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Which A1’s look expensive at the moment?

Companies, Investing Education | Comments (32)

Which A1’s look expensive at the moment?

While share prices move every day, valuations move much more slowly.  But move they do.  Especially in the next few weeks as companies report their annual results.  Many analysts however and a great deal of the commentary will focus on earnings growth, revenue growth and dividend growth but all that matters is whether return on equity is being maintained and the company is increasing in intrinsic value.  Once you have established that and found a company that ticks every box, then all that matters is buying at a big discount to intrinsic value.

I have been saying for some time that the vast majority of A1 and A2 companies appear to be expensive.

In response to several requests to be more specific on the subject, I thought I would list a few companies that I believe are currently above their intrinsic values.

The following companies are those that come immediately to mind and that I believe are both very high in quality AND very high in price:  Servecorp, ERA, Seek, Navitas, ASG Group, Domino’s Pizza, Fleetwood, Carsales, David Jones, Cochlear and Reckon.

Obviously, I will be interested in the full year results for these companies and indeed every company, which may change the intrinsic values dramatically.  Moreover, I am NOT predicting that the shares of these companies will fall in price.  As much as I would like to be able to share that information with you, I just do not have it.  I am not able forecast share prices and as I have repeatedly noted, estimating the value of a company is not the same as predicting their share price.

For now however, those listed above look sufficiently expensive for me to conduct research on other companies.  Be sure to seek and take personal professional advice BEFORE undertaking any activity in shares or derivatives or any securities.

Posted by Roger Montgomery

31 July 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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32 Comments

  1. Craig
    :

    Hi Roger,

    Firstly, great book. Succinct, readable and brilliant. One of the best investment books I have read (and I don’t really read much else!)

    I have a question for you that I would guess some others might be wondering if you haven’t been asked already:

    I notice you state in Chaper 9 – Cashflow & Goodwill – that you use companies reported earnings for your valuations and you say that has been enough to identify extraordinary businesses and avoid the lemons.

    You also give great advice on how to check the cashflow statement and balance sheet to make sure that the reported earnings are not masking anything more sinister.

    But I am interested in why you have not included any mention of Buffetts term ‘owner earnings’ as was popularised in his 1986 letter to shareholders and that your valuation techniques do not seem to focus on this method of finding a companies true ‘take home’ cash before running your formula, as it appears Buffet does.

    I note you make two comments about separating out maintenance and growth expenditures and how acquisitions make this difficult. So presumably this is something you do focus on. You provide no advice as how to estimate maintenance capital or why one would need to do so. This observation comes because I have been trying for awhile to determine a good way to do this.

    Is it the inherent difficulties in seperating growth and maintenance capital (with or without acquisitions!) that put you off utilising Buffets owner earnings calculation in your book?

    I may also have misinterpreted Buffetts comments on capex and ‘owner earnings’ in some way.

    Your thoughts and comments would be much appreciated. Keep up the good work, your successful use of modern media for marketing is inspiring. And it’s great how accessible you are (at least for us punters ;).

    Regards,
    Craig

    • Roger Montgomery
      :

      Hi Craig,

      You have hit the nail on the head. A book that becomes too technical may turn investors towards paths of lesser resistance and that would be a shame because a few simple steps are really all thats needed. The cash flow method I have described in the book will give you the answer you are looking for. The next step is the explanation. Whether its maintenance or growth may be less important than whether its positive or negative.

  3. Eamon
    :

    With a 60% ROE from NVT performance, I cant be more prouder. Its abit like your kid getting an award at your shool graduation night, for excellences in what ever field he/she was good at during the year. I felt like a proud shareholder, tears of joy.

    Yes I do understand that this business is second best to ones that retained all of its profit and compounded the earnings, but its still second best, and through my eyes its still a champion.

    Eamon ;)
    (please note I’m not suggesting you should go out and buy some, please seek personal financial advise to deterimine whether this stock mets your financial needs/objective. You could loss all your money buying in as it is overpriced compare to its intrinsic value, calculated using Rogers book, Value-able)

      • Eamon
        :

        Very true Roger,

        My comments are for your enjoyment only.

        (I do own shares in NVT, so dont go out and buy some. Just because I own them, it doesnt mean they are right for you)

      • Eamon
        :

        Dear Roger,

        I was shock to discover that using your book to value NVT 2010 results concluded a valuation of $1.80 or thereabout. I’am correct with the valuation calculation, as the price for NVT is way……way above its head.

        Perhaps there should be something in the calculations that should take into consideration current market sentiment. Example; During good periods, valuation should be higher to reflect prices, optimistic investors are prepared to pay. Similarly during bad periods, valuation should be lower to reflect pessimistic sentiment of investors attitudes towards taking risk, to better reflect prices.

        As it seems, through using your book there is alot of stocks, I shouldnt have sung my bat at even though my dad keeps telling me to swing.

      • Roger Montgomery
        :

        Absolutely not! It is not the job of a valuation to come up with a number that looks like the price. If you want the price it is there for free to see. You don’t need a calculation for that. Valuation is based on performance. End of story.

  4. Paul
    :

    Roger

    (NB Haven’t read the book yet) I’d be very interested in your thoughts on Navitas after today’s results. This looks like a well run company, strong returns, building a record of good performance. But I note your ‘very high in price’ comment above – and after today it’s higher. I guess this means we have to get in before the crowd or wait patiently for price weakness. I ‘d also like your thoughts on the 100% payout.

    Thanks for your time

    • Roger Montgomery
      :

      Hi Paul,

      Navitas is a wonderful business. Wouldn’t you love to own a business that generated a 60%-80% return on equity, paid all the profits out as a dividend and then grew the profits again next year? That’s Navitas. Even though all the earnings are paid out to owners, the earnings. A business that can grow earnings (while generating high returns on equity) without requiring any reinvestment by the owners, is surely great. They are my thoughts on 100% payout in this case. Of course it would be even better if they could retain all the profits, grow the equity and then generate another 80% on the total – growth would be much faster, but in the absence of that, what Navitas demonstrates is an excellent second prize. The company however does only have 29 cents in equity so the multiple of that equity I am willing to pay to purchase the 60% returns it generates, will determine the value.

  6. Gavin
    :

    Hello Roger

    I have just received the book in the mail. First thing I went skimming for was your definition of A-C and 1 -5 for your quality ratings. Seems the general principles are there but nothing more specific. When you talk A1 it doesn’t really mean much to me, other than ‘Roger thinks it’s the best quality’, if I don’t know the specific criteria you use for the designations.

    Maybe the detail is in the book and I will get to it on thorough reading. Otherwise could you please provide some specifics around the criteria you use for your quality ratings, or direct me to where it has been discussed in the past?

    Without knowing the criteria defining A1, B3 C5 etc., talking in such terms, looses a lot of its value able meaning.

    • Roger Montgomery
      :

      Hi Gavin,

      The ingredients are there. Return on Equity, Competitive advantage, changes in equity, dilution, debt are all considerations in the assessment of quality. The scoring system I have simply quantifies those things so that I am being consistent in the comparisons.

      • Gavin
        :

        Hi Roger

        This one probably doesn’t need to be posted.

        I think the term “intrinsic value” is a general term; it has no exclusive meaning or numerical value until you clearly define the parameters. In another thread I’m chasing a formula so that ‘your definition’ of intrinsic value is fully defined.

        So to with A1, B3, C4 etc. They have no real meaning until you fully define the parameters.

        I think, if you are going to communications using these terms than your scoring system should be in the public domain.

        I bought ‘your’ book so that I could understand ‘your’ parameters, for when you talk in terms of “Intrinsic Value” and “A2, B etc. But the full information was not in there.

        I hope you will provide the information I seek – buts it’s your choice, “an air of mystery” or a solid basis for communication and knowledge sharing.

        Regards

        Gavin

      • Roger Montgomery
        :

        Hi Gavin,

        I have taken you to the river I fish in. Its is full of fish and you will catch a lot of fish in this river. Would you mind ever so, If I ask that I go to my fishing hole on my own and you find one yourself. WIth some time, you will no doubt come across mine too. In the meantime, I will keep bringing you some of the fish I have caught for you to study. Buffett in his annual letters gives all the information you need to calculate the intrinsic value, but neither his formula nor his estimate. I give you all the information, tables, steps and estimates with worked examples.

      • Chantal Wiessner
        :

        Hi Roger,

        How do you quantify competitive advantage? I can understand how you can quantify the other ingredients.

  8. costas
    :

    hi roger.
    i like the way you do the valuations and talk about there intrinsic value.just a question to ask is after a company’s full year release can your opinions change dramatically from one day to the other?(can it become a c5 from an a1?).
    i am waiting to see carsales release.

    thx roger

    • Roger Montgomery
      :

      Yes Costas, the scoring can and does change from year to year. While it may seem as though the numbers change from one day to the next, the reality is that the results are reflecting activity (in the case of the profit and loss statement) over the course of the year.

  9. Andrew
    :

    Hi Roger,

    Interested to know if you have ever come across Allied Brands ABQ and what your thoughts are? Fundamentally the has had write downs after write downs it of late. What is interesting to note is the recent volume that has come into a once very illiquid stock. From a techincal perspective (which is my main interest as you may remember from previous posts) it is telling me either insiders are dumping the stock and it’s heading to zero or they believe the company is getting itself in order by selling down some brands and re focusing. All of a sudden the quarterly chart is up on big volume so I will keep my eye on it very speculative though. Pays a rediculous dividend too.

    • Roger Montgomery
      :

      Hi ANdrew,

      Looking at ABQ, the quality has deteriorated in the last three years and that appears to also be reflected in the share price. It looks like it might be at a big discount to intrinsic value, but its not an A1. When the full year results are out I can say more, unless you have access to some forecasts.

  10. Eddy
    :

    Hi Roger,
    I am looking forward to receiving your book. I am interested in buying some Leighton shares and have seen their intrinsic value around the $32 mark. Is there enough margin of safety at the moment and what is their value likely to be in 2012? I know their ROE is greater than 20 in the next two years.

    Regards,
    Eddy

    • Roger Montgomery
      :

      Hi Eddy,

      They seem to be at a small discount to intrinsic value. They are not an A1. Be sure to seek and take personal professional advice from someone familiar with your circumstances and needs, and that goes for everyone.

  11. Craig
    :

    Hi Roger
    I absolutely agree, a great bunch of businesses but not great prices but what about if one already owns some of those great businesses purchased at prices way below current instrinsic value.
    I am happy to continue to hold knowing the value rises over the coming years but if the full year results show a deterioration, I don’t expect this, I’ll join the lemmings at the door.
    If a great capital gain exists and the return on original capital is very pleasing and the business continues to grow why not stay there? As you said you cannot predict if prices will fall, I know I can’t!

    • Roger Montgomery
      :

      Hi Craig,

      Read and consider the chapter called Getting Out in my book. It sounds like you are giving the issues some serious thought. That chapter might give those thoughts some direction.

      • Craig
        :

        Move over Graham and Fisher, Montgomery has arrived!

        Just read Getting Out and in respect to my comments above I understand that continuing to own these great businesses when the price has risen above value will depend on the level of overvaluation and their future prospects at the moment I am comfortable with both and will keep my interest free government loan until the greater fool comes along.

        By the way Roger it’s a great piece of work you have completed here, congrats and thanks the intrinsic value exceeds the price by a very large margin

  12. Damian
    :

    Roger,

    The financial crisis convinced me, with only a few years of investing experience, of the importance of the Buffett rules of selecting companies with low debt and consistently high return on equity.

    I find it strange that so few brokers and financial planners, with much more investing experience, understand these two very simple rules.

    With your experience dealing with brokers, do you have an explanation for this? Do you think brokers don’t know these rules, don’t understand them, or don’t believe them?

    I think it would be good if these concepts were part of the mandatory training they do to get a licence, especially as they are responsible for investing the money of others.

      • Rici Rici
        :

        there is a very good reason why brokers ‘dont understand them’.
        The financial industry relies on transactional volume for remuneration.

        I suggest you read
        Margin of Safety by Seth Klarman

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