What happens when you buy great businesses cheap?
What happens when you buy great businesses cheap?
Shares need to be treated as pieces of businesses rather than bits of paper that wiggle up and down on a computer screen. This seems pretty rational and yet professional investors might buy a company that is a manufacturer of pet rocks loaded with debt because its inclusion in the portfolio reduces its overall volatility.
The same professional might not buy shares of a great business when they are truly cheap, having instead to wait until the shares have risen sufficiently to cause them to be included in the S&P/ASX 200. Buying shares this way, or simply buying in the hope they will rise, is not the same as buying a piece of a business.
The purchase of shares on the baseless hope of a capital gain is no different to betting on black or red at the casino.
Perhaps, because it is seen as too difficult, few investors simply purchase at attractive prices, a portfolio of 10 – 20 great businesses. This is despite the fact that such an approach produces substantial outperformance.[1]
To prove that quality counts, back in the June 2009 issue of Money Magazine I listed eleven stocks that I believe constitute great businesses – Cochlear, CSL, all four major banks, Realestate.com, Woolworths, Reece, The Reject Shop and Fleetwood. Their combined return since July 1 has been 30 percent compared to the S&P/ASX 200 Accumulation Index return of 24 percent. Four of those companies have also risen by more than 40 percent in that time.
In July 2009 I also commenced a portfolio of eight stocks for Alan Kohler’s Eureka Report that included JB Hi-Fi and Platinum Asset Management. An equally weighted portfolio invested in those eight stocks would have risen 27 per cent and Platinum, one of the companies in the portfolio, is up over 53 per cent.
And the shares at the time were not even bargains. Imagine the returns if you had purchased them when they were at significant discounts to their intrinsic values back in February and March this year!
By Roger Montgomery, 26 October 2009
[1] For the year to June 30, 2009, and prior to my resignation, the boutique funds management firm I established, floated and sold, produced a return of +11% for clients with individually managed accounts (IMA). The Listed Investment Company I founded and was Chairman and Chief Investment Officer of produced a return of +3%. For the same period the S&P/ASX 200 Accumulation Index produced a negative return of -20.7%.
By Roger Montgomery, 26 October 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.
INVEST WITH MONTGOMERY
Mick
:
Hi Roger – your always a help – cheers!
I should perhaps clarify out of respect as you have shaped my thinking immensely – ROE is the first thing I look at hands down. I want to know what I get back when I buy equity in a business; what is my return on the equity I am buying?
Viewing anything in isolation including ROE is hazardous, but when looked at in association with other measures, I feel it represents my return as an equityholder best.
It’s inputs can also be tweaked to take other factors into account, hence it is a very adaptable symbol. ROE is a key part of my analysis, along with Debt. (I prefer % Debt to D/E as I get a better feel for the chunk the business owes, 0 is preferable; each to his own and all that).
If there is no debt, then I don’t need to look even at ROCE – already done via looking at ROE. I guess that’s the point I was trying to make, along with the SAFEST position you can be as a business debtwise, is without any.
If a reasonable debt level exists, then by all means use ROCE as part of the process to investigate whether it’s “good debt” ie value accretive. Then there are all the other measures to assess the business, and the more that look good, then the better the business. Too easy(!)
As you say, there are alot of good businesses out there, it’s just getting them at a good price, and that means assessing their value… so how’s that book coming along anyway? :)
admin
:
Hi Mick,
I forgot to mention, the book should be printed towards the end of March.
Mick
:
Indeed a great question Wayne, one I had been considering myself! I like the idea of ROCE as it takes debt into account, but got to thinking: what happens when a business has no debt? ROCE has to equal ROE – it IS the ROE, as the total capital is all equity capital (no debt capital exists). So you and Roger kind of agree that ROCE is a great metric for a business with no debt! From a purely safety perspective, it must be wiser to invest in a debtless company as opposed to one with liabilities…after all creditors get paid before us.
My guess is that RM likes ROE because it represents profitability directly related to our investment as a shareholder. In other words “what return did we get for our money? To me ROCE feels a little more like what did the business get for it’s money – mine and what they borrowed. I don’t mind if the company uses debt to make me some more money but it does add more risk so I want a bit more return.
I’ll try an eg, bear with me. If the basic accounting equation holds Assets = Liabilities + Equity, or rearranged, A – L = E, and if Business X has 100m in assets and no liabilities, it’s equity (therefore total capital) is 100m. (100m – 0 = 100m)
If X made 20m last year then ROE = 20% (20m/100m), and ROCE would be the same: 20m/100m or 20%. That’s pretty good. If X’s twin, Business Y, instead had 40m liabilities, then equity changes to 60m (100m – 40m = 60m) and ROE becomes 33% (20m/60m). ROCE still remains at 20% as capital is still 100m: 40m debt plus 60m equity.
On an ROCE basis both companies are the same: 20%. On an ROE basis Y returns 13% more but has 40m debt to contend with; so if you have a higher tolerance for risk, you can get a potentially greater return from Y.
Remember that movie Highlander: “There can be only one”? Unfortunately that doesn’t apply to financial metrics, and we will always have to consider at least several (if not more!) to make a good investment decision. Whether debt is considered by looking at debt ratios or through ROCE (or otherwise), it needs to be taken into account. I’m sure RM looks at debt somewhere along the line – even if he doesn’t use ROCE! Thanks so much for mentioning DuPont too (a bit nicer than Penman-Nissim). I hadn’t heard of it until now and always appreciate learning something new, cheers :)
admin
:
Hi Guys,
There is an appropriate quote or two from Mr Buffett:
“Focus on Return on Equity”
and
“I do not like debt and do not like to invest in companies that have too much debt, particularly long-term debt. With long-term debt, increases in interest rates can drastically affect company profits and make future cash flows less predictable.”
There are enough companies with little or no debt in Australia that I don’t need to stray too far. If I am looking at companies with no debt, then ROE = ROCE because Assets = Equity.
The bigger issue is not so much the debt, but the constant increase in debt and its use to buy hot air. By that I mean watch out for companies with loads of debt and high levels of acquired goodwill.
I hope that helps.
Wayne
:
I am a interested observer but novice at evaluating the financial performance of listed companies. Notwithstanding my limited knowledge, it seems to me that ROA and ROE have inherent deficiencies in measuring performance. Each of these ratios seem to be easily obtainable from research houses and used a method of comparison between investment opportunities. Would not Return on Capital Employed (ROCE) be a more stringent measure after reorganising the balance sheet according to the duPont method? Any thoughts?
rogermontgomeryinsights
:
Great question…
I look at a number of ratios to ascertain the quality of a company and breaking down ROE with DuPont provides some of the information that I use, but not its interpretation. ROE for a company with little or no debt is what I use. That doesn’t make it right or wrong, but I believe it is best.
Ian
:
Of course I’m sure Roger would be the first to agree that 4 months is way too short a time to evaluate returns of a portfolio picked on the basis of being great businesses.
One could argue that a rising tide lifts all ships, and a portfolio of AIG, FMG, CDU, IIF and VBA would have returned > 60% since June, but value investors might not like ROEs below 15% coupled with debt ratios > 60%, coupled with net losses (or no revenue at all except for more capital raising).
I would concur that not much looks cheap right now.