ASX:FMG). Let me be the first to say that, like IT businesses, companies in the resources sector are notoriously difficult to value. This is not because they are in a fast changing industry whose long term economics are difficult to predict, but because the economics are based on commodity prices that change daily and whose prediction is almost impossible.

Having said that I should offer a caveat; Buffett’s announcement that he is buying the railroad operator Burlington/Santa Fe in a $44 billion deal – his biggest ever – suggests he truly believes that fuel prices are going up a lot. Indeed while higher diesel prices will raise the costs of running trains, it will raise the cost of operating trucks over trains by a factor of four.

But I digress, FMG – based entirely on 2010 consensus analyst forecasts – is worth $1.90 to $2.00. Another caveat – consensus analysts predictions could be wrong.

By Roger Montgomery, 4 November 2009

by rogermontgomeryinsights Posted in Companies, Energy / Resources.

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In short, the answer is no. Three years ago Myer was purchased from the Coles Myer Group by a private equity team called TPG/Newbridge. The Myer Family was also involved and together the consortium acquired Myer for $1.4 billion. The group used $400 million of their own money and borrowed the rest.

Before the first anniversary, a very long-term lease on Melbourne’s Bourke Street store was sold for about $600 million, and a clearance sale reduced inventory and netted $160 million. All this additional cash allowed the new owners to reduce debt, pay a dividend of almost $200 million and produced a capital return of $360 million. In other words, before the first year was out the owners had received all of their $400 million outlay back, and arranged a free ride on a business with $3 billion of revenue.

But as a participant in the upcoming float of Myer you are not being invited to pay $1.4 billion, which was 8.5 times the Earnings Before Interest and Tax (EBIT). You are being asked to stump up to $2.9 billion, or more than 11 times forecast EBIT. You are also being asked to replace the vendors as owners and while they know a lot about extracting maximum performance out of department stores, you don’t.

In estimating an intrinsic value for Myer, I have ignored the fact that the balance sheet includes $350 million of acquired goodwill as well as $128 million of capitalised software expenses. I will also ignore 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 (meaning it has been left in) of $21 million in capitalised interest costs; all regarded as non-recurring.

While ignoring these in my estimate of intrinsic value seems irresponsible, it merely means that whatever number is produced by the calculation, it is going to be higher than it really should be. That’s fine; I just have to ensure a larger margin of safety.

Taking a Net Profit After Tax figure for 2010 of $160 million and assuming a 75 per cent fully-franked dividend payout, I arrive at a return on equity of about 28 per cent 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 percent required return I get a valuation of $2.90.

Alternatively, I am buying $738 million of equity that is generating 28%. If I pay the $2.9 billion that is being asked 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 per cent. For ‘my’ money it’s just not high enough for the risk of being in the department store business.

And looking into the future, things don’t become dramatically more attractive either. Based on the numbers in the prospectus I estimate the value only rises by 6 per cent per year over the next five years and delivers a value in 2015 of $3.90 – the price being asked today.

In valuing Myer I am not predicting its price. Remember what Benjamin Graham said; In the short run the market is a voting machine.  Shares that are popular can go up a lot even if the value is much lower. In 1999 and 2000 Telstra’s value was less than $3.00 and yet the shares traded around $9.00 for a long time. But Ben Graham also said in the long run the market is a weighing machine. In the long run, Myer’s share price will reflect its value.

So no, I have not changed my view of Myer’s float.  I am going to pass on My piece of Myer.

By Roger Montgomery, 26 October 2009

by rogermontgomeryinsights Posted in Consumer discretionary.

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