Value emerges when you least expect it
As any adherent to professional value investing will attest, the practice in Australia has been challenging in 2016. For a length of time that we’d prefer not to dwell on, we have rued the broad lack of opportunities. As a result, Montgomery portfolios have not been fully invested, even as our funds have grown.
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.
James
:
Hi Roger,
Thanks for all the helpful articles you and your team post.
Im new to investing and just have a question about ROE, i noticed in an above question that you mentioned when calculating the ROE on HSO that you removed the Goodwill from the calculation. Should you always remove the Goodwill from the ROE calculation or does it depend on if the Goodwill contributes to the company’s profits?
Thanks!
Kelvin Ng
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Hi Roger, does that mean that you’re buying cheap growth stocks in the domestic funds and reducing cash levels even though bond yields look like they’re trending up?
Thanks.
Kelvin
Roger Montgomery
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We are always net buyers Kelvin.
Justin Carroll
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One question: where is the margin of safety in a stock trading at more than 22 times forward earnings?
Roger Montgomery
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Suppose two businesses each generate a 20% return on their respective equity, but one pays all of its earnings out as a dividend and the other retains 100%. Now assume the investor buys, and some years later sells, each on a P/E of 10 times. The return from the company paying all the dividends out will be 10% per annum and for the company that retained all of the earnings the return to the investor will equal the ROE of 20%. The cheapest to buy was the investment that produced the highest return. But both were on a P/E of 10. So what did the P/E say about which was cheaper?
A stock on a P/E of 22 can be cheap and a stock on a P/E of 5 can be expensive.
Justin Carroll
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Thank you, Roger. But HSO does not earn 20% on its equity, does it. So my question remains: where is the margin of safety in HSO trading at 22 times forward earnings?
Roger Montgomery
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You need to look at the balance sheet and consider if return on tangible equity and/or return on incremental equity offers a more sensible picture.
Justin Carroll
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The return on both is currently less than 8% and HSO trades on EV/EBIT multiple of 16.5. It is not an inexpensive stock.
To say it was priced for perfection and still is after its recent decline is really to state the obvious. A stock that is priced for perfection leaves no room for error or disappointment.
Stuart Jackson
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Hi Justin,
The appropriate earnings multiple is a function of the return generated on incremental investments made in future periods. To the extent that historic rates of return reflect a good proxy for the rate of return that is expected to generated on future capital investments, it can be used in the calculation of a valuation multiple. In the case of Healthscope, you are correct in saying its current ROE is around 8%. However, the ROE is heavily diluted by the A$1.94bn of goodwill and other intangibles created when private equity acquire Healthscope in 2010. This has no relevance to Healthscope’s historical investment in its businesses, nor does it reflect any future capital requirements. Excluding this from the ROE calculation shows that that Healthscope is earned an ROE of around 40% in FY16.
Justin Carroll
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Thanks Stuart. I agree that excluding the goodwill on the balance sheet gives a truer picture of the return that HSO is generating on its assets. I suppose that, even with that adjustment, HSO’s price still seems to leave no room for error.
I am increasingly of the view that, what determines superior stock outperformance is not the Buffett approach of buying-good-companies-at-a-fair-price strategy but buying cheapness first and last. Forget about ROE, ROIC, ROCE and ROTE.
Support for this can be found in the Buffett’s own career when between 1957 and 1969 Buffett’s partnerships averaged a compound return of 29.5% a year. Those returns were generated when Buffett was still buying cheapness over quality (quality being understood as high return-on-invested-capital businesses). Tobias Carlisle in his book “Deep Value” also recently found that cheapness based on a low EV/EBIT multiple significantly outperformed the good-companies-bought-at-a-fair-prices approach of Buffett and Greenblatt et al.
Ultimately, I think the adoption of the good-companies-bought-at-a-fair-prices approach has come at the expense of the question of: which approach really delivers the best returns – cigar-butt-investing or good-companies-bought-at-a-fair-prices investing?
All the evidence that I have seen suggests that the medal goes to the former rather than to the latter.
Roger Montgomery
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I am pleased that Stuart had the time to explain return on tangible equity more fully for you. We really want high quality companies at a bargain price. There has been precious little of that this year. There are managers in OZ who simply go for deep value regardless of quality. This is not our preferred approach however there is no reason why an investor couldn’t blend the two managers and investment styles effectively in their portfolio.
Justin Carroll
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The bottom line, Roger, is which approach delivers the highest alpha.
Pitching the fact that one is buying “quality” companies at fair prices no doubt purrs in the ears of prospective investors more soothingly than that one is buying just cheap companies. But every asset manager of the value school is a buy-good-companies-at-fair-prices manager these days. It is a very crowded space.
The returns from this style of investing are, and will increasingly be, arbitraged down.
Roger Montgomery
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You re implying that by being ‘crowded’ value cannot emerge and yet, in the last 60 days we have seen corrections, nay crashes, in the share prices of many smaller high quality, high growth companies. ISentia is down more than 30 per cent in the last month as is APN Outdoor. Healthscope has fallen 32 per cent from a high of $3.14 to a low of $2.15, REA Group is down 27 per cent from its highs and Carsales is down 28 per cent from its highs. An examination the Small Ordinaries, for example, reveals a plethora of companies whose share prices have fallen as much as 45 per cent in just the last 60 days. The ‘crowded’ argument is like the ‘weight of money’ argument in its support of the ‘always-elevated’ share price thesis- Wrong.
I like David Buckland’s summary of Howard Marks’s rules and observations:
Investment markets follow a pendulum-like swing:
between euphoria and depression;
between celebrating positive developments and obsessing over negatives; and
between overpriced and underpriced.
This oscillation is one of the most dependable features of the investment world, and investor psychology seems to spend much more time at extremes than it does at a “happy medium”.
There are two concepts we can hold to with confidence:
Rule number one: most things will prove to be cyclical
Rule number two: some of the greatest opportunities for gain and loss come when other people forget rule number one.
Justin Carroll
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Roger, no, I don’t suggest that value cannot emerge when so many value managers follow the buy-good-companies-at-fair-prices approach.
When I say that the returns from this approach will increasingly be arbitraged down, I mean that the mispricing or spread between value and price of these “good companies”(i.e. high ROCE/ROE companies) will, in normal times, increasingly narrow where it exists at all. In times of extreme market sell-offs, of course, the spread will widen. But those events – years to 30%+ returns – only take place once a decade if one is lucky.
If one accepts that the goal of the investor is to identify mispricings in securities, it follows that the wider the mispricing between value and price, the higher the alpha that a manager will deliver for his or her investors. And that really should be the sole focus of the paid money-manager: to seek out and to exploit the widest risk-adjusted mispricings available in the market.
This is the approach that Buffett followed in the first 12 years or so of managing the partnerships and it is the reason for his almost 30% compound returns over that time. Buffett’s current approach of buying good-companies-at-fair-prices (increasingly even at fully valued prices), by contrast, has not been chosen, as far as chosen first and foremost with the aim of seeking out the highest alpha. It is has been imposed on him by the sheer weight of capital that he’s managing. As Buffett said himself:
“If I was running $1 million today, or $10 million for that matter, I’d be fully invested. Anyone who says that size does not hurt investment performance is selling. The highest rates of return I’ve ever achieved were in the 1950s. I killed the Dow. You ought to see the numbers. But I was investing peanuts then. It’s a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that.”
“The highest rates of return I’ve ever achieved were in the 1950s”: which is precisely the time when Buffett’s investing decisions were based first and foremost on seeking out securities having the widest spread between value and price.
“Quality” was altogether a secondary consideration.
Roger Montgomery
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And yet despite it only being six years (not a decade) since the last sell off, here we are again surrounded by high growth prospects with prices that have fallen as much as 45%.
Justin Carroll
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Those stocks are still not cheap enough for me.
peter latham
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Rog. Isentia (ISD) has been discussed by you in various media articles. ISD seems to have fairly sticky earnings; but has been hammered due to the earnings/profit downgrade. Do you believe that it has been thrown into the same pile as HSO in that the share price correction is a knee jerk reaction ?
Roger Montgomery
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Hi Peter, See our comments elsewhere here on this thread. In short yes, we currently think it sits in the HSO camp.
Phil Nicholson
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Thanks Roger.
You may be interested in an Australian named David Sinclair who is at the forefront of research into treating age-related diseases and even into treating aging itself, it’s pretty exciting stuff. Google is an investor in this field of research. One of the biggest breakthroughs has been in increasing the number of “healthy years” as a percentage of total years and could impact your long term estimates for age-related hospitalisations. They’ve already done this in mice and human trials are on the way.
Roger Montgomery
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we should be investing in mouse hospitals then!
Peter
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I have discovered that private insurance cover in a public hospital is by far the most economically beneficial means of funding surgical procedure. This will be my third surgery. After considerable reflection, I believe that growth in admissions/separations in public accommodation within the private system will experience the predominance of separation growth. Private accommodation may make sense for elective surgeries. But not non-elective ones. The latter is key with respect to the aging population. The cost of insurance coverage and health service delivery grows comfortably above inflation and disproportionately above wage growth. I believe a tipping point will be reached in the medium term, where private bed revenue growth and supply will attenuate and then flatten. The cost of building private beds may be advantages to private accommodation providers, but that does not mean that health service will move to the private system. To be sure, private bed supply may be used as an alternative to bringing additional public supply online, but there is no reason why the government could not simply rent the capacity out.
Roger Montgomery
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Of course its right that it would be cheaper Peter, but if you put them all in the public system there will be no room for public patients.
Matt
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Hey Roger,
Ultimately, i think the title to your article is as relevant as ever. In the past weeks the markets have been acting according to that famous ‘Mr Market’ theory. It’s leaving a lot of investors either feeling great or silly about their decisions, regardless of the logic and thought that may have gone into their decision making process.
I’m a young investor and I’ve picked two companies for my portfolio. I’ve put a lot of effort into my selections and no doubt i’ve got a lot to learn (diversification may be a lesson to come…). But one company caught my eye through the ‘buy it if you’d want to own it’ mindset.
Platinum Asset Management is a great company and has copped an undeserved beating recently in my opinion (i’m not complaining with the decreasing average cost per share though). Subsequently however, it has surged more than 20% in a few trading days. I’m no guru and i view the current price of PTM as much better value than any bank account i could get my hands on… But I’m perplexed! i can’t find any news or comments on this surge. I know you’ve praised this company before and maybe you could shed some light as to why it has jumped so much?
Roger Montgomery
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Thanks for sharing Matt. We aren’t aware of any information that could cause the jump. You might note that BTT is also up strongly.