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What are my top five ROE stocks?

What are my top five ROE stocks?

Some time ago Peter Switzer invited me on to his program to discuss five stocks for the long term that met my criteria for quality at least, and value if possible.

We didn’t end up with enough time to cover them so I was asked back on October 28. By that time the market had rallied hard so the three I could find were MMS ($3.99 back then) now $4.44, JBH (then $21.50) now at $22.96 and WOW (then $28.82) now $28.42.

The other two I mentioned, to satisfy the more speculative viewers, were ERA (then $24.70) now $24.46 and SXE ($1.62) now $1.63.

The 2009 valuations for MMS, JBH, and WOW are $4.69, $25.76 and $27 respectively. For ERA and SXE the 2009 valuations are $33 and $1.97 respectively.

At all times I have deliberately based these valuations on consensus analyst’s estimates so that there is no favouritism. But keep in mind analysts estimates are prone to change and therefore so are the valuations.  Further, it is worth remembering that when I run my aggregate valuations over the market, it tells me that the market as a whole is about 15 percent above its valuation.  In other words the market in aggregate is no bargain and may be a little expensive.

Also keep in mind that if you go and transact in any security in any way based on these opinions, you do so at your own risk. I really do mean it when I recommend that you seek advice from a professional adviser, broker or planner that knows your financial circumstances.

By Roger Montgomery, 19 November 2009

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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  1. Hi Roger,

    Why should the following matter at all to a value investor?

    “Further, it is worth remembering that when I run my aggregate valuations over the market, it tells me that the market as a whole is about 15 percent above its valuation.”

    We are investing in individual companies are we not.


  2. It was easy to pick 5 top ROE stocks 12~ months ago however now with the market up many previous stocks which I researched are no longer the bargains they once were. I have had a look through the market but can’t really find five stocks I would pick as the top ROE stocks or ones that I would purchase at the moment. If the Dubai news drives the market down a little lower it might get a little easier.

    There are a few top ROE stocks but for the price you need to pay they don’t return enough of that ROE to yourself as a new shareholder. Most of them are already mentioned here JB Hi-Fi, Woolworths etc. I think unless you are passionate about it an index fund for most investors is the way to go with the main benefit of buying an index fund been the prevention of overly speculative impulse buys! I know in the past I have had to learn my lesson on that one that hard way. If you lose 50% of your money you have to find a stock that is going to rise 100% to just get back to a break-even level! One mistake can undo a lot of hard work.

    A top ROE stock I would have previously picked was Nick Scali with no debt on the balance sheet, all the stores leased and its current assets (excluding non-current assets) exceeding its total liabilities. The company had a total net equity of $18m and at the time a market cap of $40.5m at 50c per share. Nick Scali in the FY08/09 year had a ROE of 26% so roughly your investment would have given you a 10% share in what was considered a poor market for retailers. Nick Scali is not overly interesting or the category killer JB Hi-fi is but they have still produced good results. With the share price now though around $1.30 I don’t think I would purchase shares at that price.

    Here is a one I picked previously at the start of the year and I have done a bit of an overview if you were to purchase it at the end of FY08/09. I still think today it would be one of my top pick ROE stocks for the future.

    Watpac (Construction, Civil and Mining, Property and Specialty Services)

    Annual Report: http://www.watpac.com.au/investwithus/latest_statements/annual_reports/Watpac_Annual_Rep2009.pdf

    (The below is based on end FY08-09)

    Shares on Issue: 120,568,000

    Price: $1.15 (roughly at end of June 30) One thing I noted from the report was the company does not seem to be overly concerned with the share price/market cap in its annual report.

    Market Cap: $140m

    Equity: $213m – there are only intangibles $26m which you may choose write off from the equity. Inventories are a large amount of net-current assets however there appears to be no goodwill etc bulking up the asset side of the balance sheet.

    Revenue: $997m

    NPAT: $11m (or $36m if you exclude one offs such as the write down of the property development inventory)

    Taking a look at the last 5 years of performance the company is not frequently ‘normalising’ their NPAT so I believe you could assume unlike some companies they truly are ‘one off costs’ rather than ‘one off – recurring costs’

    Since the company did have to write down their property inventory I am going to work on a NPAT of $11m as the write downs are a real cost. I am doing this as well as it is much better to have a large margin of safety.

    Based on this the company has a ROE of 5.3% which is low (no better than a bank account considering the risks in the construction/property industry) however from 2002 to 2008 ROE has averaged 23% and their equity has risen from 23m to 218m in the same period. Watpac paid dividends during the period 2002-2009 uninterrupted and earned 20%+ on retained earnings.

    Considering $220m of equity is earning 5.3% and you could purchase it for $140m in the market you are earning 7.3% on your money. This is still not much more than a high interest bank account paid in 2008 though it was a poor year for the construction industry in general. I believe to have still achieved a positive NPAT in the industry and earned 5.3% on shareholders’ funds (after write downs) the company has done well. The company seems to be focused on their business rather than the stock market and the Chairman holds 26m of the 121m outstanding shares on issue so you could say his views are the same as that of the company/shareholders.

    I believe the main risks with this are:

    1) NPAT is a small percentage of revenue which doesn’t leave much room for error (it was only 1% in FY08/09)

    2) The company is unable to achieve the same growth rate and ROE in the future

    3) The market continues to worsen and there is a downturn in the construction industry

    The company has since done a share purchase plan which will change the above now with the figures I have shown somewhat irrelevant since total shares on issue has increased. However if the company is cashed up and can earn a 20%+ ROE in future years the capital will be used well on shareholders behalf. The share purchase plan was handled well which favoured real owners rather than those buying a few shares with the hope to make a quick profit (you can see this in the market release to the ASX).

    Let me know what you think or if you disagree with any of the above as I am interested to hear other people’s perspectives on the companies mentioned. For anyone looking to make an investment there will obviously need to be some more in depth research then I have shown above.

  3. Fantastic article Roger and very impressive reply Gary. It is great to know that our market does have a population of intelligent investors although small. Gary’s analysis is so comprehensive I hope he might be able to give an insight to his top 5 ROE companies (sorry Roger but I cannot refer to a business as a stock).
    Mine (i own them) are CSL, JBH, MND, WTF and CRZ. The last two have reached my assessed value but for now.

    • rogermontgomeryinsights

      Hi Amanda,
      Unfortunately, having only recently left the businesses I founded and sold, I am not yet in a position to provide individual valuations or stock recommendations.

  4. Hi Roger, After reading your ROE article and noticed you mentioned Woolworths as one of your top five picks. After reading the 2009 Annual Reports for both Wesfarmers and Woolworths I have come up with the below info just from taking a basic look at the balance sheet and profit and loss statement:


    Market Cap $34bn
    NPAT $1.535bn
    Equity $24.252bn
    ROE 6.3%


    Market Cap $35.073bn
    NPAT $1.860bn
    Equity $7.057bn
    ROE 26.35%

    I tried to look at this from the perspective of a new shareholder entering the business today based on the fact that they had $35bn and had to choose between either Wesfarmers or Woolworths.

    With Wesfarmers I assume we would say roughly the business equity is closer to $8bn (Equity of $24bn less the $16bn of goodwill which you would exclude since $13bn of it is coles, officeworks etc). The ROE now is 19% once you remove good will, though I know you can’t just ‘write it off’ if you’re a current shareholder to show an impressive ROE as you did in fact pay $16bn in cash for a group of low ROE businesses. With Woolworths you are paying $35bn as well for $1bn less of equity and a ROE of 26.35%. Since now we are paying roughly 4-5x the equity on the balance sheet for each business our own return attributable to us is 4.75% for Wesfarmers and 5.25% for Woolworths.

    To buy either business I assume you would purchase Woolworths since you earn a higher return and based on the prior management of Woolworths/Wesfarmers and how they have allocated capital and the shareholder value/destruction they have created Woolworths is the better choice. If you assume with them every $1 of equity added to the balance sheet is going to create a 26% ROE on Woolworths and a 6.3% ROE on Wesfarmers since Wesfarmers will likely lose some value when it over pays Woolworths is clearly the better choice. (Please let me know if I have looked at this the wrong way.)

    Assuming all the above information do you know why Wesfarmers sells for nearly the same as Woolworths? If you were to purchase Woolworths do you think they are ‘cheap’ would you pay 5x the equity of the business for Woolworths? Based on other listed securities available on the ASX is either business really attractive enough to buy?

    I am not looking for any recommendations as I know you can’t provide that information more just you opinion on the comparison if you think it’s logical and if you think either are really worth $35bn.

    • rogermontgomeryinsights

      Hi Gary,

      For everything you have said before the penultimate paragraph beginning with “Assuming all the above” my response is Yes! Yes! Yes! Brilliant and well done! Regarding what you have asked after that; I don’t know why stocks continue to go to such extraordinary levels of over and undervaluation when the world and its constituents are apparently so much more sophisticated. But grateful I am that they do – that is what presents rational value investors with the opportunity to generate outsized returns. Finally, at the moment my valuation for Woolworths is $28.40 (see the Eureka Report column I write called ValueLine). My valuation for Wesfarmers is significantly lower and between $14 – $20. One should spend less time obsessing about what the market price is (as Ben Graham said its not the market’s wisdom we should be interested in) and more time focused on business values. Now, WOW’s price is so close to the estimate of value that its too close to call. Its when the price is closer to $20 that WOW becomes an outrageous money maker for you (As Buffett said – you know value when you see it). Having said that my valuations for the next few years rise dramatically for WOW if they can meet the analyst’s forecasts I have at hand.

    • rogermontgomeryinsights

      Hi Gary,

      One of the best summations I have read. WOW seems a little on the expensive side now. Wesfarmers even more so. I cannot explain why the market is willing to pay so much for Wesfarmers (although I have plenty of educated guesses about it) or why Telstra ever traded at $9.00 or why ABC traded at $8.00. Ben Graham said, in the short run the market is a voting machine and in the long run, it is a weighing machine. He was right. Popularity reigns supreme in the short term.


  5. Hi Roger,
    After discussion with my broker I did by some of your favoured stocks 2 weeks ago – WOW,JBH,MMS.
    In relation to MMS the only negative thing I have picked up on is the possible changes to salary packaging for profesionals and how that might impact MMS (Henry’s fringe benifits/tax review currently underway).
    Are you able to comment about that?

    • rogermontgomeryinsights

      Hi Joe,

      Thanks for letting me know that you bought a few shares. Please be aware however that when I discuss, in the media, stocks I like or have bought or sold, that it is not a recommendation for you to do the same. I am simply answering the question given to me during the interview. What you should be doing is your own due diligence and making sure either on your own or with the help of a qualified adviser whom is familiar with your financial circumstances and needs, that the suggestion suits those circumstances and needs.

      With regards to MMS, you are right but you have to deal with the knowns. The bigger the discount the easier it is to accept the those knowns. As the discount narrows, the uncertainties ahead become more concerning.

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