Toothpaste and lounge chairs – which is the easier investment decision?

Companies, Consumer discretionary | Comments (40)

Toothpaste and lounge chairs – which is the easier investment decision?

“Roger, would you buy Nick Scali (NCK) over the likes of TRS, ORL and JBH?” This last week, its been a frequently asked question.

Let me start by saying that I consider Nick Scali to be a high quality business. While the business listed in May 2004, I have run my ruler over the business financials since the year 2001. In every single year its been an A-Class company and an A1 in most. This is impressive. Few businesses have such an excellent track record, which speaks highly of management.

Indeed, given my tough quality and performance criteria, NCK would be in the top 5% of all companies listed on the ASX.

But are high quality financials and a good track record of performance enough to justify buying a business?

Let’s consider the businesses of NCK and The Reject Shop – another high quality retailer.

NCK is engaged in sourcing and retailing of household furniture and related accessories. The Company’s product portfolio includes chairs, lounges, outdoor, dining, entertainment  – what are called ‘big-ticket’ items as well as and furniture care products. It has 28 showrooms located in New South Wales, Victoria, Queensland and South Australia under the Nick Scali brand, and additional showrooms in Adelaide under the Scali Living and Scali Leather brand.

TRS on the other hand is engaged in discount variety retailing. Its footprint of around 187 ‘convenience’ stores is focused on low price points, offering a wide variety of merchandise. Stores are spread throughout Australia.

TRS has an exceptional history of quality and performance, and in that respect is not dissimilar to NCK.

While NCK and TRS both have top tier fundamentals, there is one major difference; their business models. And this is the important difference that puts TRS far ahead of NCK in my mind from an investor’s perspective.

Consider the economic cycle and the impact it could have on each business; NCK is a retailer of ‘big ticket’ items and TRS is a retailer of ‘low price point items’. Cast your mind back just a few years to when the stock market was crashing, and depression talk filled the media. Do you think spending on big-ticket items like a sofa or a $2 tube of parallel imported toothpaste selling at a cheaper price than a major supermarket, would have been reined in first? This is where TRS offers arguably a more stable and slow-changing revenue stream. TRS of course has its own issues and risks, just as any business has, but the stability of earnings is perhaps superior to that offered by NCK.

TRS has positioned itself as providing ‘low price points’ on everyday goods. Things you always need – daily essentials. I’m guessing you wouldn’t stop brushing your teeth, even during a credit crunch, but you may defer the purchase of that new sofa or outdoor furniture. TRS gets you in by offering really low prices on the daily essentials and then tempts you to fill your basket with other cheap items that have a higher margin for the retailer.

The problem for investors deciding between TRS and NCK is therefore not the quality of each business – they are both very high quality and have excellent management teams – it lies in the cyclical nature of NCK’s earnings.

After determining the quality and risks for a business, the next step is determining its intrinsic values. If you don’t complete this step, you are not investing, you are speculating.

Now to me, investing in a business like TRS is a fairly straight-forward decision. An investment decision in NCK on the other hand requires much more thought about consumer sentiment toward big-ticket discretionary purchases and how susceptible leveraged households are to increases in interest rates. Buffett once said find the one-foot hurdles that you can step over.

I’m not saying I would never buy shares in NCK. There is always a time and a price at which even a cyclical business is cheap, provided its of the highest quality of course.  I just prefer to stick to the one-foot hurdles rather than trying to jump over seven footers.

I’m off to brush my teeth. Don’t forget to leave your thoughts.

Posted by Roger Montgomery, 5 June 2010.

INVEST WITH MONTGOMERY

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

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

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40 Comments

  1. Horea
    :

    Hi Roger,

    Last week I call in to Money News with Ross Greenwood with a question about Netcomm (NTC). In case you have an opinion or a valuation for this company I would greatly appreciate it if you could share it with us.

    Thanks a lot.
    Cheers,
    Horea.

  2. James
    :

    Hi Roger,

    I have a few thoughts on TRS and business valuation in general:

    1. Whilst opening 20 new stores in FY09 and investing in a new distribution centre, TRS managed to generate $12.20 million in free cash flow. I find it difficult to believe that your valuation of $13.22 reflects this aspect of the business (i.e. high operating cash flow/low capex). A conservative free cash flow model provides a valuation much higher than $13.22. I think it’s important to remember that while indicators like ROE and P/B ratios provide useful hints as to where your valuation will lead you (I’m paraphrasing Buffett here), the value of a business comes down to (a) it’s ability to generate future cash flows and (b) the risk associated with those cash flows. Buffett may not admit to using free cash flows to value businesses, but it’s clear he understands the concepts exceptionally well.

    2. JBH has share of mind, TRS does not. A low cost retailer ultimately wants to instil in the mind of consumers that for any given product that they are likely to sell, they will be able to sell it at the lowest cost. JBH has this in spades (rightly so, given their remarkably low operating costs), but TRS has significant competition – KMart is starting to get its act together, Chickenfeed is expanding in Victoria, and Go-Lo has a significant number of stores. To be fair, people are more likely to shop around for a new TV than they are for pet food or confectionary, but I find it difficult come up with a good reason as to why someone would shop at TRS over KMart.

    3. I’m often perplexed by your unwavering distaste of debt. Sure, for any given return on equity you would be foolish to prefer higher debt. However, financial risk is ultimately a function of business risk. Why shouldn’t a business like Woolworths engage in sensible capital management to maximize returns to shareholders? When a manager promotes his business on the basis of “balance sheet strength”, I’m left pondering one question: what’s wrong with the income statement? I liken it to a car manufacturer promoting their vehicles by highlighting the inclusion of seat belts – a worrying sign indeed.

    • Roger Montgomery
      :

      Great thoughts James,

      Who am I to disagree with such strongly held views. You might be surprised by The Reject SHops share of mind although I can’t disagree with JBH’s. I should add, I haven’t given you my 2011 and 2012 TRS valuations. Keep in mind however that Australia has a small population and retailers on aggressive store roll outs, saturate the best sites rather quickly. Having said that Chris Bryce knows the business well.

  3. ron
    :

    hi Roger any chance to get your thoughts on customers limited and what is your estimated value? it seems like they are expanding into new zealand soon. thanks Ron

    • Roger Montgomery
      :

      Hi Ron,

      I will put it on the list. What I can say is that while the intrinsic value has risen 20-fold in the last 2 years, the price has risen 35-fold and its now above my estimate of intrinsic value.

  4. Adam
    :

    Hello, I’m guessing most of the readers on this blog have come across the name “Michael Burry” in recent years but I have only done so in the last few days. This fascinating individual is profiled in Michael Lewis’ new book “The Big Short” and his story is well worth reading (Google – Betting on the blind side).

    The reason I’m mentioning this on here is because (a) he is a value investor and one of obvious and significant talent, and (b) some of the things he has written correlate closely with Roger’s views.

    A case in point is an old quarterly report that MIchael wrote to his fund investors just after 9/11 – he comments that one of the stocks held was in an airline company – “buying an airline stock rarely looks like a good idea”.

    He also gave Greenspan a bit of a backhander recently for saying that no-one foresaw the housing bubble, when clearly some people did.

    Anyway, just thought I’d throw that out there to people who haven’t heard of Burry. He no longer runs a fund (another similarity?) but his fund’s old website still exists with a few quarterly reports on it.

    Roger, I only discovered your blog and writings in the last 6 months and I enjoy hearing your views. Although I have access to several brokers’ research, I rarely read it any more. They seem to all sing from similar song-sheets.

    And if I could be so rude as to ask about in a stock in my first post, SHL has obviously taken a fair whack in recent weeks. I know you commented on the healthcare sector recently but I believe that was just prior to the downgrade in SHL. I have a feeling it may still be above your intrisinic value but I was wondering if there was any hint of value.

    • Roger Montgomery
      :

      Hi Adam,

      Thanks for the suggestion to do a little more reading. I will be having a look at Michael Burry. Regarding SHL, at $10.30 odd – its still a dollar or so above the current estimate of value but nothing like the premium it was commanding when it was trading above $15 six months ago. remember, seek personal professional advice before entering any activity in the market.

  5. Ashley Little
    :

    Hi Roger,

    I have noticed a thread of comments through your blogs regarding the liquidity of the stocks

    What I would like to point out is that Warren Buffet built the vast majority of his wealth by buying very illiquid busineses.

    They don’t come more illiqiud than say the Nebraskan Furniture Mart.

    Given that he owns the business if he wants out he has to find a buyer then negotiate a price, then get the legal vutures to draw up a contract. Then he gets paid, The whole process may take 18 months to 3 Years.

    This is obviously a much slower process than selling his Coke stake on market. Given his holding this would take at worst 3 to 6 months but a fund manager would probably take it in a day.

    This is what Warren Buffets means when her says he buys a stock (or business) with the view that the stock market will be turned off for 10 years.

    My view for what it is worth, is that their are two reason that liquidity of a stock becomes an issue.

    1) Gearing (Buffet says don’t gear – You can’t go broke if you don’t owe other people money)
    2) I have made a mistake and this is not as good of an investment as i first thought.

    Perhaps liquidity should be an issue in your required return decision. That way it is not as big a problem if you make a mistake

    Just a few thoughts. Hope nothers get something from this.

    • Roger Montgomery
      :

      Thanks Ashley,

      You will also often hear a company talking about wanting to split shares, for example, to improve liquidity. Thats a bit like the minister at Church wanting to see 1/2 his parishioners turnover each week, so “there’s good liquidity”. Its nonsense.

      • Michael
        :

        Roger,

        Thankyou for you ideas.
        I agree share splits are not in shareholders best interests.

        Could you explain your reasons?

        Mick

      • Roger Montgomery
        :

        Hi Michael,

        I assume you were reading the post from some time ago about Buffett splitting the Berkshire B class shares. Its not that splits are bad for shareholders. They are in fact neither here nor there. They don’t change the value of a company. A company with an intrinsic value of $10 billion, is worth $10 billion irrespective of whether it has 10 shares on issue or 10 million shares on issue. When shares are illiquid, sometimes its used to allow shareholders the opportunity to sell a fraction of their holding – but while this might be relevant if your shares are trading at $20,000 each, its hard to use as an argument if you are changing the price from $100 to $50 for example.

  6. Damian
    :

    Roger,

    I’m still relatively inexperienced when looking at balance sheets, but when you look at half year results, the balance sheet shows the total equity but the profit is only for the half year.

    Do you double the profit to get an approximate ROE or how do you handle it? (or is it covered in the book?)

    • Roger Montgomery
      :

      Hi Damian,

      There’s a bunch of things you can do, but simply doubling profits is not usually one of them. You will find for example, some retailers generate the bulk of their profits in the period before Christmas. This would mean that the second half will be a poorer result than the first. During the half year, the company may disclose an estimate for the full year result (they may not), its preferable to use that number.

  7. Wing
    :

    Hi Roger,

    Another good post! I’m also a fan of low cost providers which can sell things cheap and able to maintain a stable revenue even in economic tough times. What’s your view on Fastastic (FAN)? I invested in FAN June last year based on the same “low cost provider” view and with a well known brand, but I’m a bit disappointed with the latest lower profit guidance though…
    It seems the new equity reinvested fails to produce a positve return. Luckily I invested with a good margin of safety which still giving me roughtly 9% return at the moment. Maybe I should have exited the business when it was @ $4 in April…
    Kindly let me know if you got any ideas about FAN.

    Cheers,
    Wing

    • Roger Montgomery
      :

      Hi Wing,

      I cannot provide you with any advice about what to do. Theoretically, the ‘low cost provider’ brand, is one source of competitive advantage, but it is preferred that it is accompanied by high turnover and repeat purchases. It is also necessary that you keep winning at it. Fantastic’s ROE has decline from circa 60% in 2004 to about 24% forecast for 2010. This is partly because equity “put in” and “left in” has increased from $32 million to $79 million. What is perhaps disappointing is that debt has risen four fold – from $4 million to $16 million. Seek personal professional advice before transacting.

  8. Bernard
    :

    Hi
    After reading all the interesting thoughts/suggestions I ‘d like to ask why do some of you still trust figures that are put in front of you on companies when we’ve in an era of falsified accounting and how can we check for the truth or do we invest on a these”figures” blindly.
    Does Morningstar Check everything?
    Also mentioning toothpaste whats wrong with the great companies that make these everyday items eg J&J ,Colgate etc.

    • Roger Montgomery
      :

      Hi Bernard,

      J&J is a great business. Not listed here though. If you would like to read the thoughts of an Aussie-based Buffett style investor buying great overseas companies like Google, J&J and McDonalds, have a look at the stuff written by Hamish Douglass and Chris Mackay at Magellan. I count them as friends and have been carefully looking at what they’re buying and how they’re going about it.

  9. Robyn Clancy
    :

    Another fantastic insight Roger. Just wondering what your estimation of the intrinsic value of TRS is compared to it’s current share price?
    Robyn

    • Roger Montgomery
      :

      Hi Robyn

      $13.22 for this year and $15.35 for 2011. Thats not a prediction about what the share price will do. The share price could double or it could halve and I have no idea about how to predict that. All I can tell you however, is an estimate of its value. Be sure to obtain personal professional advice before doing anything.

  10. Steve
    :

    Hi Roger, another great article. For me, I feel comfortable investing or avoiding businesses I can easily experience as a customer. A few years ago, I had terrible trouble with a company who showed staggering incompetence handling a routine inquiry. After a terrible experience, I was left thinking this is a business in trouble. Sure enough they were in financial trouble and the reason for the poor service was bad staff morale. Interestingly their share price has almost halved since my bad experience and remains in a steady downtrend. In stark contrast, I was shopping in JB HiFi the other day and was amazed at the speed of the money entering the four cash registers, pleased with the efficiency of the staff and the large crowd of people in the store. So I feel happy holding JBH after a positive customer experience. While a downturn in the economy might hit their sales of the big items, I think people will always spend on the other smaller stuff… CDs, DVDs, video games etc. They’re well diversified in their sales. I get the same feeling shopping at Woolworths, eg with the new automated registers speeding up sales and reducing costs. I’m looking forward to reading your book to learn how to value a company and hopefully spot when these top businesses are good value.

  11. MattB
    :

    Thanks for the post Roger

    You have highlighted some of the reasons why despite the figures I can’t bring myself to buy ORL at $6.

    Another reason (albeit a bit left field) is based on your glowing references, I think the CEO, Sally Macdonald is likely to move onto bigger and better things. I would be very keen to see what business she steps into next (if she moves at all) and see what opportunities there are for growth in it.

    • Roger Montgomery
      :

      Hi Matthew,

      Sally is a future retailing giant. Following her (IF she ever leaves Oroton) would be wise. While she is ensconced there with energy, drive, enthusiasm and passion (intelligence is a given), there might be few better company/manager combinations an d certainly very few at a discount to my estimate of their intrinsic value. The share price could double or it could halve and I have no idea about how to predict that. All I can tell you however, is an estimate of its value. Be sure to obtain personal professional advice before doing anything.

  12. Stephen
    :

    Hi Roger,

    Thanks for your article on NCK and The Reject Shop. The issues raised by yourself, and some of the other posts provide some interesting points concerning products of necessity and products considered as luxury.
    I was lucky enough to catch the interview with Sally MacDonald on last weeks Switzer program. Impressive is the word that came to mind as the interview progressed. Her enthusiasm for the task at hand, her obvious yet understated ability to lead the company, and her vision for its future leaves me in no doubt that this is a business worth watching.
    I found myself in an Oroton store some weeks ago and found the presentation of the store, the quality of the stock, and the overall shopping experience (gift for lady friend) was outstanding.
    I’m not to sure where I would place Oroton on the scale between The Reject Shop and Nick Scali, but I am sure after listening to Ms MacDonald and visiting a store, that at the right price I would quite happily buy a stake in the business.

    • Roger Montgomery
      :

      Hi Stephen,

      I am sure Sally would be very interested to hear about your experience and thoughts. And I am pretty confident she will. You might be surprised by how many CEO’s are visiting the blog (and who!) and they’re as interested in your comments as they are in mine – perhaps even more so.

  13. Andrew
    :

    Hi Roger,

    Wondering what your thoughts are on Gunns (GNS) they carry soem debt and as a result were smashed during the GFC all the way down to 26cents a few eeks ago before a rally to 44cents now.

    I hear rumours of takeover as there assets are worth 1billion but at current share prices the stock is worth significantly less than the asset value.

    • Roger Montgomery
      :

      Hi Andrew,

      Reminds me of IIF at the lows but that was easier to value the assets of – even under a distressed sale situation. This is much more complicated. You could be right so seek advice. Also remember Buffett’s chats about one-foot hurdles versus 7-footers.

  14. Dan S
    :

    Cheers for some useful comparison and insights into the “soft” issues around investment decisions. Perhaps some discussion of the valuation issues is worthwhile.

    Based on my back-of-the-paternity-claim-envelope calculation, at first glance, my valuations of NCK of c.$1.25 p.share and TRS at c. A$13.00 per share, do not provide a suitable margin of safety.

    It’s interesting to note that TRS’ margins and hence return on equity (ROE) and ultimately growth in book value equity is expanding, which clouds my valuation, as I’m conservative with perpetual growth rates and returns on equity.

    TRS’ competitive advantage is that their efficiency as a retailer is expanding as they grow, resulting in better margins and ROE.

    By contrast NCK’s margins and ROE are declining THROUGH the cycle, ie: pre-GFC, although some uptick in the last twelve months is noticeable.

    It’s likely there’s upside potential to my TRS valuation and perhaps some downside risk to my NCK valuation.

    Ultimately businesses with a Glenn McGrath solid competitive advantage and who are growing their ROE and equity rapidly are probably the best investments, but are also the hardest to value.

    Navitas (NVT), which has tripled its ROE in the last five years, (with negative net debt all the while) is my favourite personal example. What do you think it’s worth Roger?

    PS – ever tried Roger’s beer from Little Creatures?

    My Dad’s name is Roger, and the beer is all he would talk about with my English Literature teacher (also a Roger) during parent teacher nights.

    • Roger Montgomery
      :

      Hi Dan,

      The first time I saw Roger’s beer, I bought six bottles to take to my neighbour Tim’s BBQ in Sydney’s inner west many years ago. He was so impressed that the following week, at a BBQ at my house he bought six bottles, removed the labels and recovered them with his own called Tim’s Beer.

  15. Robert
    :

    Hi Roger,

    I like your thinking on toothpaste, in that it is one of life’s mundane essentials. You really cant go too far wrong in investing in (good) business that manufacture or sell products or services associated with day to day living – and this seems to be Warren Buffets thinking also. The other day it occurred to me that at home and at work I am purchasing products from several of Mr Buffett’s companies..At home I use Gillette and there is Coke in the fridge, at work we sometimes purchase from TTI and Iscar. TTI sells electronic components essential for electronic circuit board manufacture and Iscar sells cutting tools essential for use in Machining centres, lathes etc – from which all the objects that surround us, both directly and indirectly are manufactured. The reach of Buffett and Berkshire just astonishes me. Anyway.. the question that I wanted to ask is: Does liquidity play any part in your investment decisions? I have noticed that some of your top companies (ORL, NCK, FGE, REH etc) can be up or down by 2 or 3 percent on only several thousand shares traded, and on some days they may not even trade at all. I know that these companies represent value in an otherwise overvalued market, but that doesn’t mean that they should be invested in. If there were to be a general market panic then the share price of these smaller companies are more likely to be hit harder. Isn’t it better to wait for the larger highly liquid companies to become cheap? alternatively, isn’t it better to wait until we have a general market panic before investing – to any great degree – in an illiquid company?

    • Roger Montgomery
      :

      Hi Robert,

      I think it was Buffett himself who said, you should purchase shares in businesses in such a way that it shouldn’t concern you, even if the stock market were closed for three years. In light of Buffett’s comments, its probably worth reconsidering liquidity sensibilities. If the vast majority of companies are expensive, as I have mentioned elsewhere here and in the Eureka Report, then “cautious accumulation” is appropriate.

  16. Paul Kloeden
    :

    Hi Roger,

    Another really great, and useful post. Once again it reinforces the necessity to look carefully at a prospective purchase from many angles and over as long a time period as possible. It also reminds me of Buffett and my search for another Gillette – until men stop shaving completely he is on a winner, something that is used daily and replaced almost as often, like toothpaste.

    One thing I like to do when first looking at a company is to put ten years worth of figures in front of me. I get them from Morningstar where they are laid out quite simply. I simply run my eye over them looking for trends – in sales, cash flow, earnings, dividends, margins, return on equity etc, all of them. What I’m looking for is a company where all these variable show a steady increasing trend. If the trend is in the wrong direction, such as declining sales, then that’s the end of it. If there is one odd blip, then I will try and find out what may have caused it. If the business is highly cyclical, this too might appear. At least it’s a starting point.

    While on the topic of retail companies, do you have any thoughts on DJS? It looks to me that it might be approaching value. It’s figures are interesting. While revenue has increased by an average of 3.25%pa over the last ten years, EBIT has had an annual 10.5%pa compound rise and net profit 13.5%pa. Book value has risen an average of 3%pa. The difficulty I have is in trying to see how profit can continue to rise at four times the rate of revenue increase. Surely margins and cost savings can only go so far. Does this mean that the ROE must inevitably start to decline, all other things being equal.

    Looking at DJS from a completely different angle, my 27 year old son simply says, “Department stores are dead. They are only useful as showrooms before ordering something online.” We live in changing times.

    Paul

    PS: Any update on the book?

    • Roger Montgomery
      :

      Hi Paul,

      Thank you for that insight into your process. I am sure it will help many visitors to the site. Something to think about is related to your comment about declining sales. If a company sells a loss making division or a loss making subsidiary, the consolidated results will show declining sales, and yet the company’s profits may be higher! Have a think through that. Its important to have an explanation and not be too agnostic. Your sons comments are an insight into a generation. Please keep posting them! The book is out of my hands and in the production process.

      • Joshua Baxter
        :

        Hi guys,

        As a 20 yearold myself I’d also agree that the majority of my Gen Y friends might go into a Myer or DJ’s to suss out the latest things, however often due to them being higher in the price range I’ll always end up doing a quick ebay search or other price comparison websites.

        After veiwing the interview with Sally MacDonald I have to say that her comment on Australians being time dead and not really needing to touch and feel the products before we buy them is spot on. It’s so easy no to do a quick google search for a “X product review” and see what people are saying rather then go to a shop and cop a big sales pitch by the retail staff.

        I think there will always be sales made at the cash registers mainly because Australia has an aging population and older people might be more hesitant to make purchases online, but the shift is happening right now to online based retail and in the future it will only get bigger.

        Looking forward to reading the book, and thanks for your great insights.

  17. Ashley Little
    :

    Looking forward to your book Roger.

    Particularly the section about how you arrive at your A1’s and C5’s.

    My thoughts for what they are worth are that a cyclical stock should demand a higher required return because it is more risky than a stock with more bullet proof earnings. If for example you have a required return before tax for say CSL of 12% you may require 15% or higher from Nick Scali. As a result, two businesses with identical return of equity and payout ratios will have different intrinsic values.

    Thereby, the buying decision still comes back to trying to get set at a significant discount to intrinsic value.

  18. Aidan
    :

    Hello Roger,

    Great post and an area of interest of mine. I have some difficultly understanding how company’s like NCK will continue to boast strong long term growth with Australia’s historically increasing marginal propensity to consume. There is only so far you can push ‘luxury’ spending without it coming back to bite. With Australia’s increased wealth over the years, indebtedness is at all time highs. How much further can you push luxury spending? It is probably just a matter of time before a lot of Australians have to reassess their spending habits. So NCK will most likely have good growth until a lot of Australians get stung. On the other hand, TRS will probably only see good things irrespective of the aforementioned. Although, one path is likely to be more exciting for investors of TRS.

    Regards, Aidan

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