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Is your portfolio filled with quality and margins of safety?

Click on the image at left to see a close up of the stocks we like.

I reckon 2012 will be the year to get set and fill your portfolio with high quality businesses, demonstrating bright prospects for intrinsic value growth and a margin of safety. That will be the topic of my talk today as I kick off the ASX’s 2012 Investor Hour series. Here are the details:

Topic: Buying opportunity

When: Tuesday 21 February
Where: Wesley Conference Centre, 220 Pitt Street, Sydney (venue location)
Time: 12 noon – 1pm. Please arrive by 12.00 noon for start
Details:

The time to get interested in share investing and make good returns is precisely when everyone else isn’t. But know that the key to slowly and successfully building wealth in the sharemarket is to avoid losing money permanently.

At this event Roger will set out his principles for stock selection.

Roger Montgomery is a highly-regarded value investor, analyst and author and a regular contributor and commentator across the media. Roger is an analyst at Montgomery Investment Management Pty Ltd.

Presenter(s): Roger Montgomery, www.Skaffold.com, www.Montinvest.com

Posted by Roger Montgomery, Value.able and Skaffoldauthor and Fund Manager, 21 February 2012.

Posted in A1, Company Valuation, Market Valuation, Value Investing

13 Comments Leave a Comment

Gold v Stocks; Who will win?

On one side of the investing coin is the idea that you lay out money today to get more back later. The flipside is that buy purchasing today you forego consumption today for the ability to consume more later.

They aren’t quite the same thing of course, because the latter idea introduces inflation and suggests the purpose of investing is to at least maintain purchasing power (generate returns in line with inflation) or increase purchasing power (generate real returns in excess of inflation).  In a useful reminder Buffett observes:

“Even in the U.S., where the wish for a stable currency is strong, the dollar has fallen a staggering 86% in value since 1965, when I took over management of Berkshire. It takes no less than $7 today to buy what $1 did at that time. Consequently, a tax-free institution would have needed 4.3% interest annually from bond investments over that period to simply maintain its purchasing power. Its managers would have been kidding themselves if they thought of any portion of that interest as “income.”"

Therefore an investment that is price stable but loses purchasing power is very risky (think US T-Bonds) while an asset that is volatile in price but almost certain to increase purchasing power over time is less risky than the conventional measures of risk would dictate.

This is how Buffett begins an excerpt of his forthcoming letter to Berkshire Hathaway shareholders HERE. One scenario his introduction does not contemplate of course is deflation. Japanese real estate and equity prices are fractions of their previous levels and a bond offering even a miniscule return would produce an increase in purchasing power. Like many readers, you might reach the conclusion that the absence of this scenario in his letter along with the knowledge of aggressive equity purchases in recent months, indicates he does not believe deflation is a possibility.

The other subject of his letter is Gold. Melted down all the gold in the world would amount to one 68 cubed foot of uselessness. Somewhat ironically he reflects on its purchasing power today – all the agricultural land in the United States, sixteen companies as valuable as Exxon and a trillion dollars in walking-around money.

But he points out that the companies will have thrown off dividends and the land would have produced food. And so the article leads to the defence of buying businesses as a superior strategy (to owning gold ‘that just sits there’) – as we believe at Montgomery Investment Management, and you might as Value.able graduates (after seeking and taking personal professional advice).

I believe Buffett’s take on the investing landscape is ultimately correct (bubbles are always followed by a bust and nothing goes up forever);

“What motivates most gold purchasers is their belief that the ranks of the fearful will grow. During the past decade that belief has proved correct. Beyond that, the rising price has on its own generated additional buying enthusiasm, attracting purchasers who see the rise as validating an investment thesis. As “bandwagon” investors join any party, they create their own truth — for a while.”

But I trust you can see the irony in claiming gold is useless and yet it can buy 16 Exxons and so on. As the chart shows, it has underperformed stocks over the long term and without boasting about it Buffett uses the S&P500 index to demonstrate the superiority of stocks. In a thinly veiled warning to gold bugs he likens the current enthusiasm for gold to the internet bubble and US housing speculation pre-2007.

In his enthusiasm for stocks being best able to retain purchasing power or increase it, I can’t but help remembering that Buffett was a more circumspect proponent of stocks in the seventies – a period of very high inflation. While in 1974, when Forbes asked Buffett how he felt about the stock market at the time, Buffett replied, “Like an oversexed guy in a whorehouse”, his 1979 letter to investors serves as a useful reminder of the limits of any asset to retain purchasing power during bouts of high inflation.

“Just as the original 3% savings bond, a 5% passbook savings account or an 8% U.S. Treasury Note have, in turn, been transformed by inflation into financial instruments that chew up, rather than enhance, purchasing power over their investment lives, a business earning 20% on capital can produce a negative

real return for its owners under inflationary conditions not much more severe than presently prevail.

If we should continue to achieve a 20% compounded gain – not an easy or certain result by any means – and this gain is translated into a corresponding increase in the market value of Berkshire Hathaway stock as it has been over the last fifteen years, your after-tax purchasing power gain is likely to be very close to zero at a 14% inflation rate. Most of the remaining six percentage points will go for income tax any time you wish to convert your twenty percentage points of nominal annual gain into cash.

That combination – the inflation rate plus the percentage of capital that must be paid by the owner to transfer into his own pocket the annual earnings achieved by the business (i.e., ordinary income tax on dividends and capital gains tax on retained earnings) – can be thought of as an “investor’s misery index”. When this index exceeds the rate of return earned on equity by the business, the investor’s purchasing power (real capital) shrinks even though he consumes nothing at all. We have no corporate solution to this problem; high inflation rates will not help us earn higher rates of return on equity.”

Another warning to stick to high ROE businesses…

Finally remember that if you are buying stocks, unlike commodities, there exists management risk, execution risk, result risk, competitor risk, economic risk, currency risk etc. Anything can go wrong in a business and frequently does. And while Chalrie Munger has pointed out that “Almost all good businesses engage in ‘pain today, gain tomorrow’ activities”, you must know what you are doing.

I think stocks are indeed the best opportunity to retain and increase purchasing power but only the good quality ones.  Knowing what you are doing and sticking to high rates of return on equity, little or no debt and A1 or A2 businesses increases your chances of doing even better than the both the stock market index of which they are constituents and inflation.

Posted by Roger Montgomery, Value.able and Skaffoldauthor and Fund Manager, 14 February 2012.

Posted in A1, Company Valuation, Insightful Insights, Skaffold

37 Comments Leave a Comment

Does your adviser agree with these stocks?

The ability to pick stocks that never go down, is NOT one of our skills.  Plenty of you can attest to that.  Value investing using the method we advocate in Value.able and using Skaffold.com cannot prevent losses, it is about minimising the cases of permanent impariment.

Asked by BRW’s Tony Featherstone which small caps we liked we nominated a few. Here’s the list and if you cannot read it properly or would like to also read about the TOP 10 Start Ups of 2011, grab this week’s copy of the BRW.

Remember to seek and take personal professional advice before engaging in any security transactions.

Posted by Roger Montgomery, Value.able and Skaffold author and Fund Manager, 9 February 2012.

Posted in A1, Insightful Insights, Mining Services, Skaffold

16 Comments Leave a Comment

How to analyse a new float or IPO.

There has been a bit of action on the IPO front over the past few months. Sixteen stocks have been added to the main board of the ASX, as set out below with their actual listing date.

I thought it might be a worthwhile task to run the ruler over them and see if any are potential investment candidates among the newcomers.

Let’s start our exercise at the more speculative end of the investment spectrum. I don’t gamble with money, so let’s eliminate those that are involved in exploration activities given their high risk/high reward dynamics. There are 12 exploration businesses among this group. I will leave these to others who are more suitably qualified in working out whether any opportunities exist here and whether they will find something before their cash runs out.

Of those remaining, well-known NZ website Trade Me and RXP Services are involved broadly in the IT space, Alliance Aviation is involved in mining services and finally Chorus, another NZ company, specialises in Telecommunications. These are the four businesses we will focus on. A brief review of these follows.

Alliance Airlines (AQZ)

I will start with a sector I know well – airlines. A capital intensive industry with lots of competition rarely makes for wonderful business economics (Qantas, Virgin) and despite Alliance operating in a niche market of fly-in, fly-out operations for the mining sector, my view remains the same: I will never invest a dollar into this sector.

Alliance has grown quickly since its formation in late 2002. From nothing, to a fleet of 20 Fokker 100 and Fokker 70LR jets as well as five Fokker 50 turboprops with established, long-term, profitable blue-chip relationships with BHP Billiton, Santos, Incitec Pivot, and Newcrest. That’s an outstanding achievement by management. A distinguishing feature is that approximately 75% of Alliance’s 2010-11 revenue was subject to medium to long-term contracts – recurring revenues.

No matter. Any airline cannot escape competition or its high level of ongoing capital requirements. And for a niche space, four other competitors (Cobham, Network aviation, Qantaslink, Skywest) appear to be a handful in terms of the prices they can charge, competition for future contracts (especially when 44% of 2010-11 revenue was from one client, BHP), ongoing operating margins and future market share gains.

A total 47.6% of Alliance’s forecast for 2011-12 EBITDA will be consumed on refurbishments, maintenance, rotables, new aircraft and property, plant and equipment. This leaves just over 50% to pay taxes, interest and for working capital requirements. And once all is paid for, only a little will be left over for future dividends, buybacks, etc. It is not surprising, therefore, that the prospectus does not forecast a dividend to be paid in 2012.

Despite a pro-forma forecast of $18.1 million NPAT, or 20.1¢ earnings per share, and the shares trading below what the business may be worth, if you ever see me buying an airline, please put me in a straitjacket.

RXP Services (RXP)

Unfortunately, this business has a very, very short history and no real track record. It was formed in October 2010, just 15 months ago, with the purpose of establishing an information & communications technology (ICT) business with a focus on medium/large enterprises and the government.

The founders have done this, but with one drawback. Rather than building a business organically, the purpose of the float was mainly to raise funds to acquire two unlisted businesses in Vanguard and Indigo Pacific. The rollup of these has seen RXP service capabilities expand overnight from nothing into a broad range of management, business and ICT consulting, delivery and support services.

With a number of already listed ICT businesses already competing for market share – SMX, CSG, OKN, many of which have had a chequered operating history as listed entities – the space appears to be a little crowded. I can’t see how RXP will differentiate a commodity product offering.

And turning to its financials, despite the consolidated accounts in the prospectus showing how the businesses may have looked had Vanguard and Indigo been owned in the past, they weren’t; what we see is what would have been a profitable little businesses. But as we have little to go on as to how they will actually function together going forward under new stewardship, we will watch this one from the sidelines for now.

Chorus (CNU)

Chorus is a spin-out from Telecom New Zealand. It is New Zealand’s largest telecommunications utility company, a technical way to describe a business that builds, maintains and repairs existing phone and broadband lines.

Following the demerger, Chorus is a business whose sole focus is on bringing fibre within reach to as many New Zealanders as possible – kind of like our own NBN Co., but not run by the government, even if it has been chosen by the Crown to build NZ’s ultra-fast broadband (UFB) network to 830,000 urban premises, as well as extend fibre further into rural New Zealand through the Rural Broadband Initiative (RBI) by the end of 2019.

Having so far deployed some 2500 kilometres of fibre optic cable, upgraded hundreds of local telephone exchanges with new broadband equipment and installed or upgraded about 3600 roadside cabinets, a target of 20,000 kilometres of fibre optic cable to deliver ultra-fast broadband will probably be met. Management’s recent experience in rolling-out ADSL2+ broadband is coming in very handy and helping to build New Zealand’s fibre future.

There are some obvious tailwinds here, with the long-term nature of this contract and ratings agency Moody’s has assigned Chorus a Baa2, stable issuer and senior unsecured rating. A rating similar to Bulgaria and Kraft foods.

Look under the hood, however, and you can see that about $NZ1.7 billion of net interest bearing debt was outstanding as at December 2011, all current. On just $NZ422 million of equity, it appears that Telecom New Zealand may have also let go of some unwanted baggage in the de-merger.

While 2011 cash flows appear to be well managed and interest payments well covered, I can’t help but be reminded of another infrastructure asset in Asiano when it was demerged from Toll holdings in 2007. It too was saddled with a large debt burden and at the end of its first trading day; Asciano had a market capitalisation of $7 billion. Today it is $4.5 billion.

Trade Me (TME)

Last but not least is the well-known NZ website Trade Me. Similar to eBay international, Trade Me is now dual-listed on both the New Zealand and Australian Stock Exchange.

While this is another spin-off, Fairfax Media Limited (ASX:FFX, SQR B3) has retained a shareholding of 66% – generally a good sign.

On one reading this might be the pick of the recent floats. The business has an  moderately geared balance sheet, produces a significant amount of free cash with low levels of ongoing capital expenditure now that the website is mature and has a history of earnings growth which any shareholder, and that includes Fairfax, would be truly happy with. On top of this, with Fairfax retaining a material level of ownership in the business, they are still highly incentivised to continue promoting the website via its vast media network.

On another reading Fairfax paid $750mill for Trade Me (TME) and have just sold 34% of it for $363.5 mill or a total ‘value’ of $1.07Bln.  This will help them justify the carrying value on their own balance sheet.  Further, since 2007 TradeMe has made net profits totalling $276mill, the bulk of which has been taken out as dividends.  So FFX have made an IRR of about 17% per annum.  Given FFX have set up the company with market cap of about $1 billion, equity of $631 mill ($721 mill goodwill and therefore negative NTA) and debt of $164 mill, the expected return on equity is just over 10 per cent means FFX have got a return that you might not.

As “Rainsford” wrote here at the blog: “Seems to me it’s a great deal for Fairfax but not so great for other investors”.  If analysts are projecting 18.2¢ for 2013, which equates to 5% growth, and with the shares trading at $2.31, they appear to be fully valued given current expectations. Patience will be need to be exercised on this one.

Posted by Roger Montgomery, Value.able and Skaffold author and Fund Manager, 6 February 2012.


Posted in A1, Floats, Skaffold, Value Investing

11 Comments Leave a Comment

An upgrade amid the malaise!

Reporting season has begun in ernest and a few companies we have been watching (and some of which we own in the Montgomery Private Fund) have reported. Today it was Credit Corp’s turn (ASX: CCP, SQR* A2). You can find the presentation here (be sure to read and agree to the ASX and our disclaimer).

Skaffold members are likely to have already seen CCP on the Aerial Viewer with an A2 rating and a discount to Skaffold’s estimate of Intrinsic Value.  In the Montgomery Private Fund, we have owned the stock for some time now and I have mentioned it as a stock to investigate on many TV and Radio programs.  Today’s 10 per cent gain is certainly a welcome boost to the gains already registered.

The highlights from the announcement of the half year results for us were 1) that earnings were at the top end of guidance, 2) a 12% increase in revenue translated to a 23% increase in NPAT, 3) a welcome reduction in debt to its lowest level since listing and 4) strong free cash flow after an increase in dividends and finally a conditional settlement of a “distracting” class action.  This final point is particularly important for many investors who will now feel vindicated that it was not the investor who erred.  The impact of the settlement on earnings will be immaterial thanks to insurances.  At current rates of cash flow generation, debt could be extinguished completely by the end of the financial year.

Grant Duggan – a regular blog poster here – was kind enough to make the following comments below:  ”If i recall on YMYC a caller asked for one xmas stock to put under the tree for 2012, and much to your dislike [Roger] to only be able to pick one it was CCP, and i know two months don’t make a market but to me this is another indicator of value able investing starting to prove its worth. Thanks to Roger and all blog posts once again.”

I know I am harping on about it but if you have not joined as a member of Skaffold, how are you planning to find the best opportunities during reporting season?  Join Skaffold who have done all the hard valuation and quality assessments for every single listed company so you don’t have to.

Posted by Roger Montgomery, Value.able and Skaffold author and Fund Manager, 2 February 2012.

Posted in A1, Skaffold, Value Investing, Value.able

34 Comments Leave a Comment

Are investors giving up?

We have talked here at the blog about hypothecation, re-hypotecation and hyper-hypothecation, about credit default swaps about a Chinese property bubble bursting, about lower iron ore prices, slower economic growth, increased savings and declining rates of credit expansion and a European sovereign default.  Always the value investor, we are on the look out for anything that can impact the values of companies and those things that might offer the prospect of picking up a few bargains.

If your portfolio still has some rubbish in it, then being able to identify it is a key part of preparing for cheaper prices if they eventuate.

I recently wrote a column for the ASX and pondered the possibility of a climactic event coinciding with a complete throwing in of the towel by equity investors who are simply fed up with poor medium term returns and increased volatility recently.

The ASX200 hasn’t generated a positive capital return since 2005 but quality companies have.  The ASX200 contains stocks that are rubbish so it is no wonder that an index based on that rubbish has gone nowhere.  Step 1 then is to clean up the portfolio and step 2 is to be ready for quality bargains when they arise.

This is just one of many scenarios and frameworks I am operating with and I wonder what would transpire if the poor returns or the recent heightened volatility continues for a little longer?  Will investors simply throw in the towel, leave equities and believe all those advisors offering their own brand of ’safe’, ’secure’ and stable investments?  On the one hand, I hope so.  It would mean certain bargains.

Here’s the Column:

As global sharemarkets decline, remain volatile and produce poor historical returns compared to other asset classes, it will be easy to be swayed by the latest investment trend – to move out of shares. I believe the trend away from shares will gather pace soon as more and more “experts” use the rear-view mirror to demonstrate why sharemarket investors would have been better off somewhere else.

In 1974 US investors had just endured the worst two-year market decline since the early 1930s, the economy entered its second recessionary year and inflation hit 11 per cent as a result of an oil embargo, which drove crude oil prices to record levels. Interest rates on mortgages were in double digits, unemployment was rising, consumer confidence did not exist and many forecasters were talking of a depression.

By August 1979, US magazine BusinessWeek ran a cover story entitled ‘The Death of Equities’ and its experts concluded shares were no longer a good long-term investment.

The article stated: “At least 7 million shareholders have defected from the stockmarket since 1970, leaving equities more than ever the province of giant institutional investors. And now the institutions have been given the go-ahead to shift more of their money from stocks – and bonds – into other investments.”

But be warned. The time to get interested in share investing and make good returns is precisely when everyone else isn’t.

Your own once or twice-in-a-lifetime opportunity may not be that far away and Labor’s promised tax cut on interest earnings may sway even more to give up shares and put their money in a bank, providing the opportunity to obtain even cheaper share prices.

If prices do fall further – and they could – you will need to be ready and will need some cash. The very best returns are made shortly after a capitulation.  Cleaning up your portfolio becomes crucial and this article looks at how to do that.

Rule one: Don’t lose money

The key to slowly and successfully building wealth in the sharemarket is to avoid losing money permanently. Sure, good companies will see their shares swing but the poor companies see the downswings more frequently.

Therefore, the easiest way to avoid losing money is to avoid buying weak companies or expensive shares. One of the simplest ways I have avoided losing money this year in The Montgomery [Private] Fund has been to steer clear of low-quality businesses that have announced big writedowns.

These are easy to spot using Skaffold.

Not-so-goodwill

I have often seen companies make large and expensive acquisitions that are followed by writedowns a couple of years later. Writedowns are an admission by the company that they paid too much for an asset.

When Foster’s purchased the Southcorp wine business in 2005 for $3.1 billion, or $4.17 per share, my own valuation of Southcorp was less than a quarter of that amount. Then in 2008 Foster’s wrote down its investment by about $480 million, and then again by another $700 million in January 2009 and a final $1.3 billion in 2010.

When too much is paid for an acquisition, equity goes up but profits do not and you can see that too much was paid because that ratio I have worked so hard to make popular, return on equity (ROE), is low.

These low rates of return are often less than you can get in a bank account, and bank accounts have much lower risk. Over time, if the resultant low rates of return do not improve, it suggests the price the company paid for the acquisition was well and truly on the enthusiastic side and the business’s equity valuation should now be questioned. If return on equity does not improve meaningfully, a large writedown could be in the offing. This will result in losses if you are a shareholder, and you have also paid too much.

Just remember one of the equations I like to share:
Capital raised + acquisition + low rate of return on equity = writedown.

When return on equity is very low it suggests the business’s assets are overvalued on the balance sheet. That, in turn, suggests the company has not amortised, written down or depreciated its assets fast enough, which in turn means the historical profits reported by the company could have been overstated.

Scoring bad companies: B4, B5, C4 and below…

These sorts of companies tend to have very low-quality scores and often appear down at the poor end of the market – the left side of the screen shot in Figure 1 below.

Figure 1. The sharemarket in aerial view (Source; Skaffold.com)

Each sphere in Figure 1. represents a listed Australian company and there are more than 2000 of them. The diagram is taken from Skaffold. Their position on the screen can change daily as the price, intrinsic value and quality changes. The best quality companies and those with positive estimated margins of safety (the difference between the company’s intrinsic value and its share price) appear as spheres at the top right.

Companies that are poor quality (I call them B4, C4 and C5 companies, for example) are found on the left of the screen and if they have an estimated negative margin of safety, they are estimated to be expensive and will be located towards the bottom of the screen.

Highlighted with blue rings in Figure 1 are eight of the companies that announced this year’s biggest writedowns. Notice they tend to be at the lower left of the Australian sharemarket, according to my analysis.

If your portfolio contains shares that are red spheres and on the lower left, you could also be at risk because these companies tend to have low-quality ratings and are also possibly very expensive compared to their intrinsic value.

As is clear from Figure 1, this year’s biggest writedown culprits were all already located in the area to avoid.

The impact of owning such a business outright would be horrendous. Table 1 below reveals the size and details of these writedowns and as you can see, collectively the losses to shareholders amount to $4.6 billion.

Table 1. Predictable losses?

Warren Buffett once said that if you were not prepared to own the whole business for 10 years, you should not own a piece of it for 10 minutes.

Clearly you would not want to own businesses that pay too much for acquisitions and subsequently write down those assets. If you are not willing to own the whole business, don’t own the shares. Although in the short run the market is a voting machine and share prices can rise and fall based on popularity, in the long run the market is a weighing machine and share prices will reflect the performance of the business. Time is not the friend of a poor company, and companies Skaffold rates C4 or C5 are best avoided if you want the best chance of avoiding permanent losses.

Look at Figure 2 below. Those big writedown companies not only performed poorly but so did their shares. These companies (shown collectively as an index in the blue line below) produced bigger losses for investors than the poorly performing indices of which they are part. And that’s just over one year.

Figure 2. The biggest writedowns compared to the market

Take a look at the companies in your portfolio. Do they have large amounts of accounting goodwill on their balance sheet as a portion of their equity? Have they issued lots of shares to make acquisitions and are they producing low and single-digit returns on equity? If the answer to all these questions is yes, you may have a C5 company.

Cleaning up your portfolio not only lowers its risk but will produce cash that may just prove handy in coming months.

If you have made it this far then here’s evidence of the giving up I referred to in the column:  http://www.smh.com.au/business/investors-turn-to-term-deposits-in-shift-away-from-equities-20111219-1p2ir.html

Posted by Roger Montgomery, Value.able author and Fund Manager, 20 December 2011.

Posted in A1, Blue Chips, Company Valuation, Insightful Insights, Market Valuation, Skaffold, Value.able

15 Comments Leave a Comment

Cochlear update

Aside from fears of reputational damage, one of the big concerns surrounding Cochlear’s recall earlier this year, was how long it would take to return to market.  As you know we purchased shares after the announcement that it had recalled its Nucleus CI500 cochlear implant much to the chagrin of some investors who follow our musings here at the Insights blog.

In NSW every child receives a hearing test within two days of birth.  Those identified as having profound hearing loss are often assisted by Cochlear.  And thats just NSW.  Cochlear sells its devices in 100 countries.  Once implanted changing devices is not easy.  Changing brands may be even harder.  Audiologists and speech pathologists are involved and the devices are finetuned to ensure the device suits the individual.

As Matthew pointed out here on the blog a few days ago:  “A family member [of Matthews’s] is a key member of a large Australian charity that does a lot of work with children that are deaf and many get the implants. All the equipment they use to “map” or finetune the device after implanting is specific to that company. For example the only brand they have is Cochlear. Recently they had a child from the US that they began to support that had a different brand implanted – they had to change many things to be able to help them. When thinking about market share with these devices I think it is important to know that the decision isn’t solely with the surgeon or specialist, because all of the support people have to change too. I don’t think market share will change quickly or by very much because of these barriers.”

Analysts at Macquarie recently surveyed 389 US-based Audiologists. Despite the product recall, Cochlear is still the world leader in CI devices and retains 60% market share selling into 100 countries.  The broker also believes the market is growing at 12 per cent per year.

Many of you know we purchased shares in Cochlear after the September recall (see below), confident this was a temporary issue being treated as permanent by a perennially short-term-focused market.

That now appears to be the case as today’s announcement, posted on the ASX platform by the company reveals; 20122011_COH CI500 impant update

The company previously covered the subject in its AGM presentation here: http://www.cochlear.com/files/assets/corporate/pdf/agm_presentation_18102011.pdf

Analysts were subsequently concerned that 1500 units are going to have to be removed through surgery and another 2800 units have been pulled from shelves. They also worry that an inventory shortfall across the entire market will lead to market share losses from insufficient inventory as well as damage to reputation.

Today’s announcement reveals any small market share loss (we estimate five percent and some analysts suggest between five and ten per cent overall) will be now stemmed by the timely identification of the manufacturing issue that resulted in the failure of 1.9% of devices and their subsequent recall.

Cochlear has ramped up production and its early intervention has enhanced its reputation rather than damaged it as evidenced by several surveys with clinicians.  In fact, 93% of doctors surveyed by Macquarie felt that Cochlear handled the recall well, while only 8% believe the company’s reputation has been tarnished.

Ultimately the company’s intrinsic value is determined by its profit and we expect there will be an impact on profit of some import.  Cochlear has already created a provision of $130-$150 million and an after tax cash cost of $20 to $30 million.  Given the news flow that will now transpire, one expects these costs may be treated by analysts as a ‘one-off’ and investors may have to wait for another temporary setback before being able to buy shares cheaply again…

For those of you interested in following our thoughts back in September 14 (COH $51.30), I wrote the following :

“Imagine spending years waiting patiently for the opportunity to buy that rare coin, vintage bottle of wine or celebrated painting, only to be outbid when it finally comes up for auction.

Sometime later the opportunity presents itself again and you are outbid once more, this time by much more. Successive auctions only take the price further out of your reach – if only you acted sooner!

Then one day you stumble across that very thing you desire being offered for sale by someone who appears to have no interest in its long-term value, for a price you regard as a fraction of its real worth.

Would you buy it?

That is the situation I find myself in today as the Cochlear share price plunges another 14% to $51.30, or about 40% since its April 2011 high of $85.

As Cochlear’s technicians work to isolate the problem with the Nucleus 5 range, the company will dust off the Nucleus Freedom range, which it has marketed successfully for many years against products such rivals as Advanced Bionics and Med-El.

Overnight one of those rivals received FDA approval to sell its product (which was itself recalled in November last year) into the US market. This turn of events is not unusual for the industry … but it is unusual for Cochlear and that’s why the news this week came as such a blow. Cochlear is one of the highest-quality companies trading on the ASX today. The company that almost never puts a foot wrong appears to have tripped itself up and investors are spooked.

The financial impacts of these events (and there will be an impact) have yet to be quantified so until they are why don’t we look at how the company has performed in the past and see if we can’t learn something about it in the interim.

Over the past decade, Cochlear has increased profits every year with the exception of 2004. Net profit was just $40 million in 2002 and last week the company reported profits of $180 million for 2011.

Operating cash flow over the same period has risen from less than a $1 million (an exception for 2002) to more than $201 million, allowing debt to decline to just $63 million from nearly $200 million in 2009. Net gearing is now minus 1.86%.

Those impressive economics have resulted in an intrinsic value that has risen by nearly 18% each year since 2004. If your job as a long-term investor is to find companies with bright prospects for intrinsic value appreciation – believing that in the long run prices follow values – then it quite possible that Cochlear is being served up on a plate.

The recently reported net profit figure of $180.1 million for 2011 was up 16% and in line with consensus analyst estimates, although this occurred despite sales of $809.6 million exceeding analysts’ estimates. It seems the analysts did not expect the EBIT and NPAT margins that were reported. These were flat, which given a very strong Australian dollar, suggests impressive efficiency gains in the operations.

If only that blasted “Australian peso” would go down and stay down!

Back on August 19, 2009, I wrote: “Fully franked dividends have risen every year for the past decade, growing by almost 500% (or 22% pa) since 2000. These are not numbers to be sneezed at; the company has produced an impressive and stable return on equity since 2004 of about 47% with very modest debt. Clearly this is a company worth some significant premium to its equity.”

Nothing changed really for 2011. A final dividend of $1.20 per share was 70% franked and up 14%.

Importantly, it seems Cochlear’s market is growing. Unit sales volumes were up 17% for the year and, given in the first half they were up 20%, it suggests the second half were up 14%. Double digit growth was reported in sales volumes for all major regions and Asia was the most impressive, rising more than 30% to the point where it makes up 16% of total revenues.

This really is impressive stuff. Just two years ago the company reported unit sales growth of only 2%, to 18,553 units, and many analysts were blaming slow China sales. Nobody expected the company to ever repeat its 2007 and 2008 volume growth of 24% and 14% respectively, and certainly not off a higher base.

Growth has always been viewed as is limited by the high cost of the devices and the reliance on insurance and healthcare schemes to subsidise the costs and those of surgery to implant to them.

According to the World Health Organization however, almost 280 million people suffer from moderate to profound hearing loss and an ageing population means this figure will rise. Cochlear is one of a handful of companies that actively contributes to improving the quality of life of its clients.

When great companies stumble, the impact can be exaggerated by the reaction of shareholders who never believed it could happen. Then comes a wave of selling amid doubts that the company will ever regain its mantle.

But strong market share and strong cash flow, high returns on equity and low debt, are rarely offered at bargain prices so I picked up some Cochlear stock yesterday for the Montgomery [Private] Fund. It is likely that I will to add to this position over the coming days and weeks when the full financial impact of the recall is known.

I must confess I didn’t bet the farm on this particular investment because the financial impact of the recall – and there will be one – remains unclear; when that changes it will impact my intrinsic value estimate (UBS has revised its forecast net profit for 2012 by 10.5% to $179.5 million).

Whatever the impact, it will be temporary, even though it won’t necessarily preclude lower prices from this point. During the GFC, Cochlear shares fell from $78 to $44. No company is immune to lower share prices and I don’t know when or in what order they will transpire.

What I do know is that in 2021 we aren’t likely to be thinking about this recall, just as nobody now talks about the Wembley Stadium delays that dogged Multiplex back in 2006. Mercifully, investors’ memories tend to be short.

Recalls, competition, marketing gaffes and wayward salary packages are all part of the cut and thrust of business and if lower prices ensue for Cochlear shares, it will be important to determine whether the recall will inflict permanent scars. My guess is that it will not.”

Posted by Roger Montgomery, Value.able author and Fund Manager, 20 December 2011.

Posted in A1, Blue Chips, Health Care, Value Investing, Value.able

45 Comments Leave a Comment

Are bargains available at Woolworths?

On Wednesday November 2 Woolworths held a strategy briefing for professional investors. Woolworth’s effectively asked us to adopt a longer time frame before judging its performance and revealed four strategic priorities that I will describe in a moment.

Prior to the strategy day, the company updated the stock market with a growth outlook that was the lowest in a decade. The market responded negatively to the change and it entrenched previous sentiment by professional investors to switch from Woolworths to Coles.

But Woolworths remains a superior business from a business economics perspective, with high return on equity and it also remains cheaper than its competitor as measured by the larger discount to an estimate of its intrinsic value.

The wider sentiment towards Woolworths Supermarkets is that the period of strong growth is over, and the other businesses, such as Big W, the New Zealand supermarkets, the Masters hardware venture and a possible acquisition of The Warehouse group could be the focus of earnings growth for the company. Gambling pre-committments would not be.

Meanwhile, the Woolworths-owned Dick Smith electronics business appears to have failed to excite consumers and has certainly failed to excite investment professionals. Dick Smith is a relatively weak offering in a market that has been hit particularly hard by the empowerment of the consumer through high Australian dollar.

Moreover, in many ways these businesses are peripheral since the Australian Food & Liquor division accounts for 80% of earnings before interest and tax.

The impact of the company’s lower growth profile on intrinsic value, particularly intrinsic values over the next two years, has been negative and intrinsic value does not appear to be going anywhere in a great hurry (see Skaffold chart below).

This combination of circumstances, in my experience, set Woolworths shares up to be vulnerable to any negative shocks.

Estimating intrinsic value is not the same as predicting price direction, however the above circumstances are not unique historically in putting a lead on price appreciation.

On top of the above combination of factors, there is also the continuing debate in Parliament about the introduction of preset loss limits for poker machines, which, if introduced, would negatively impact Woolworths’ gaming business. Though it is most closely associated with supermarkets, Woolworths is actually the largest poker machine owner in the country, with more than 10,700 pokies.

And a few weeks ago, The Economic Times of India also reported that Woolworths appears to have been dumped by its Indian partner, Tata Group. Woolworths enjoyed a five-year partnership with Tata, introducing Dick Smith-style electronics stores to India under the Infiniti Retail brand. Even though foreign retailers are not permitted to have a direct presence in India, Woolworths partnership offered the hope of growth – albeit with a partner – if the rules were ever relaxed.

Nonetheless, despite these accumulative negative factors, Woolworths is regarded by conventional analysts and investors as a defensive’ company. Its strong cash flows and its status as a major retailer of food makes it an ideal investment in a recessionary or slow or low growth environment. The company also enjoys entrenched competitive advantages over smaller rivals that, until now, the ACCC has done little about. One example of this are the new EFTPOS charges.

From the first of this month, the new Eftpos Payments Australia Limited (EPAL) fees mean retailers incur a 5¢ fee for every transaction over $15 (75% of all EFTPOS transactions). Previously there was no fee and that will still be the case for transactions under $15, which means 25% of transactions.

The retailer’s bank will charge the retailers, some of whom are describing the charges as an “EFTPOS tax”, and they will have no choice but to pass on to the consumer.

Unsurprisingly, EPAL’s members include the major banks, Coles and Woolworths and, because they manage their own terminals, they can opt out of the new charges.

But despite these entrenched advantages, Woolworths has been hit – or so it says – by the state of the economy, noting in its annual report: “Consumer confidence remained historically low as customers reacted adversely to rising utility costs, interest rate hikes in the first half of the year and general global uncertainty, and opted to save rather than spend their money”.

From an investment perspective it is worth noting that retail investors now have a choice of supermarkets, with Coles improving its offering to consumers and taking market share from the incumbent Woolworths.

The investment community is not convinced that further changes to private-label offerings or more innovation around the supply chain will make a dramatic difference to the growth prospects for Woolworths, which set below forecast growth in household income, population and the economy.

One other source of earnings growth is cost-cutting, but the reality is that gains from such strategies are one-offs and again unlikely to excite investors.

Having presented the negatives – which have caused the share price to fall 12% since July, one positive was the strategy briefing’s opportunity to showcase new CEO Grant O’Brien, who replaces Michael Luscombe. The company announced that it planned to extend and defend its leadership in food and liquor, act on the “portfolio” to maximise shareholder value, maintain its track record of building new growth businesses (we’ll ignore Dick Smith) and finally, put in place the enablers for a new era of growth.

In the supermarkets business WOW hopes to grow fresh produce from 28% market share to 36% market share. If achieved this would be an additional $2.5b in sales. Woolies also wants to target a doubling of home brand sales and this aim flies in the face of the ACCC’s stated concerns.

The company will also open 35 new BIG W stores in next 5 years reaching 200 by 2016.

In a reflection of the massive structural shift online, BIG W’s 85,000 in-store SKUs will be expanded and all put online.

And the topic on the tip of everyone’s tongue; Masters. There are now five stores open, another two are due to open in December/January, there are 16 under construction another 100 in the pipeline and the company reported the venture is well ahead of budget.

I also note the advertised sale of $900 million of property ($380 million of which was sold last financial year); and, most recently, the oversubscribed $500 million hybrid note raising that substantially extend the balance sheet strength of the company.

Below we examine the intrinsic value track record and prospects for Woolworths based on current expectations for earnings growth and returns on equity using Skaffold.com

Woolworths (MQR: B2) is currently trading at the same price it was in December 2006 and February 2007, despite the fact profits have risen 11.1% pa, from $1.3 billion to a forecast $2.2 billion in 2012. This growth in profit however is offset by having 16 million more shares on issue; by increased borrowings – up $1.8 billion to $4.8 billion; and by retained earnings, which have risen by $2 billion. The increase in shares on issue and retained earnings have offset the positive impact on return on equity rising profit would normally have.

The latest estimate of its intrinsic value, of $23.23, is forecast to rise modestly over the next two years. For investors looking at opportunities to investigate only when a meaningful discount to intrinsic value is presented, a price of $19 or less for Woolworths would represent at least 20 per cent.

Posted by Roger Montgomery, Value.able author and Fund Manager, 17 November 2011.

Posted in A1, Blue Chips, Company Valuation, Insightful Insights, Retail, Skaffold, Value Investing

22 Comments Leave a Comment

Are the banks robbing sensible investment returns?

Amid all the talk of GFC II and the Eurozone unravelling, Warren Buffett’s Berkshire Hathaway Inc. (BRK/A) has been increasing its stake in US bank, Wells Fargo & Co (WFC – 420 Montgomery Street San Francisco).

Buffett (or was it Todd Combs?) topped up Berkshire’s holdings in the world’s 24th biggest bank by 9.7 million shares in the three months to June 2011 (we don’t have more recent information because Berkshire requested and was granted permission to withhold stock specific information).  Between 1 March and 30 June – the three months during which the stake was increased – Wells Fargo traded as high as $33 and as low as $27.

WFC currently trades at $25.65 and its book value is $26.10 per share. Paying a small discount to book value for a bank that earns a return of 11.86 per cent on that book value doesn’t seem like a fantastic bargain and paying a premium to book value is perhaps less so.  But the fact remains one of the best investors of our generation, reckons it is ok to be selectively buying US banks.  Is Buffett going to make off with a bank fortune the way Butch Cassidy did or will he be caught red handed this time?  Should you be doing the same as Buffett with Australian Banks?

Wells Fargo is the biggest U.S. home lender (think Commonwealth Bank) and Berkshire is its biggest shareholder.  Given Berkshire’s interest in Wells Fargo and Bank of America should be taking a look at our own Banks?

I know there are conflicting and well-articulated opinions here at the blog about the banks, so feel free to add your own thoughts.

Here are mine.

Broadly, the local banking system is in a relatively strong position compared to peers globally.  The funding, capital and liquidity position of the major banks has been strengthened and those who fear a housing collapse in Australia should be mindful that such an event would impact consumer confidence and credit growth more than the immediate profits of the banks, who have insured their exposure.

From a funding perspective, bank deposit growth has outstripped lending growth and while further increases in wholesale funding costs could reasonably be expected, the banks are ahead of schedule in raising term wholesale funding that is said to provide 6 months grace. Of course if deposits continue to grow faster than loans, the gap that is funded from overseas wholesale markets diminishes.

As I have previously noted, high levels of leverage at the consumer, company and country level simply take time to pay off.  You just don’t go off spending aggressively again until you feel your debt is under control.  As a result, it is reasonable to expect bank balance sheet expansion will be muted over the next year or two at least. Some of you may think even longer or permanently…

Globally, the banking picture is at the very least, interesting to watch. The five biggest US banks excluding bank of America posted 8 per cent profit growth, while in the UK the five majors posted H1’11 profits that were half of those reported the year before.  Predictably this has resulted in announcements of an intended five billion Sterling cost cutting drive by 2014.  In Europe, the largest ten banks saw profits fall less than 8 per cent.  Curiously some observers suggest that the present problems befalling sovereigns will have less of an impact on banks than the GFC because sovereign debt is less complex than credit default swaps on collateralized debt obligations and stress testing has been completed and widely reported. With little exposure to European debt and strong growth domestically, Asian banks (with the exception of Japan) are the one bright spot.

Globally, banks are targeting cost to income ratios of less than 40 per cent despite the higher costs associated with reengineering systems and procedures to meet a heightened regulatory environment.

Locally, our major banks have posted more than acceptable profits considering global financial conditions and local consumer and business sentiment, which has remained muted

Growth has been achieved at least partly by the reduction in the provision for bad and doubtful debts.  Additionally, the reduction in the aggregate loan impairment charge was 37%; from $8.4 billion to $5.3 billion.

While significant reductions in loan impairment charges can be seen as a positive, future growth in profits – in the absence of a recovery in consumer and business confidence – will have to come from cost cutting.

Collectively, cost cutting is being reflected in some results – cost to income ratios improved for the CBA and NAB and less so for the ANZ and Westpac.  Further improvements should be expected and I have been reliably informed to expect significant retrenchments – in the thousands – in the financial services sector, even though full time employees increased at the ANZ and CBA last year.  The changes in cost to income ratios should also be seen in the light of the dramatic reductions achieved since the early nineties when cost to income ratios were; ANZ 74%, WBC 68%, CBA 67% and NAB 57%.

Net interest margins – the net margin earned or the difference between interest paid on deposits and interest earned on loans – were broadly unchanged and while the CBA recorded an improvement, this has not been widely reported elsewhere as being materially due to an accounting reclassification of net swap costs.  Competition for retail deposits and higher-cost, post-GFC funding as well as regulatory changes forcing an increase in liquid assets put pressure on margins.  A broad maintenance of margins is therefore laudable.

The banking industry’s preferred measure of profit is Cash Profit (after tax), which removes the impact of discontinued operations, adjustments for acquisitions, Treasury shares and fair value adjustments.

On this measure, all the banks posted healthy increases.

The ANZ increased profits from $5.1 to $5.6, the CBA $6.1 to $6.8, NAB $4.6 to $5.5 and Westpac from $5.9 to $6.3.

Non-interest income, which includes trading, fees & commissions and Wealth management & insurance (which includes life insurance, superannuation and investment management products), declined in aggregate.  Fees & commissions across the major banks were largely steady at just under $12 billion due to a drop in lending offset by an increase in corporate M&A.  Wealth management profits fell for all the banks bar Westpac (BT).  Profits here are largely a function of equity market performance given the big brand’s focus on index hugging and fund inflows/outflows.  Funds under management and administration grew only for the CBA.

The outlook for Australian banks will remain mired by the general ‘funk’ Australian consumers and business are in.  Our one-cylinder economy is not going to spur rapid balance sheet expansion (read credit growth) for the banks in the near term.  With property prices and volumes in some areas also depressed the number of mortgages and the size of a loan on any individual property is necessarily lower.  Banks love mortgages the most because their perceived lower risk means the banks have to provision less for each one they write.  You are welcome to discuss your views about the direction of property in Australia in the comments below and I would welcome your thoughts.  I think that we shouldn’t expect any immediate recovery in property activity to spur bank balance sheet expansion.

With the details broadly out of the way what are the current estimated valuations and prospects for intrinsic value growth for each of the banks?  Keep in mind the intrinsic value expectations for the next three years are based on earnings growth and equity figures as stated in the table included with this column.

Skaffold’s (www.Skaffold.com) current estimated intrinsic values for the banks are: WBC $22.12, ANZ $24.49, CBA $51.54 and NAB $27.69.  Of course these will change over the next weeks and months as estimates are updated and the banks make announcements about prospects, acquisitions or capital raisings etc. and I may not update those details here at the Insights Blog.

The bank displaying the greatest estimated margin of safety currently is ANZ, which at the current price, is displaying an estimated safety margin of 16%.  Of the others NAB appears to be next, with an estimated margin of safety of 11%, WBC 5% and CBA 3%.

Despite being second on this list, the NAB has produced the lowest returns on equity and assets but also the lowest cost to income ratio, second highest Net interest margin and the highest forecast earnings per share growth for the next three years.

In aggregate the opportunity to buy at either very large discounts or smaller discounts but with solid growth potential does not appear to be available.  An investor requiring meaningful margins of safety, would demand lower prices before being seriously interested.  I will leave that decision to you after taking personal professional advice of course – from Buffett or your advisor. Growth doesn’t have to be sensational to make attractive returns but in such cases, one should require a large margin of safety to be more certain of a reasonable return.

What are you thoughts about the banks?  Have I missed an angle that you would like to add?  For example do you think the economic growth prospects are bright for the US compared to Australia? What are your estimates for earnings growth and what are your expectations for the residential, agricultural or commercial property market?  I would be delighted to facilitate a discussion on these subjects.

Posted by Roger Montgomery, Value.able author and Fund Manager, 16 November 2011.

Posted in A1, Banks, Financials, Insightful Insights, Skaffold, Value Investing

45 Comments Leave a Comment

Can you feel it?

There’s something in the air…. And you may be able to assist.

Skaffold® is set to go live and I am incredibly proud of what Team Skaffold have achieved.

Before Skaffold, the stock market was noisy and confusing. Very soon, all that will change.  Skaffold will reinvent and reignite the way you invest.

The data that automatically updates Skaffold each day is from arguably the world’s most reputable source (that’s right, not all data is the same!). With customers that spend hundreds of millions of dollars a year for our provider’s data, we have been delighted with their fascination and interest in Skaffold.

As you may already know, Skaffold’s designers and developers have been recognised by design awards and industry accolades and already work for Nintendo, EA Games – the world’s biggest games company, Google, HTC, and Porsche. Like us, they are immensely proud of Skaffold and are putting together their own video for the launch to showcase Skaffold to international IT media and judges. Their Managing Director is even flying to Sydney for the launch!

Here at home, we are building a team with amazing international credentials and their task is simple: make sure Skaffold stays at the cutting edge of stock market applications.

Here is how you could help: We’re still searching for someone super smart, who can mentor, teach and lead a team, who knows, understands and loves the stock market, can be RG 146 compliant and is truly passionate about talking one-on-one with and helping private and professional investors. If that’s you, or you know someone that fits the bill, we want to hear from you!

A1 or C5, Skaffold’s Quality Scores are powered by more than 40 years of published academic research into the predictors of company failure and and investment returns. And the secret herbs and spices in Skaffold’s valuations – and the ways they change – have won me over time and time again.

I must confess to having a bit of fun recently… I uploaded some international data, and looked at IBM, Apple, Google and Microsoft and… nothing surprising. Skaffold just worked. No whacky valuations either like the $800 for Apple or $400 for IBM or $60 for Microsoft that I have seen elsewhere. In time, I imagine we’ll be able to switch on Turkish stocks, if that’s what you want!

The team and I have been genuinely encouraged by your excitement. What’s also been really amazing is the anticipation, not only from private investors like you and me, but from brokers, other fundies, planners and advisers who have expressed a real need to independently ’stress test’ their own research or the stocks on their approved lists.

One friend recently said we had developed a Ferrari that Volvo drivers will love to drive. I reckon that’s about the sum of it. And congrats, by the way, to Ian -  one of very first investors who jumped the gun, sent in his cheque and guaranteed himself Member #2 status for life.

Get ready to enjoy looking at the Australian stock market like you have never seen it before. Put 1 November 2011 in your diary to Join Skaffold and be part of our mission to make every investor a professional.

Skaffold is the world’s most reputable company data married to half a century of leading investment thinking and the world’s most exciting and easy-to-use interface for investors. We can’t wait to hear what you think of Skaffold after you have made it part of your investment routine.

Posted by the Skaffold Team, 28 October 2011.

Skaffold® is a registered trademark of Skaffold Pty Limited

Posted in A1, Company Valuation, Value.able

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If value nags, are you listening?

Value.able investors can be forgiven for giving up.  You wait so long for value to be presented and then when it appears it just hangs around, remaining ‘good value’ for what seems an age.  Value can sometimes nag and nag and by the time action becomes urgent, the newest and least patient value investors are no longer listening.  I can see it in the statistics of my friend’s financial services businesses and no doubt it’ also being felt by tip sheets purveyors and CFD merchants.  For all the talk of value investing, few really have the patience to succeed.

Value.able-style investors can be forgiven for giving up.  You wait so long for value to appear and then when it does, its just hangs around.  STocks that were expensive, become cheap and then, simply, boringly, stay cheap.  Value can sometime nag and nag and by the time action becomes urgent, the newest and least patient investors are no longer listening.  I have no doubt this is impacting the revenues of the tip sheet purveyors and the CFD merchants, indeed any business in financial services whose revenue is dependent on investors maintaining the faith.

That is the situation I was recently delighted to observe as the Cochlear share price plunged another 14% to $51.30, or about 40% since its April 2011 high of $85.

Recently I ascribed to Cochlear’s shares, a valuation of $59. Since 2004 the price has been persistently above my intrinsic value estimate, which means the combination of circumstances that have pushed the share price below value most recently are worth exploring.

Cochlear has the largest market share for cochlear hearing implants worldwide and, after announcing a voluntary recall of its flagship Nucleus CI500 implant range recently (the Nucleus accounts for more than 70% of sales), investors voted with their feet and the stock fell more than 20%.

The recall was voluntary and relates only to those devices that have not been implanted. The devices have a fail rate of about 1% and the fault – due to moisture on 1 of 4 diodes from loss of seal - is not believed to be harmful in any way, the device simply shuts down.

With about 25,000 of the units in use globally, that implies around 250 recipients of the implant will be affected and although that is significant, the proactive and patient-focused response of the company should ensure the reputational damage is contained.

As Cochlear’s technicians work to isolate the problem with the Nucleus 5 range, the company will dust off the Nucleus Freedom range, which it has marketed successfully for many years against products such rivals as Advanced Bionics and Med-El.

Med-El is gaining market share in the US generally but patients waiting for implant surgery have switched to the Cochlear Freedom product and apparently with no delays.

At the same time as Cochlear’s recall, Advanced Bionics received FDA approval to sell its product (which was itself recalled in November last year) into the US market. This turn of events is not unusual for the industry … but it is unusual for Cochlear and that’s why the news came as such a blow. Cochlear is one of the highest-quality companies trading on the ASX today. The company that almost never puts a foot wrong appears to have tripped itself up and investors became spooked.

And in that reaction a potential opportunity may be presented.

The financial impacts of these events won’t be fully known until later in the year but is expected currently to be $130 – $150 mln, translating to an after tax impact of about $20 mln.

Over the past decade, Cochlear has increased profits every year with the exception of 2004. Net profit was just $40 million in 2002 and most recently the company reported profits of $180 million for 2011.

Operating cash flow over the same period has risen from less than a $1 million (an exception for 2002) to more than $201 million, allowing debt to decline to just $63 million from nearly $200 million in 2009. Net gearing is now minus 1.86%.

Those impressive economics have resulted in an intrinsic value that has risen by nearly 18% each year since 2004. If your job as a long-term investor is to find companies with bright prospects for intrinsic value appreciation – believing that in the long run prices follow values – then it quite possible that Cochlear is being served up on a plate.

The recently reported net profit figure of $180.1 million for 2011 was up 16% and in line with consensus analyst estimates, although this occurred despite sales of $809.6 million exceeding analysts’ estimates. It seems the analysts did not expect the EBIT and NPAT margins that were reported. These were flat, which given a very strong Australian dollar, suggests impressive efficiency gains in the operations.

If only that blasted “Australian peso” would go down and stay down!

Back on August 19, 2009, I wrote in the Eureka Report: “Fully franked dividends have risen every year for the past decade, growing by almost 500% (or 22% pa) since 2000. These are not numbers to be sneezed at; the company has produced an impressive and stable return on equity since 2004 of about 47% with very modest debt. Clearly this is a company worth some significant premium to its equity.”

Nothing changed really for 2011. A final dividend of $1.20 per share was 70% franked and up 14%.

Importantly, it seems Cochlear’s market is growing. Unit sales volumes were up 17% for the year and, given in the first half they were up 20%, it suggests the second half were up 14%. Double digit growth was reported in sales volumes for all major regions and Asia was the most impressive, rising more than 30% to the point where it makes up 16% of total revenues.

This really is impressive stuff. Just two years ago the company reported unit sales growth of only 2%, to 18,553 units, and many analysts were blaming slow China sales. Nobody expected the company to ever repeat its 2007 and 2008 volume growth of 24% and 14% respectively, and certainly not off a higher base. Growth has always been viewed as being limited by the high cost of the devices and the reliance on insurance and healthcare schemes to subsidise the costs and those of surgery to implant to them.

According to the World Health Organization however, almost 280 million people suffer from moderate to profound hearing loss and an ageing population means this figure will rise. Cochlear is one of a handful of companies that actively contributes to improving the quality of life of its clients.

When great companies stumble, the impact can be exaggerated by the reaction of shareholders who never believed it could happen. Then comes a wave of selling amid doubts that the company will ever regain its mantle.

But strong market share and strong cash flow, high returns on equity and low debt, are rarely offered at bargain prices so I picked up some Cochlear stock for the Montgomery [Private] Fund. It is expected that I will to add to this position over the coming weeks and months (provided value remains) when the full financial impact of the recall is known.

I must confess I didn’t bet the farm on this particular investment because the financial impact of the recall remains uncertain; when that changes it will impact my intrinsic value estimate.

Whatever the impact, it will be temporary, even though it won’t necessarily preclude lower prices from this point. During the GFC, Cochlear shares fell from $78 to $44. No company is immune to lower share prices and I don’t know when or in what order they will transpire.

What I do know is that in 2021 we aren’t likely to be thinking about this recall, just as nobody now talks about the Wembley Stadium delays that dogged Multiplex back in 2006. Mercifully, investors’ memories tend to be short.

Recalls, competition, marketing gaffes and wayward salary packages are all part of the cut and thrust of business and if lower prices ensue for Cochlear shares, it will be important to determine whether the recall will inflict permanent scars. My guess is that it will not. I wonder whether you are listening for value?

Posted by Roger Montgomery, Value.able author and Fund Manager, 19 October 2011.

Posted in A1, Blue Chips, Company Valuation, Health Care, Value Investing

87 Comments Leave a Comment

What closed Sydney Harbour Tunnel last night?

Vocus Communications is in the business of selling bandwidth. The company resells it on the cable that runs under the Pacific between Sydney and the US.  Last night they laid some of their own under another sea; Sydney Harbour. The company – in which I have previously disclosed I own a small number of shares – sent me these photos of the process. As we have met with management as part of our analysis, we were delighted they remembered our interest in everything they are up to. I thought these photos were fascinating and given its something most of us wouldn’t ever get a glimpse of, I thought you’d be interested too.

There’s no investment merit in the photos so don’t go rushing off to buy shares (certainly not without conducting your own research and after seeking and taking personal, professional advice).

Think of this post as a Value.able photo essay of what some people are up to while you were sleeping.

Meeting point and briefing at the North end of the Tunnel

A closed Sydney Harbour Tunnel

A very empty Sydney Harbour Tunnel

Hauling starts about 900mtrs from the South Exit. It’s a single piece of fibre from end to end

3kms of conduit installed the previous few nights

First meter of fibre coming off the drum

Energy Australia, the RTA and the other carrier’s fibre exiting the tunnel on the South Side

Fibre coming out of the Tunnel on the North side

Posted by Roger Montgomery and his A1 team (courtesy of Vocus Communications), fund managers and creators of the next-generation A1 stock market service, 6 October 2011.

Posted in A1, Telecommunications, Value Investing, Value.able

30 Comments Leave a Comment

Which A1 twin is outperforming?

This journey began with the simple question Will David beat Goliath?

Value.able Graduate Scott T resolved to take up a fight with conventional investing, by tracking the performance of a typical and published ‘institutional-style’ portfolio against a portfolio of companies that receive my highest Montgomery Quality Ratings.

By 30 June 2011 the A1 portfolio was up 1.8 per cent compared to the XJO, which was down 2.9 per cent. As for the conventional ‘institutional’ portfolio, the bankers were down 6.2 per cent.

Over to Scott T for his third quarter update…

“For new readers to Roger Montgomery’s Insights Blog, welcome. Here at Roger’s blog we are conducting a 12-month exercise measuring the performance of a basket of 10 stocks recommended by Goldman Sachs, against a basket of 10 A1 or A2 businesses that were selling for as big a discount to Intrinsic Value as we could find.

“Nine months have now passed since our twin brothers each invested their $100 000 inheritance, and it has been a very turbulent time in the market.

“Our Queensland regional accountant has had his head down at the office for the entire quarter. The end of the financial year had come and gone and hundreds of clients where sending in their tax documentation, calling with questions and chasing their refunds. Time flew by in the office, and he hardly had time to try to attract new clients, let alone watch the daily gyrations of the global equities markets. By the end of September when he was finally able to take a breath and look at the performance of his portfolio.

“He was surprised at how poorly his portfolio of A1 and A2 companies, acquired at prices less than they were worth, had faired. But he quickly realised the overall market had done even worse. Loosing 12 per cent, or $12 000, YTD was bad. But it could have been worse, much worse.

“His twin brother was in a world of pain. The federal department he worked for felt like it was under attack. The mood in the department was that the media seemed hell bent on criticising everything the government did. No initiative was well received and every announcement was instantly compared to last months failure. To top it all off, every night he would check his portfolio, to see how much more of his inheritance had vanished. The red negative number on his spreadsheet just seemed to steadily increase. With little information to go on, and a feeling of helplessness washing over him, he thought seriously about visiting his financial advisors, desperately seeking reassurance, and perhaps changing the mix of the stocks held. He resounded, “Buying what they advised would be good for 2012″.

“As per the first half of the year, dividends will be picked up in the fourth quarter, when shares have finished going ex-dividend and the dividends have actually been received.

“In summary for the nine months to 30 September 2011:

The XJO ​​is DOWN 15.5 per cent
The Goldman Sachs Portfolio​​​is DOWN 19.7 per cent
The A1 and A2 Portfolio ​​is DOWN 12.0 per cent
The A1 and A2 Portfolio has achieved an OUTPERFORMANCE of 3.5 per cent over the XJO and 7.7 per cent over the Goldman Sachs portfolio.

“Here are the portfolios in detail, including cash dividends received in the first half (click the image to enlarge)

“We will visit the brothers again at the end of December for a final wrap up of their first year, and discuss their strategies for 2012

“All the Best
Scott T”

Thank you Scott.

How is your A1 portfolio performing?

Posted by Roger Montgomery and his A1 team, fund managers and creators of the next-generation A1 stock market service, 6 October 2011.

Posted in A1, Company Valuation, Insightful Insights, Value Investing, Value.able

36 Comments Leave a Comment

Should you be readying yourself?

If you’re sitting at home or in your office wondering if the party is over and it’s all turned to pumpkins and mice, allow me to offer you a few insights.

I know of seasoned market practitioners that have deferred the upping of stumps to set up new businesses because they believe there is worse to come. I also know of prominent Australians that are cashing up and I have met with many professional investors who liken the current conditions to those preceding a severe recession or even depression. Berkshire Hathaway shares are trading below $100,000 for the first time in a while (not that it matters). And Bill Gross at Pimco reckons the fact that you can get a better yield over two years by ‘barbelling’ – putting 10 per cent into 30 year bonds and 90 per cent into cash – and beat the yield on 2yr T-Notes is destroying credit creation and so low yields are having the opposite effect to the stimulation they are intended to generate.

Ok. So what do I think?

These are the times to prepare yourself for the possibility of another rare opportunity to buy extraordinary businesses at even more extraordinary discounts to intrinsic value. You have to be ready, you have to have your Value.able intrinsic valuations prepared and your preferred safety margins calculated.

In the short term (6-12 months), on balance, I think shares could get even cheaper (As I write those words, I log on to see the European markets down five per cent and the Dow Jones opening down more than 3 per cent and I am conscious of the fact that an outlook can be tainted by the most recent price direction). But our large cash proportion/position in The Montgomery [Private] Fund since the start of the calendar year has reflected for some time the impact of this possibility on future valuations and our requirement for larger discounts to intrinsic value.

Longer term, I like some of the research put out by McKinsey. The new infrastructure, such as roads, ports, railways and terminals that developing countries such as China, India and South America will need, will require tens of trillions of dollars. McKinsey Global Institute analysis reckons that by 2030 the supply of capital could fall short of demand to the tune of $2.4 trillion – a credit crunch that will slow global GDP growth by a percentage point annually. Even if China and India cool off, a similar gap could occur.

Back to the immediate outlook and there is a simple mental framework that I have been using to think independently about all the ructions impacting our portfolios.

I am no economist, but its pretty easy to see that if trend line US economic growth is barely 1 per cent, then any slowdown in the business cycle will push the economy towards the zero growth line. One per cent is quite simply very close to zero and the business cycle can push growth rates around more than the difference between them. Every time there is a whiff of a slowdown, there will, at the very least ,be fears of another recession. Again, I am not forecasting a recession nor am I forecasting slow growth. Indeed, I am not forecasting at all. I am simply pointing out the fact that tiptoeing on the edge of a precipice (the US at 1 per cent growth) is more frightening than doing circle work in a paddock a long way from any edge at all (China at 7, 8 or 9 per cent growth). Bill Gross’s comments about the destruction of credit further feeds the idea of a slowdown.

On balance I believe there will be some very attractive buying opportunities in the next six to twelve months. Before you read too much into this statement, I should alert you to the fact that I say it every year.

Analysts are prone to optimism too.

I think it’s also appropriate to remember that analysts typically are generally optimistic about earnings forecasts at the start of a financial year. This can be seen in another McKinsey research note (as well as thousands of other similar studies), where analysts commented:

“No executive would dispute that analysts’ forecasts serve as an important benchmark of the current and future health of companies. To better understand their accuracy, we undertook research nearly a decade ago that produced sobering results. Analysts, we found, were typically overoptimistic, slow to revise their forecasts to reflect new economic conditions, and prone to making increasingly inaccurate forecasts when economic growth declined.

Alas, a recently completed update of our work only reinforces this view—despite a series of rules and regulations, dating to the last decade, that were intended to improve the quality of the analysts’ long-term earnings forecasts, restore investor confidence in them, and prevent conflicts of interest. For executives, many of whom go to great lengths to satisfy Wall Street’s expectations in their financial reporting and long-term strategic moves, this is a cautionary tale worth remembering.”

And concluded:  “McKinsey research shows that equity analysts have been overoptimistic for the past quarter century: on average, their earnings-growth estimates—ranging from 10 to 12 percent annually, compared with actual growth of 6 percent—were almost 100 percent too high. Only in years of strong growth, such as 2003 to 2006, when actual earnings caught up with earlier predictions, do these forecasts hit the mark.”

Demand bigger discounts

Those thoughts provide the ‘Skaffolding‘ in my mind around which I construct an opinion of where the landmines and risks may be for an investor. I tend to 1) look for much bigger discounts to intrinsic values that are based on analyst projections for earnings and 2) lower our own earnings expectations for those companies we like best.

Cochlear is one example of this. Many analysts have forecast a 10-20 per cent NPAT decline from the recent recall of their Cochlear implant. Only one analyst has considered and forecast a 40-50 per cent NPAT decline. The truth will probably be somewhere in between. Such a decline however would come as a shock to many investors if it were to transpire. And so it is important to be aware of that possibility when calibrating the size of any position in your portfolio. In other words, be sure to have some cash available for such an event because intrinsic value based under that scenario is between $23 and $30.

Your “Top 5”

Earlier this month I asked you to list your “Top 5” value stocks – those that you believed represented good value at present. I was delighted to receive so many contributions.

On behalf of the many Value.able Graduates and stock market investors who read our Insights blog thank you for sharing with us the result of all your fossicking, digging and analysis.

There were more than 115 suggestions. The most popular was Forge Group with 16 mentions.

The following table presents the Quality Score, FY2011 ROE, FY2011 Net Debt/Equity and 2012 Value.able Intrinsic Value for Forge Group (FGE), BHP, Cochlear (COH), M2 Telecommunications (MTU), Woolworths (WOW), ARB Corp (ARP), CSL , Data#3 (DTL), Matrix (MCE), Fleetwood (FWD), JB Hi-Fi (JBH), Mineral Resources (MIN), Blackmores (BKL), Flight Centre (FLT), Lycopodium (LYL), Monadelphous (MDN), Integrated Research (IRI), 1300 Smiles (ONT), ThinkSmart (TSM) and ANZ.

As you know these quality scores and the estimates for intrinsic values can change at a moments notice (just ask those working at Cochlear!) so be sure to conduct your own research into these and any company you are considering investing in and as I always say, be sure to seek and take personal professional advice.

Posted by Roger Montgomery and his A1 team, fund managers and creators of the next-generation A1 stock market service, 23 September 2011.

Posted in A1, Company Valuation, Insightful Insights, Market Valuation, Value Investing

90 Comments Leave a Comment

Are these the best value stocks right now?

With reporting season over, and armed with the Value.able mantra, how are you uncovering the very best stocks worthy of your attention?

Lifebuoy soap was once marketed as Floating Above the Rest. Are there any companies post reporting season doing the same?

While many of my peers believe 2012 could be a very difficult year for investors, there are currently a selection of companies that appear to be both high quality and trading at prices offering a rational safety margin compared to our estimates of their intrinsic value.

Each reporting season we present a short-list of companies worthy of careful analysis. This reporting season is no different. As always, the list is not exhaustive. You are free to agree, disagree or append the list. Indeed, I encourage you to do so. For debate often brings A1 ideas.

I decided to look for Large Caps, Mid Caps, Small Caps, Micro Caps and Nano Caps with an A1 or A2 Quality Score across all sectors and industry groups.

I’m also interested in companies for which there are analyst forecasts for at least one year ahead and whose current market price offers a safety margin of more than 10 per cent.

From over 2080 listed companies, 17 meet the criteria.

An attractive and sustainable Return on Equity is also important, so let’s seek out companies whose ROE is greater than 20 per cent in the most recent financial year, have a forecast dividend yield of more than four per cent and whose intrinsic value that is forecast to rise at least six per cent per annum.

The result?

Nine companies trading at a discount to intrinsic value that may be worthy of your attention.

Here they are: Seymour Whyte (ASX:SWL), Nick Scali (NCK), Codan (CDA), M2 Telecommunications (MTU), Credit Corp (CCP), Global Construction Services (GCS), Breville Group (BBG), GR Engineering (GNG) and Flight Centre (FLT).

If we were in a bull market, I suspect a stampede to get ‘set’ may ensue, without proper research. With the luxury of a market where the tide may still be going out, you may just have the indulgence of time to conduct plenty of research. Regardless, independent research is essential. As is seeking personal, professional financial advice.

So, what have you been researching? Go ahead and list your “Top 5″. We’ll put together a worthy riposte.

Alternatively, put forward your A1 suggestions and we’ll compile a list of intrinsic valuations and Skaffold® Quality Ratings for the next blog post.

Finally, keep in mind that I cannot predict where the share prices for these companies are headed. They could all halve, or worse. And remember, seek and take personal professional advice.

Posted by Roger Montgomery and his A1 team, fund managers and creators of the next-generation A1 stock market service, 8 September 2011.

Posted in A1, Company Valuation, Insightful Insights, Market Valuation, Value Investing, Value.able

317 Comments Leave a Comment

Your next-generation A1 invitation

The time has arrived.

My team and I are delighted to invite Value.able Graduates to pre-register for Skaffold®, our next-generation A1 service.

Skaffold is the stock market like you’ve never seen it before – the world’s best visuals combined with its most reputable information and ideas.

Amazing, incredible, simple. That’s Skaffold.

Those who have already seen Skaffold called it “the missing piece”.

Value.able Graduates will receive a personal invitation today. Keep an eye out for an email from me with the subject line “Your next-generation A1 invitation. Here it is”.

IMPORTANT: It has come to our attention that some @optusnet.com.au email addresses did not receive my invitation. Rest assured, if you have contacted us, posted a comment here at the blog or on my Facebook page, or simply not received your invitation, my team will be in touch.

Posted by Roger Montgomery, Skaffold® member #1.

Skaffold® is a registered trademark of Skaffold Pty Limited.

Posted in A1, Value Investing

87 Comments Leave a Comment

How much capital intensity does it take to sell seats?

Did you know some of Qantas’ planes are more than twenty years old? And our estimate is that they fly, on average, 14 hours per day. The rest of the time they mimic that expensive bit of fashion in your garage, earning no income. That garage/hangar time has expensive ramifications for the economics of airlines, just as your decision to buy an expensive but garaged ‘fashion’ item has expensive ramifications for you.

Capital-intensive businesses, such as airlines, erode shareholder wealth. Inflation ensures their maintenance and replacement is a significant proportion of cash flow, which could otherwise be paid out to shareholders. Parts plus labour, which protect the business assets from wear and tear, actually causes wear and tear on shareholders’ funds.

Raising capital and increasing debt, has hitherto been easy for Qantas, but the market is slowly coming to the realisation that it cannot continue.  The market capitalisation of Qantas – the ‘value’ the market ascribes – is less than all the equity that the company has raised – much less.

As a result of the market’s slow migration to understanding the economics of airlines, fresh management have had to respond quickly.

The best measure of economic performance is Return on Equity (ROE). This year QAN achieved a ROE of just over four per cent.  Meanwhile, Oroton shareholders have been enjoying eighty per cent returns. Did you know there are 267 companies that earn more than 15 per cent returns on equity?

The business of selling seats is an expensive one for Qantas, and while the business of selling the hope-of-getting-a-seat (the Frequent Flyer program) is extremely profitable, owning planes means the cash is always inhibited – it can’t be distributed to shareholder owners.

Qantas however isn’t the only seller of seats on planes. Indeed there are businesses that sell seats on planes and they don’t have any planes. Let’s compare two seat-sellers: Qantas and Webjet.

I believe the very best businesses online are lists – lists of jobs, lists of apps, lists of songs, lists of cars, lists of houses, list of flights and lists of seats. What is particularly attractive is that a business with a list of seats doesn’t have any planes. Sure its revenue is going to be lower, but what about its profit?

Let’s compare…


Now, lets take a look the economics of these businesses over the past ten years.

As the following sneek peek charts from our soon-to-be-released next-generation A1 stock market service display, Webjet has scored, on average, an A2 since 2005.

In this example, the Quality Score information tells us that something dramatic happened in the 2004/2005 financial year.

Webjet was once called Roper River Resources Company and in July 1999 the shares, under the ASX code; RRR, were trading at 25 cents. By March 2000 – near the peak of the internet bubble – RRR shares were trading at $1.38.

The reason is now obvious, although at the time it may have been a bit of a mystery.

In January 2000, Roper received a ‘speeding ticket’ from the ASX to which it responded on 14 January with the following statement:

“1. There are no, matters of importance, about to be released to the market.

“2. The Company is not aware of any information to explain the recent trading in the shares.

“3. The Company can offer no other explanation for the price change and increase in volume in the securities of the Company.”

“4. I confirm that the Company is in compliance with the listing rules, in particular, listing rule 3.1.”

On 27 January 2000 however – less than two weeks later – Roper River Resources (ASX:RRR) announced it was issuing 50 million shares to acquire Webjet Pty Ltd.

By June 2004 the shares were still trading at 15 cents, however the company announced the previous October that it was trading in the black for the first time. By November 2004, it was reporting 400 per cent monthly increases in sales. Almost every month to its full year results in June 2005, it continued to report 400 plus percentage increases in monthly sales.

And in that year Webjet’s Quality Score jumped from C4 to A1. As you can see, Webjet has maintained an A1 or A2 quality rating since.

By comparison, Qantas’s Quality Score profile has been more marginal. This should be unsurprising to many, if not most Value.able Graduates, who understand the downside of capital intensity. Lots of property plant and equipment results in more equity for a given profit, and that means lower returns.

So, what do you think?

With reporting season about to end, your mission, if you choose to accept it, is:

Source the latest Annual Report for each business in your portfolio. Go to the Balance Sheet and under ‘Non-Current Assets’ find ‘Property, Plant and Equipment’.

If you have any, how many capital-intensive businesses are hiding in your portfolio?

Making this process simple and easy is something we have been working on for you. We created our next-generation A1 service because we wanted to make finding extraordinary companies offering large safety margins easy. And, of course we love investing. The above graphics are just one

It’s an A1 service that is like nothing you have ever seen before.value

Value.able Graduates – your invitation to pre-register is coming soon.

If you haven’t graduated to guarantee your invitation, click here to order your copy of Value.able immediately. Once you have 1. Read Value.able and 2. changed some part of the way you think about the stock market, my team and I will be delighted to officially welcome you as a Graduate of the Class of 2011 (and invite you to become a founding member of our soon-to-be-released next-generation A1 service).

Posted by Roger Montgomery and his A1 team, fund managers and creators of the ext-generation A1 stock market service, 30 August 2011.

Posted in A1, Airlines, Insightful Insights, Value.able

36 Comments Leave a Comment

What has probing the reporting season avalanche revealed?

With reporting season in full swing, I would like to share my insights into whose Quality Score has improved, and whose has deteriorated. Remember, none of this represents recommendations. It is intended to be educational only. You must seek and take personal professional advice before acting or transacting in any security.

To date, 232 companies have reported their annual results. I am sure you can understand why we feel snowed under. With almost 2,000 companies listed on the ASX, the avalanche still has a way to roll.

We have updated all of our models for each of the 164 companies that we are interested in. As you know, we rank all listed companies from A1 down to C5. The inputs for those rankings always come from the company themselves. I would hate to think how bipolar they would be if we allowed our emotions and personal preferences to infect those ratings (or be swayed by analyst forecasts)!

Rather than arbitrary and subjective assessments, we download some 50-70 Profit and Loss, Balance Sheet and Cash Flow data fields from each annual report to populate five templates. All of these templates employ industry specific metrics to calculate the Quality Scores. This allows us to rank every ASX-listed business from A1 – C5. Its our objective way to sort the wheat from the chaff.

For Value.able Graduates not familiar with our scoring system, company’s that achieve an A1 Score are those we believe to be the best businesses, and the safest. C5s are the poorest performers and carry the highest risk of a possible catastrophic event.

A1 does not mean nothing bad will ever befall a company. A1 simply means to us that it has the lowest probability of something permanently catastrophic. Further, ‘lowest probability’ doesn’t mean ‘never’. A hundred-to-one horse can still win races, even though the probability is low. Similarly, an A1 business can experience a permanently fatal event. In aggregate however, we expect a portfolio of A1 businesses to outperform, over a long period of time, a portfolio of companies with lesser scores.

With that in mind, we are of course most interested in the A1s and – on a declining scale – A2, B1 and B2 businesses.

So, who has managed to retain their A1 status this reporting season? And which businesses have achieved the coveted A1 status? If you hold shares in any of the companies whose scores have declined (based of course on their reported results), please read on.

Of the companies that have reported so far, last year 20 of them were A1s, 28 were A2s, one was a B1 and 13 scored B2. That’s an encouraging proportion, although we tend to discover each reporting season that the better quality businesses and the better performing businesses are generally keen to get their results out into the public domain early.

Its towards the end of every reporting season where the quality of the businesses really drops off. This is always something to watch out for – companies trying to hide amongst the many hundreds reporting at the end of the season. It’s always a good idea to turn up to a big fancy dress party late, if you aren’t in fancy dress.

This year we have seen the number of existing A1s fall to nine from 20, A2s from 28 to 24, B1s rise from one to two and B2s fall from 13 to six.

The first table shows all twenty 2009/2010 A1 companies that have reported to date. You’ll see a number of very familiar names in here, including ARB Corp (ARP), Blackmores (BKL), Cochlear (COH), Carsales.com (CRZ), Fleetwood (FWD), Mineral Resources (MIN), Platinum Asset Management (PTM), REA Group (REA), DWS (DWS), Forge (FGE), K2 Asset Management (KAM), Macquarie Radio Network (MRN), Nick Scali (NCK), 1300 Smiles Limited (ONT), SMS Management & Technology (SMX), Webjet (WEB), JB Hi-Fi (JBH), Navitas Limited (NVT), Saunders International (SND) and GUD Limited (GUD). Nine have maintained their A1 rating this year.

Now, before you go jumping up and down, a drop from A1 to A2 is like downgrading from Rolls Royce to Bently. When we talk about A2s, its not a drop from RR Phantom to a Ford Cortina, not that there’s anything wrong with the old Cortina (if you are too young to know what I am talking about Google it!).

The only big rating decline is GUD Holdings, which made a large acquisition (Dexion) during the year. Indeed, a common theme amongst the higher quality and cashed up businesses this reporting season has been the deployment of that cash towards, for example, acquisition or buybacks (think JB Hi-Fi).

Moving onto the 2009/2010 A2 honour roll: Codan Limited (CDN), Advanced Share Registry Limited (ASW), Commonwealth Bank (CBA), Credit Corp (CCP), CSL Limited (CSL), Decmil (DCG), Domino’s Pizza (DMP), NIB Holdings (NHF), OZ Minerals (OZL), Plan B Group (PLB), RCG Corporation (RCG), Sedgman Limited (SDM), Slater & Gordon (SGH), Super Retail Group (SUL), Wellcom Group (WLL), Argo Investments (ARG), AV Jennings (AVJ), Carindale Property Trust (CDP), Computershare (CPU), Euroz Limited (EZL), Oakton (OKN), Tamawood (TWD), Austal Limited (ASB), LBT Innovations (LBT), Academis Australasia Group (AKG), Chandler Mcleod Group (CMG), The Reject Shop (TRS) and Primary Health Care (PRY).

The businesses that make up this list showed slightly more stability. The biggest fall in quality this year was Primary Healthcare (PRY),which is still struggling to digest the large purchases it made a few years ago. The Reject Shop (TRS) also declined, to B3. TRS is still investment grade and we would lean towards believing this is a short-term decline, given the floods in QLD that caused the complete shutdown of their new distribution center and the massive disruptions subsequently caused. As the company said, you can’t sell what you haven’t got!

Finally, B1 and B2 companies: Leighton Holdings (LEI), Alesco Corp (ALS), Mount Gibson Iron (MGX), Amcom Telecommunications (AMM), Data#3 (DTL), Ansell Limited (ANN), Fortescue (FMG), Little World Beverages (LWB), Stockland (SGP), iiNet (IIN), MaxiTRANS Industries (MXI), Newcrest Mining (NCM), SAI Global (SAI), Gazal Corporation (GZL) and Salmat (SLM).

About half the companies in the B1/B2 list retained or improved their ratings from last year. Mind you, half also saw their rating decline!

The clear fall from grace is Leighton Holdings, whose problems have been well documented in the media and via company presentations.But once again, like The Reject Shop, this could be a temporary situation. If the forecast $650m profit comes through, I expect LEI’s quality score will improve. What the dip will do, however, is remain a permanent reminder that Leighton is a cyclical business. Getting the quote right on a job is important, even more a massive enterprise like Leightons.

Are you surprised by any of the changes? We certainly were!

Sticking to quality is vitally important. That’s what my team and I do here at Montgomery Inc, and its what our amazing next-generation A1 service is all about. Value.able Graduates – your invitation is pending.

If you are yet to join the Graduate Class, click here to order your copy of Value.able immediately. Once you have 1. read Value.able and 2. changed some part of the way you think about the stock market, my team and I will be delighted to officially welcome you as a Graduate of the Class of 2011 (and invite you to become a founding member of our soon-to-be-released next-generation A1 service).

Remember, you must do your own research and remember to seek and take personal professional advice.

We look forward to reading your insights and will provide another reporting season update soon.

Posted by Roger Montgomery and his A1 team, fund managers and creators of the next-generation A1 service for stock market investors, 24 August 2011.

Posted in A1, Company Valuation, Insightful Insights, Value Investing, Value.able

164 Comments Leave a Comment

What are our thoughts on MCE’s results? And Big Air?

What is the value of a company that wakes up to find it has sold very little or even nothing in the last six months? My very long-term outlook for the price of oil hasn’t changed, but I can make the argument that the shares of Matrix C&E cannot currently be valued as a going concern any more confidently than I can a speculative exploration company.

While its a very harsh interpretation and its not the only interpretation, there are things to be concerned about.

Before I go into what disappointed me about the result, let me make an observation about the short term share price action.  It appears that many short term investors could be overreacting to the report.  Management are very confident that they will win new business and if they do, the share price represents and opportunity.

First, cash flow. Its something I have mentioned here at the blog previously – as have others.

Submitted on 2011/07/05 at 1:08am: “The short and mid term outlook for Matrix will be dependent on them securing some contracts and their cash flow will be dependent on them getting a few deposits paid. We have put a call into the company to see if we can get an answer but they may soon be in blackout so we’ll have to wait and see.”

Submitted on 2011/06/24 at 1:46pm: “Great stuff Ash. Good to challenge and shake things up. Any opposing views, go right ahead and put them up. I know that lots of you are concerned about Matrix. Watch their cash flows…”

There were many useful insights provided here at the blog about Matrix and their cash flow.

Prior to those comments, in April in fact, I noted we had participated in the capital raising at $8.50. But our holdings were small and hadn’t exceeded 1% of our portfolio because of our concerns about cash flow.  You may also remember I demonstrated declining intrinsic values for Matrix in the future, which triggered some concerned responses.  You really do need to understand the business, and the benefits of diversification.

Many might throw their hands up and give up on the intrinsic value approach, and while I would be delighted to see fewer value investors, this is as much an overreaction as the plunging share price may be today. There are critics who suggest there’s a problem with the intrinsic value approach.  Gloating is predictable, but they do fail to understand that any shortcoming is not the approach but its application; You need to understand cash flow (heck, there’s a whole chapter in Value.able!) and you need to understand the business (it’s what Value.able is all about).

So here are some of the facts, thoughts and reasons I think the market is reacting the way it is.  Don’t forget, in the short run, the market is a voting machine.

First:

MCE missed analysts’ expectations. Thats the first reason for a negative reaction by the market.  I should point out that the share price has been declining significantly for two trading sessions prior to this blog post and has fallen 50% from its highs in April.

Second:

Profit grew 85 per cent (but not by as much on a per share basis). While the question should be if an analyst’s forecast is missed, is it the company’s fault or the analyst’s, in this case those forecasts are a function of company guidance. Guidance was $40 million at the start of the year, then $36 million. This week profit came in at $33.6 million. Earnings per share grew 56 per cent (less than the 85% growth in total NPAT) thanks to a capital raising that was used to construct a facility that hasn’t yet generated returns.

Third:

Fifty six percent growth in earnings is stunning.  Make no mistake about that.  Again, all things being equal, if such growth were to continue it would almost certainly cause intrinsic values to rise and materially.

Fourth:

The company is forecasting revenue growth of 20 per cent. This is “company guidance”. If NPAT margins can be maintained – duplication costs could be removed next year, which would be positive for margins – profit will equate to 52 cps. But in the face of few or no new contract wins in the last 12 months, are management being optimistic?  Thats probably the key to working out if the current price is an overreaction and therefore an opportunity.

To grow revenue by 20 per cent to $224m, they need $114m of new work, on top of the current order book of $110m, which declined 70m in the last six months. Note the zero balance under Deposits in the Balance Sheet too.  There’s $500 million of work in the tender pipeline.  If they win 30% of that (a figure the company suggests is reasonable) that is $150 million and if won this year, will help the company achieve its target.

Fifth:

Analysts were forecasting 2012 EPS of 66 cents in July. Using these numbers, MCE’s valuation is over $10.00. But your valuation is only as good as your inputs. Those analysts are now forecasting earnings of 61 cents per share for 2012 and my own number is now closer to 51 cents (see above). In the absence of any announcements of contract wins, expect further downgrades from analysts.

Sixth:

Significant contract wins would have the opposite impact on intrinsic value and it could rise again.

Seventh:

If they achieve 52 cents of earnings per share, my intrinsic value becomes $6.80 – still significantly higher than the current share price but well down on the previous estimates of intrinsic value. The fact that $6.80 is above the current share price is one of the reasons I am keen to talk to the company!

But don’t forget, they have to win some contracts, because at the moment the [declining] order book is just 58 per cent of last year’s revenue. More importantly, in the absence of any contract wins, that intrinsic value could fall precipitously.  As I say above; “There’s $500 million of work in the tender pipeline.  If they win 30% of that (a figure the company suggests is reasonable) that is $150 million and if won this year, will help the company achieve its target.”  Its important the company make clear (at the AGM for example) details about the length of the tendering and commissioning cycle for all shareholders.

Eighth:

Aaron Begley is confident that they will convert about 30% of the work they tender for.  With $500 million in tender work thats will satisfy their revenue growth targets.

Ninth:

In the first half of last year cash declined, despite the fact the company borrowed more money and raised more capital. In the second half, the business generated just $900,000 of cash. There is no way to dress this up though and its not impressive for a company with a market cap earlier in the year of over $700 million and $350 million now.  As mentioned in some of the posts, it could merely be a function of the long lead cycles of commissioning oil rigs, in which case there may be an opportunity worth investigating.

Tenth:

In conclusion, the results revealed this:  Order book fell from $180m in the first half to $110m now. The $70 m decline is matched by the cash receipts in the second half. Given the fact that deposits in liabilities on the balance sheet fell to zero, we can assume the company made little or no new sales in the second half. Its with this in mind that you need to consider whether the companies forecasts are bullish or not.  They need to win some business to justify the estimate of intrinsic value

As at June 30, 2011, MCE’s quality rating is A2. There is virtually zero chance of a liquidity event. But non manufacturing overheads are running at $750k a month, so the cash will be diminishing if there are no contract wins. That is what is driving the share price lower.

THEY NEED TO WIN SOME CONTRACTS OR SHAREHOLDERS NEED TO BETTER UNDERSTAND THE TENDERING CYCLE LENGTH.

Finally:

It is quite fair for critics to point out the one-eyed focus many investors have on the Value.able intrinsic value formula. The formula is a good one, but it is only as good as the inputs you feed it and they must come from an understanding of the business. I took a call from an share market investor who didn’t understand why the share price for Matrix was falling after reporting such strong profit growth. If that sounds like you, take a break and get back to the books to understand the business and its prospects. At the very least, it will help to either, 1) temper your enthusiasm for a company that is at a discount to your intrinsic value estimate, 2) change your estimate of intrinsic value or, 3) give you a better understanding of whether that intrinsic value is rising or declining.

On a separate note, there is a very real chance of a downside overreaction too, something we are always on the lookout for!

General and Educational Information only.  Not a solicitation to act or trade in any security in any way.  Always seek and take personal professional advice.

BigAir Group?

Digging in a little deeper to BigAir’s financials and you may notice a few things to be cautious about too – always important to read past what management tell you about revenue numbers climbing to the moon and do your own thinking.

These are all symptoms of a fast growing business, and a business which has grown by acquisition.

Firstly, a little cash strapped? Current Liabilities > Current Assets by 400k. This is mainly due to the $3.6m they owe on their acquisitions in the next 12 months. They have announced the acquisitions but hadn’t paid for them at June 30. Don’t forget that they also owe $1.375m, which is in non-current liabilities – a total of $5m in payments are still to be made for past acquisitions already announced. See note 18 to the accounts for more.

The next 12 months are important, and with Current Liabilities > Current Assets, its not an not an ideal position to be in, although they may be able to cover this by working their working capital. What you now need to work out is if future cash flow and of course CAPEX, which seems to run @ $2.5-$3.2m, will provide enough free cash for them to self fund their operations and liabilities. It is of course is hard to work out because maintenance CAPEX and growth CAPEX is harder to separate when a company grows quickly through acquisitions.

The university business may prove distracting, but some serious players in the industry really like fixed wireless broadband.

General and Educational Information only.  Not a solicitation to act or trade in any security in any way.  Always seek and take personal professional advice.

Posted by Roger Montgomery and his A1 team, fund managers and creators of the next-generation A1 service for stock market investors, 24 August 2011.

Posted in A1, Blue Chips, Financials, Retail, Telecommunications, Value Investing

176 Comments Leave a Comment

What’s your stock market survival story?

Last night, First Edition Value.able Graduate Scotty G shared his stock market story at our blog. Scotty’s story is far too value.able to not receive its own, very special post! Over to you Scotty…

A Tale of Two Crashes

by Scotty G

2008/2009

An ‘investor’, whom we’ll call Scotty G for anonymity purposes, has woken for work at 05:00 to see that the Dow is off 700 points. He nervously heads in to work to check what it means for his portfolio of ‘blue chips’. He’s down badly and it’s only made worse by the fact that he is in a margin loan, which he kept at a ‘conservative’ 50 per cent level of gearing.

His ‘great’ stock picks are not holding up well in this environment and his ‘genius’ ‘value plays’ like buying Babcock and Brown at $7 because ‘its fallen from $28 and surely at a quarter of the price it represents value’ no longer looks like genius at all. He had imagined himself some sort of Buffet-ian hero, stepping into a falling market and making the tough buy call that would surely pay off. No actual analysis is done to back up these calls.

Finally he is 1 per cent off a margin call. He is tense at work, snapping at friends and chewing a red pen so hard it stains his lips and chin. He capitulates, calls his broker and sells out, including his ‘value pick’ Babcock and Brown at 70c.
 He feels relieved to be out, but is bruised and jaded by his experience. He vows to return to the stock market some day and do better, but doesn’t know how.

2010

Our ‘hero’ comes across a beacon of light in a sea of information. It is the Value.able column in Alan Kohler’s Eureka Report, penned by a knight known as Roger M (name changed to protect the innocent). He follows the link to the Insights blog and is astounded that the information he has been searching for is all here. He eagerly orders the Tome of Wisdom (known as Value.able to some). Upon receiving it, he reads it in one sitting. Wheels click in his head and light shines in the dark. Could it be so simple? Knowing what something is worth and then refusing to pay above it? In fact, demanding a discount? He set off onto his journey for the Grail.

2011

Our hero is now equipped with a spreadsheet devised from the Value.able rule book. He can value companies quickly and decisively. Many don’t make it onto the spreadsheet, as he can now spot a ‘Babcock and Brown’ coming from a mile away. Stock ‘tips’ from colleagues can now be waved away. When they ask why, he tells them. If they say he’s crazy, he smiles and feels at peace. He knows he is still not perfect, but he’s a darn sight better than he was three years back.

The markets turn down. The spreadsheet is rechecked. MCE and FGE are added as they shift below his 20 per cent discount rate. JBH is added soon after. The markets shift lower. But reassured by the facts this time, and not the hype, he buys more of the above.

Markets shift lower still. Figures are checked and rechecked as more great businesses come within range. The panic of a fall is now replaced by a calmness and certainty that an anchor of value provides.

The market finally slides steeply over several days.

Finally! Some of his best targets are in range.

VOC falls, then MTU (a company he has waited ages to acquire), and finally DCG. Sadly, ARP refuses to come within range, but he his patient and does not chase it.

He retires to his castle (lounge/bar), content with the work he has done and happy to await the next chance to hunt and switches on the sport, deftly ignoring the news and business channels hosting ‘experts’ eager to proffer their take on why things were the way they were. He feels at peace and sleeps soundly that night.

“Ok, stripping out all the ‘poetic’ and imaginative stuff, this is pretty much how it went in real life. I suffered a loss due to poor decisions with no research. I found Value.able, I converted (or got innoculated as some of the greats say) and took advantage of the recent situation. And I do sleep soundly at night.

“Thank you Roger for your willingness to share and to all on the blog for the same spirit of camaraderie. I look forward to many years of sleeping soundly at night.

To Value.able and to Value!”

Thanks Scotty.

If you are yet to join the Graduate Class, click here to order your copy of Value.able immediately. Once you have; 1. read Value.able and 2. Like Scotty, changed some part of the way you think about the stock market, my team and I will be delighted to officially welcome you as a Graduate of the Class of 2011 (and invite you to become a founding member of our very-soon-to-be-released next-generation A1 service).

Posted by Roger Montgomery and his A1 team (on behalf of Scotty G), fund managers and creators of the next-generation A1 service for stock market investors, 10 August 2011.

Posted in A1, Insightful Insights, Value Investing, Value.able

144 Comments Leave a Comment

Are there really five bargains to research further?

With markets falling on fears that political brinkmanship in the US may result in an embarrassing default on the country’s extraordinary debt obligations (not to mention a reputationally damaging event), I wondered whether we could dig anything up with a more-than-slightly different approach to finding value.

As you would know from reading Value.able, I am not a fan of the Price to Earnings Ratio. Nothing has changed on that front. Nevertheless, value may just be in the eye of the beholder and not only is the P/E Ratio common in literature about investing and in market commentary, it is, whether rightly or wrongly, in wide use.

Indeed, if you are like many Baby Boomers now on the cusp of selling your business, you will be spending a great deal of time in negotiations and assisting in due diligence to arrive at a simple multiple of earnings.

The humble P/E Ratio may be misused, misunderstood and relied on far too heavily, but popular it remains.

One version of the earnings multiple that is adopted for comparison purposes by private equity buyers is the enterprise model. The enterprise model takes the market value of the equity (market cap) and debt, less cash, and divides the whole lot by the EBITDA (earnings before interest tax depreciation and amortisation). Of course, if you have a company with high operating margins but lots of property, plant and equipment (PP&E) to maintain, you may find the results a little optimistic.

Simply take a standard price to earnings approach, but subtract the cash the company has in the bank.

If you were to buy a business outright, you may take into account the cash the company has in its bank accounts. After buying the business you may be able to access this cash and withdraw it to lower the purchase price. Alternatively, if you are selling a business, in an IPO for example, you may be just as keen to take the cash out before selling it to maximise the return to you and reduce the return available to otherwise anonymous share market investors (this latter strategy is very popular).

The arithmetic result of taking out the cash is a lower P/E multiple. And that is what I thought you may be interested to discuss.

Are there any companies listed in Australia that are trading on very low multiples of earnings once their cash is taken into consideration? The broad based market declines have ensured there are indeed a few.

Step 1

My search began by opening our next-generation A1 service (Value.able Graduates – your exclusive invitation to pre-register is not far away). I applied a filter to discover those companies whose shares were trading at a P/E-less-cash ratio of less than 6 times. From the more than 2000 companies reviewed, there are 18 such companies that meet the criteria today. Keeping in mind some businesses have cash on their balance sheet that would NOT be accessible to a buyer (legislated, regulation or simply working capital needs), here are the eighteen:

Step 2

Next, I retained only those companies that have a current estimated forecast increase in intrinsic value of 10% or more. This filter reduced the field to just 11 companies, removing ASX, OZL, CGS, CFE, BTA, PBP AND MOC. Here are the eleven:

Step 3

Finally, I removed companies whose previous year’s ROE was less than 15%. I also removed any companies with a C1-C5 Quality Score. Low ROE stocks removed were; CLQ, CLH, SVW AND STS and C-rated companies removed were; SFH AND PEM. That left just five companies. Here they are:

And there you have it, companies trading at enterprise multiples that may be attractive to a buyer who could potentially use the cash on the balance sheet to reduce their purchase price.

Amazing, incredible simple. No manual calculations required (ever again).

Remember, this exercise did not incorporate any of the traditional Value.able investing considerations we usually discuss at the Insights Blog… safety margin, intrinsic value.

For the record, only two of the listed businesses look cheap on the Value.able score today. With reporting season about to begin in ernest, keep in mind the results and cash balances of these companies will all change.

You must do your own research into their prospects and remember to seek and take personal professional advice.

Very soon, finding extraordinary A1 companies offering large safety margins will become simple and even fun. Our next-generation A1 service that my team and I have been tirelessly working on will inspire your investing and re-energise your portfolio.

Value.able Graduates – stay tuned. Your exclusive invitation to pre-register will arrive in your inbox very soon. If you are yet to join the Graduate Class, click here to order your copy of Value.able immediately. Once you have 1. read Value.able and 2. changed some part of the way you think about the stock market, my team and I will be delighted to officially welcome you as a Graduate of the Class of 2011 (and invite you to become a founding member of our soon-to-be-released next-generation A1 service).

Back to the program… this reporting season, who do you think will surprise with better than expected earnings?

Who do you think will struggle?

And what stocks are looking cheap to you right now?

Posted by Roger Montgomery and his A1 team, fund managers and creators of the next-generation A1 service for stock market investors, 29 July 2011.

Posted in A1, Company Valuation, Floats, Insightful Insights, Takeovers, Value Investing, Value.able

87 Comments Leave a Comment

What did Ash and the team talk about?

Yesterday we had the pleasure of meeting Ash in person. If you scroll through any of the threads on our blog, you will no doubt find some extraordinary insights from one of Value.able’s founding Graduates.

Indeed, Ash’s generosity and willingness to share his experience and insights with new investors has fostered a spirit of camaraderie that has become integral to the Value.able community.

What did we talk about? It’s been a hot question at the Facebook page!

…Matrix, the recovering Lockyer Valley, cotton, gas explorers, an exciting new float, Lloyd, rugby and the 2GB podcast about a small cap gold stock that resulted in 170 comments and the thought to shut this blog down!

Thanks again Ash. We look forward to catching up with you again when you are next in Sydney.

Now to the photo… can you spot some familiar faces?

The first four of six framed artworks are now featured at the entrance of our office.

It was a proud moment indeed. We will publish some more photographs of the artworks in coming days.

Posted by Roger Montgomery and his A1 team, fund managers and creators of the next-generation A1 service for stock market investors, 7 July 2011.

Posted in A1, Insightful Insights, Value.able

81 Comments Leave a Comment

How are the A1 twins performing?

For those who may not know, Value.able Graduate Scott wanted to know just how useful this A1 to C5 quality rating stuff, that my team and I talk about so much, really is. With our next-generation A1 service not far away, its a worthwhile question.

A1 is the highest quality rating a company can receive. A company that earns an A1 has the lowest chance of catastrophe, a C5 the highest chance. Of course it is possible that something bad could happen to an A1, but the probability is a lot lower. As a Value.able Graduate you may, like many, consider A1 companies the truest of ‘Blue Chips’.

Take for example the recent announcement of an impairment charge by Transpacific (ASX: TPI). ‘Impairment charges’ are a loss in any other language. TPI is another example of the process working – Transpacific has long received a score of C4 or C5. The shares have fallen 50 per cent recently, but more importantly, are now at or close to all time lows.

Our Quality and Performance Rating is applied without any subjectivity. That means there is no human intervention. There is no ‘tinkering’. All companies are judged according to the metrics they generate. A1s have the lowest probability of a liquidity event and C5’s have the highest. A liquidity event includes a capital raising, debt default or renegotiation, administration, receivership, etc.

Another way to test the efficacy of our approach is to track the performance of the A1’s against, say, the ASX/S&P 200. The following chart, first published here, shows that sticking to A1s and avoiding C5s should, over time, produce better returns. The chart shows the performance of a portfolio of the 20 largest companies listed on the ASX rated ‘A1′. The red line is the poor old ASX/S&P 200.

Back to Scott…  he came up with a third way to test the approach. He’s been watching a portfolio of A1s and comparing it, in real time, to a portfolio suggested by a large investment bank. Take it from here Scott!

For new readers to the blog, welcome. Here at Roger’s Insights blog we are conducting a 12-month exercise measuring the performance of a basket of 10 stocks recommended by Goldman Sachs, against a basket of 10 A1 or A2 businesses that were selling for as big a discount to Intrinsic Value as we could find.

The original story that inspired this study can be found here.

The first chapter of our story was published earlier this year – Will David beat Goliath?

Six months has passed since our twin brothers each invested their $100,000 inheritance. The first quarter saw the ASX 200 (XJO) grow 2.0% and the two portfolios performed very differently to each other. At the end of the second quarter, the XJO is now 2.9% below the start of the year, and the impact of this sell off on the brothers, has been as stark as the impact on their portfolios.

Our Queensland regional accountant decided it was time to help his flood ravaged community and took six weeks annual leave. He went over to Grantham and helped rebuild the lives of so many flood ravaged families. Whilst physically taxing, it was an enormously rewarding experience, and reminded him of what life is really about. Upon arriving home six weeks later, in mid June, he was surprised to discover that the market had continued the decline it had begun before he left. Whilst his portfolio had taken a bit of a beating, he was very pleased to see it had outperformed the Index, and was still in the black.

His brother, on the other hand, was not feeling so grounded. Every morning he found himself starring at the CNN web page and shaking his head in disbelief… the Dow was down AGAIN (that almost inevitably led to a poor performance of his portfolio that day). Six weeks later, he found himself sitting in the office of the Departments Deputy Secretary, with a Human Resources specialist, being asked, “Is every thing alright at home?” There was a litany of concerns raised about the sudden deterioration in his performance, from missed meetings to reports that looked like someone very distracted wrote them. Having not really understood the quality of businesses he was invested in, nor understanding the importance of turning the market off, he was turning a market sell off into a major personal crisis.

In summary, for the six months to 30 June 2011:

The XJO is down 2.9%

The Goldman Sachs Portfolio is down 6.2%

The A1 and A2 Portfolio is UP 1.8%

Here are the portfolios in detail, including cash dividends received in the first half. (click to enlarge)

We will visit the brothers again at the end of September.

All the Best

Scott T

Thanks for that Scott.

Have you checked your portfolio for C5s? Are all the stocks in your portfolio worthy of the A1 rating? According to one Value.able Graduate, Charles Munger said; “If the business earns 6% on capital over 40 years and you hold it for that 40 years, you’re not going to make much different than a 6% return – even if you originally buy it at a huge discount.”

Sticking to quality is vitally important. That’s what my team and I do here at Montgomery Inc, and its what our amazing next-generation service is all about. We will invite Value.able Graduates to pre-register soon.

Good investing to everyone… including Goldmans.

Posted by Roger Montgomery and his A1 team, fund managers and creators of the next-generation A1 service for stock market investors, 5 July 2011.

Posted in A1, Blue Chips, Company Valuation, Insightful Insights, Market Valuation, Value Investing, Value.able

147 Comments Leave a Comment

Who is being watched this reporting season?

Now on the cusp of reporting season, it is worth reviewing our expectations for Value.able intrinsic valuations and double-checking those that belong to higher quality (MQR: A1, A2, B1, B2) businesses.

There were more than 107 suggestions! Thank you.

Our new A1 service allows us to whip up all the data required for all your nominated stocks in less than a minute (soon you can too!). For now, let’s put stakes in the ground for those which achieved at least three nominations.

In order of mentions…

Matrix C&E, followed by JB Hi-Fi, Forge, Vocus, BigAir, Credit Corp, Woolworths, Thinksmart, BHP, M2 Telecommunications, Zicom, Oroton, ANZ, CSL, ARB Corporation, Thorn Group and Cash Convertors. The remaining companies received less than 5 mentions each. The companies with only a single mention (and therefore arguably least followed) were: ILU, RFG, SMX, KRS, AMA, LNC, RQL, COU, TBR, CPB, AVM, BDR, REA, AIR, CKL, AJJ, FXL, CTD, STU, MIN, TGR, CXS, CMI, CDA, CGX, DGX, RCO, MND, CIX, MOC, RHD, DLX, RMS, MYE, SEA, DPG, SFR, NCK, SRX, NCM, CLV, NFK, CLX, NOE, CMG, NST, IPP, CDD, WTF, OGC, KNH, DWS, FRI and KCN.

Well without further delay, here’s the list with our 2012 forecast Value.able intrinsic valuations.

<Temporarily removed for updating and additional stocks and data columns>

Over the next few weeks we will build on the list, include some additional useful information and data and generally prepare you for reporting season.

Stay tuned. This is a period when even developed markets can be inefficient.

Posted by Roger Montgomery and his A1 team, fund managers and creators of the next-generation A1 service for stock market investors, 1 July 2011.

Posted in A1, Blue Chips, Company Valuation, Financials, Insightful Insights, Value Investing, Value.able

179 Comments Leave a Comment

What are you cooking up Roger and team?

I am working tirelessly to generate superior returns for the Montgomery [Private] Fund. That is the number #1 goal. But stay tuned, because I am also writing a post for next week that will list some of the companies you should be seriously watching this reporting season (and there may be a few gems). Stay tuned and keep checking in.

Today’s earlier post (What if the sell off is just a Flash?) lists some out-of-favour A1 companies.

If you have a company that you believe investors should be watching this reporting season, please  start posting them here. Check in next week to see if  they’re on our list too.

Posted by Roger Montgomery and his A1 team, fund managers and creators of the next-generation A1 service for stock market investors, 23 June 2011.

Posted in A1, Company Valuation, Insightful Insights, Value Investing, Value.able

241 Comments Leave a Comment

What if the sell-off is just a Flash?

Did you overhear a prominent investment commentator (not a Value.able Graduate, of course) recently express how upset/annoyed they were that the market for big companies’ shares was deteriorating?

In the short run prices move independently of the underlying business, so let’s encourage the market to decline further!

For those truly concerned about Australia’s prosperity, relax. Be comfortable in the knowledge that short-term share price moves are unlikely to impact the employment policies of Australia’s largest listed businesses.

Looking over the financials of fifty-six A1 companies, little has changed. While Telstra and Fosters share prices are beating to the drum of hoped-for franked dividends and a takeover, the fundamentals of many other companies, particularly A1s (and indeed A2 and B1), are resolute. Are these businesses worth 10% to 26% less than they were worth before? No chance. The Value.able intrinsic valuations of companies that were cheap before haven’t changed.

So what has changed?

Only investors’ perceptions. Perceptions about the global economic outlook; perceptions about a US slowdown becoming a recession; perception about a Chinese slowdown causing a global rout the world cannot afford; and hope that Australian house prices will fall to levels people can actually afford.

Think about that for a moment. Baby boomers own $1m + homes that they will be forced to liquidate to fund their retirements and health care. Meanwhile, Generation Y is struggling to afford a property. Something has to give. Economics 101 suggests price declines.

Investors have simply been reducing their appetite for risk.

Armageddonists are spouting scenarios similar to those that followed Britain’s exit from the gold standard in 1931.

But this fear may be unfounded. It’s most certainly not a cause for permanent worry. Even if a recession does transpire, it will not be permanent.

Our job as Value.able Graduates is not to guess the gyrations of the economy – while they are vital in determining the sustainability of a given return on equity, many of the world’s very best investors do not even employ economists (they employ former US Federal Chairmen).

Your mantra is to simply put together a list of ten extraordinary businesses that you believe will be much more valuable in five, ten or twenty years time.

Of course trying to fit all this into your daily life can be a challenge. Completely eliminating the drudgery, and making it simple and fun, is something my team and I have been working on for you. We created our A1 service because we wanted to make finding extraordinary companies offering large safety margins easy. And, of course we love investing. We have worked really hard to create our next-generation service because its what we all want to use. We are its first members! Soon, you will be able to make your investing life simpler too (remember, Value.able Graduates will be invited first – have you secured your copy?). It’s an A1 service that is like nothing you have ever seen before.

You may sense our excitement…

… back to the regular program.

So, here it is. Our list of out-of-favour-but-extraordinary businesses. WARNING: out-of-favour does not always mean ‘bargain’.

Steve Jobs once said; “People think focus means saying yes to the thing you’ve got to focus on. But that’s not what it means at all. It means saying no to the hundred other good ideas that there are. You have to pick carefully.”

With that in mind, here are my thoughts on ten businesses we have discussed over the past few months with a back-of-the-business card reason for interest…

JB Hi-Fi (ASX: JBH, MQR: A1) – Bad news across the board in retail may get worse, but it will turn around and JB Hi-Fi is not Harvey Norman. The buyback has increased intrinsic value at the same time the price slides below.

Cochlear (ASX: COH, MQR: A1) – The shining star amongst A1s (COH is one of this country’s best export successes), yet the worst performer on the share market amongst its peers. Rational, anyone? Australian dollar fluctuations doesn’t change the quality of COH’s business, only the nature or shape of its earnings. Aussie dollar appreciation may last a while, but is not permanent.

CSL Limited (ASX:CSL, MQR: A1) – Another A1 amongst A1s. Like COH, earnings are affected by currency fluctuations.

Woolworths (ASX: WOW, MQR: B1) – Trading at a premium to current Value.able intrinsic value, but a small discount to 2012. Intrinsic value has taken five years to catch up to the price and the price has complied by waiting. In the absence of further downgrades, intrinsic value for future years now rises beyond the price at a good clip.

Reece (ASX: REH, MQR: A2) – Great quality business. Wait for weaker prices or intrinsic value to catch up.

Platinum Asset Management (ASX: PTM, MQR: A1) – Whilst few businesses can compete with Platinum on an ROE and low capital intensity basis, patience is required before acquiring.

Matrix C&E (ASX: MCE, MQR: A1) – Matrix is unique amongst its small capitalisation peers also servicing the resources sector. Watch the full year results closely.

ANZ (ASX: ANZ, MQR: A3) – Short of swimming off the island, we don’t have much choice when it comes to choosing a banking partner. Thanks to fears of an ineffectual Asia roll-out, ANZ is the cheapest of Australia’s big four at the present time.

Vocus Communications (ASX: VOC, MQR: A1) – Run by some of the best in the business, the intrinsic value of Vocus has the potential to be much, much higher in five years time.

Zicom Group (ASX: ZGL, MQR: B2) – Like Matrix, Zicom is exposed to both small-cap and resource sector engineering negativity. And like Vocus, the intrinsic value could rise much higher on the back of further rises in the price of oil and demand for gas.

What’s on your list?

This market, with an increasing number of companies hitting 52-week lows, is demanding your attention!

Posted by Roger Montgomery and his A1 team, fund managers and creators of the next-generation A1 service for stock market investors, 23 June 2011.

Posted in A1, Company Valuation, Insightful Insights

177 Comments Leave a Comment

Tech Wreck MkII: Is this time different?

“If you’re playing a poker game and you look around the table and can’t tell who the sucker is, it’s you.”  Paul Newman

“Great men are not always wise” Job 32:9

“If one man says to thee, ”Thou art a donkey’,’ pay no heed. If two speak thus, purchase a saddle.”  ”Doubt cannot override certainty”  The Talmud

“The seed ye sow, another reaps; The wealth ye find, another keeps; The robes ye weave, another wears; The arms ye forge, another bears.”  Percy Bysshe Shelley

If you are watching events unfold in the US like me, you’re probably hearing a lot about the tech stock frenzy going on over there.  Stunning IPO successes this financial year are once again drawing a crowd. But are we looking at a Tech Bubble MkII? Are the big banks, without a suite of CDSs and CDOs to sell, now performing the same cup-and-ball trick on a different table? Or is this time genuinely different?

Read on – you be the judge (my mate Jim Roger’s is short “US Tech”, and I never ever allow myself to believe this time is different to the last).

YouKu

Based in Beijing and now listed on the Nasdaq, YouKu is China’s answer to YouTube. The stock closed at $33.44 on its first day of trading in December 2010 (its now $28.04) – that’s 160 percent above its offer price of $12.80! The company offered 15.8 million shares of American Depository Receipts (ADRs), representing 16 percent of the total shares, giving it market cap of $3.3 billion or 71 times revenue. Youku generated revenue of $35 million in the first nine months to 31 December 2010 and lost $25 million during the same period.

Founded in November 2005 and launched in December 2006, YouKu never really relied on user-generated content. More than 60 per cent of its videos are from traditional media companies in China. The company has 40 per cent penetration amongst China’s 420 million internet users. YouKu claims 200 million unique visitors a month in China, however independent comScore estimates a smaller 78 million.

LinkedIn

LinkedIn was priced at $45 per share but traded between $80 and $120 for more than a week after listing, giving the company a market ‘valuation’ as high as $11 billion. Unlike many of the tech stocks that tempted investors in 1999 and early 2000, LinkedIn is profitable.

The company reported its first quarter revenue in 2011 was up 110 percent to $93.9 million compared to pcp (previous corresponding period) and ‘Net income’ increased to $2.08 million for the same period, compared to $1.81 million for pcp.

But there is profitable and there is ridiculous. An $11 billion valuation, or more than 22 times revenue for a business that earns 2 per cent on its revenue, seems, at best, unconnected to the underlying financials. Even someone like me that pays no attention to price or revenue multiples can see that.

Yandex

On 26 May 2011, Yandex NV (YNDX), owner of Russia’s version of Google and the country’s most popular Internet search engine, listed on the NASDAQ. Yandex sold 52.2 million shares (or 16.2 percent) at $25 per share, raising $1.3 billion and valuing the company at $8 billion. On their first day of trading the shares rose $13.84, to $38.84, giving the company a market capitalisation of $12.4 billion or a multiple of 43 times next year’s forecast earnings. For those seeking a reference point (not a valuation), Google trades at about 13 times estimated 2012 earnings.

Total online advertising in Russia climbed 51 percent from 2008 through 2010, but still amounts to just $940 million! Private equity accounted for seventy per cent of the shares sold in the Yandex float.

Renren Network

The demand for shares in Renren – the Facebook of China with 117 million users* – was clear days before it floated on 2 May 2011 (the company raised the expected price range of its IPO of 53.1 million shares by 30 percent to $12 to $14 per share from a previous range of $9 to $11). The float raised about $743 million and gave the company a valuation of more than $4 billion, or 52 times sales. Renren’s net revenues were $76.5 million in 2010, up 64 per cent from $46.7 million in 2009 and up from $13.8 million in 2008. Renren had a net loss in 2010 of $64.1 million, down from $70.1 million in 2009.

The head of Renren’s audit committee, who is also a board member, quit after allegations of fraud against Longtop Finanicial Technologies. The company also revised down its unique user numbers to a rise of 19 per cent (it originally advised 29 per cent).

Renren said in its prospectus that it operates under a prohibition against posting content that, “impairs the national dignity of China” or is “superstitious”, or content that is “socially destabilising.”

If Renren fails to comply, the company says its websites could be shut down. Clearly that could put it out of business.

The company also has a “material weakness” and a “significant deficiency” in its internal financial controls: it doesn’t have enough people with knowledge of U.S. GAAP (Generally Accepted Accounting Principles). Eighty seven per cent of Renren’s leased office floor area did not have the proper title documents.

*Renren doesn’t really seem sure how many users it has. According to its April 27 revised IPO filing, monthly unique log-in user base grew by only 5 million, or 19 per cent, in the first quarter of 2011 – not the 7 million, or 29 per cent, it reported in its first filing only 12 days earlier.

Pandora (not the charms)

Online radio operator Pandora runs an online personal music service – with applications for the iPhone and Google’s Android mobile operating system - that lets users pick songs, styles/genres and bands from which to build a personal radio station. As at the end of April, Pandora has about 94 million registered users, of which 34 million are considered active. This is up from 18 million at the same time last year.

Pandora offered 14.7 million shares, or just 10 per cent of the total float at $16, raising around $235 million and putting a valuation of $2.6b on the whole shebang. Pandora was priced at about 19 times revenue for last year. Revenue Value.able Graduates, not NPAT.

Pandora has not reported any profits in 2010 or 2011. Indeed in the last three years, Pandora has lost $46.7 million and the company said in its IPO filing that it doesn’t expect to be profitable this year or next. Worryingly, it doesn’t say when it expects to be profitable.

In the weeks prior to listing, the lead manager, Morgan Stanley, raised the expected price range from $7-$9 to $10-$12. Then, after the marketing period ended, priced the shares at the final listing price of $16.

And it gets more fascinating. On its first day of trading, Pandora shares rose as much as 63 per cent to a high of $26, giving it a market capitalisation of $4.2b. A competitor listed on the Nasdaq, Sirius XM, trades at 2.6 times revenue.

According to documents filed with the SEC just six months ago, Pandora’s own board reckoned its stock’s value was/is $3.14 a share, or a market capitalisation of about $500 million.

Pandora generated revenue of $51 million in the first quarter ending April 30 – more than double the $21.6 million for the pcp. The company however lost $6.8 million in the first quarter this year, up from around $3 million in the same quarter last year.

Until recently advertising has represented more than 90 percent of revenue, however revenue from subscriptions (which lets subscribers skip the advertisements the company’s other customers pay for to appear between songs) has been growing. At the end of April, subscription revenue was about 15 per cent and is growing at more than 100 per cent per annum.

But more than 50 per cent of total revenue is paid for song rights and the more people that listen to music through Pandora, the higher this royalty grows. Pandora has an agreement with SoundExchange for its streaming rights that expires in 2015. Between now and 2015, the rates Pandora pays are expected to go up by 37 per cent for songs streamed by free listeners, and by 47 per cent for songs streamed by paid subscribers. In addition to these fees, Pandora has deals with BMI and SESAC to pay 1.75 per cent and 0.38 per cent of gross revenue respectively. In order to become profitable, Pandora will need revenue per user to go up. And it will need a new deal with the music labels.

The share price is now below $16.

Bubbles? This Time is Different!

Ok. Enough of the fundamentals, no one is paying attention to those anyway. From what I have been reading there are many experts who are saying… what exactly? That this time is different!

Those who believe this time is different to the tech boom of the late 90’s point out that 90’s technology companies never generated profits or even revenue. Pandora however has a revenue model, and it’s rare to see today’s tech IPO without one. Effectively the ‘experts’ are suggesting the tech stocks listing today are more mature. Some investors and analysts even brushed off red flags like Renren revising down its user and user growth numbers just before its float, saying China is still the biggest internet market in the world and its rapid growth will continue. They suggest that figures reported by Chinese companies should be used for directional guidance, rather than as quantitative truths.

And that’s pretty much their argument.

My team and I have the ability to analyse every single listed company, globally (and the indices on which they are based), with fundamental data that is updated daily (very soon you will have the opportunity to use our extraordinary A1 service for every Australian company too, so don’t be tempted by all those end of financial year special offers).

Our intrinsic value analysis for the companies described above, and many of their more mature peers in the US and elsewhere, reveals gullible investors are once again being taken for a whimsical ride accompanied by a flagrant disregard for value.

Bubbles can go a long time before popping, and given that bubbles are best identified by credit excesses, not solely valuation excesses, we may be only in the very early stages of the bubble in technology stocks (but very close to the bubble bursting in US TBonds).

Your thoughts?

Posted by Roger Montgomery and his A1 team, fund managers and creators of the next-generation A1 service for stock market investors, 19 June 2011.

Posted in A1, Company Valuation, Financials, Floats, Insightful Insights, Value Investing, Value.able

14 Comments Leave a Comment

Have you submitted your photograph to the Value.able Graduate Album?

Jesse, Michael, Young Les, Justin, Matt, Rad, John, Ron, Young Max, Gary, Dan’s mum, Gary, George, Steven, JohnM, Paul, Steven and Sophie, Michael, Alya, Martin, Bernie, Amit, RBS Morgans Gosford, Jim Rogers, Daniel, Keith, Gavin, Graeme, Nick, Gelato Messina, Chris, Rodger, Phil, Vikki, Mark, Hien, Kenneth, Greg, Peter, Bernie, Paul, John, Bill, Bryan, Di and Lesley, Craig, Scotty, Chris, Main Amigo Stan, Charles, Fred, David, Mark, Collin, Nevada Cody and Winston, Peter, John, Nathan, Mal, John, Tony, Les, William Grant, Greg, Mike, Paul, Roger, Mike, David, Paul, Sinaway, Anders, Frank, Jake, Johan, Mark, Rob, Ian, Joan, Claude, Toni, Richard, Matt Jnr, Indrash, Sara, Garry, Jonathan, Ganesh, James, Kevin, Jim, Peter, Greg, Stuart, Craig, Eric, Robert, Ermin, Mike, Syed, Wilma, John, Alf, Tony, Phillip, Robyn, James, Carolyn, Roy, Peter, Jack, Kevin, Howard, Leo, Jonathan, Carole, Eileen, James, John, Martin, Ordan, Warren, Andrew, Liz, Jim, Anthony, Bob, Douglas, Christine, Frank, Martyn, Michael, John, Dave, Peter, Darrell, Jeffrey, David, Joof, Tom, Leigh, Mervin, Paul M, Paul K, Noel, Bob, George, Leigh, Bob, Steve, Monica, Richard, Frank, Brett, Steven, Colin, Wayne, Joanne, Dan, Garry, Lin, Judi, Allan, Stephen, Garth, John, Joab, Phillip, Kevin, John, Robert, Tweety and Bert, Peter, Mike, Patrick, Eugene, Brian, Harold, Russell, Brad, Rajest, Tim, Gemma, William, Bill, Robert, Geoff, Gary, Emily, Kent, Lucas, Neil, Peter, Rowley, Jason, Simon, Charles, Russell, Grahame, Lester, David, John, Richard, Mitra, John, Dave, Peter, Geoff, Paul, Derek and Rod have already submitted their photographs for inclusion in the Graduate album. My team – Russell, Vanessa, Rachel and Chris, will add theirs shortly.

Have you emailed yours?

We plan to frame the album and hang it at the entrance of our office, next to another invaluable piece – Stay Calm and Carry On.

Posted by Roger Montgomery and his A1 team, fund managers and Value.able Graduates, 9 June 2011.

Posted in A1, Insightful Insights, Value Investing, Value.able

13 Comments Leave a Comment

Is it time to clean up your portfolio?

Stuart sent me an email yesterday that provides some insight into what investors are experiencing right now.

Stuart wrote “…each time the level at which I would like to sell has seemingly been within short striking distance, somewhere around the world there has been an earthquake, tsunami, nuclear meltdown, Eurozone bailout, currency fluctuation, credit downgrade, flood, famine, pestilence, war or some other extraneous event – that spooks the markets and triggers another backslide in the portfolio valuation. The investment headwinds just don’t seem to be letting up…”

I hear you [Stuart], but what is anyone doing about it? Many investors hold verrucose portfolios of A5/B4/B5/all ‘C’ MQR companies, waiting for the price to rise back to some psychologically relevant level – their purchase price, for example.

But the market does not recognise such nostalgia. By holding onto stramineous stocks, you not only miss out on hoped-for gains. You also miss out on the gains from companies you could otherwise own – an opportunity cost! At best, the existing portfolio thus produces occultation, if not obfuscation. What are you doing this weekend? Re-reading Value.able?

When I was young, I spent time on the land fox hunting, under the tutelage of my friend’s father. I remember I had a tough time pulling the trigger. John and Ray explained to me that a single feral cat can devour more than a 100 lizards, birds and native mice in a week. The destruction wrought on native fauna by the fox is not dissimilar.

John and Ray then explained; don’t think of the fox you are aiming at, think of the many thousands of other animals you are saving. It’s a harsh reality and surprisingly, it applies to your share portfolio.

Don’t think about a perfect exit from the rubbish in your portfolio. Think about the extraordinary companies you could own if you no longer held the rubbish. The best time to clean your portfolio is always ‘now’.

What would you prefer? A portfolio of A1 businesses whose value is forecast to rise from $170.00 today to $211.39 in 2013 (yielding $8.98 this year, rising to $12.41 in 2013)? Or a portfolio of so-called ‘blue chips’ whose value has decreased 30 per cent over the past ten years and is forecast to increase just five per cent over the next three?

Take a look at the following chart. It’s the A1 Index from January 2009 to today. The constituents are the 20 biggest A1’s listed on the ASX by market capitalisation. The red line is the poor old ASX 200. As you can see, there is genuine merit to sticking with quality.

So who are A1s?  It’s been a while since I last published a list of A1s with conservative valuations… Go and research the companies in this list, then return and share your comments with our Value.able community.

* MIN 2012 valuation substantially higher ($9.78). 2011 is low here because of the capital raising’s impact on ROE that year.

What makes Matrix Composite, Nick Scali, JB Hi-Fi, Oroton, ARB Corp., Centrebet, DWS Advanced, Mineral Resources, Platinum Asset Management, M2 Telecommunications, Monadelphous, Wotif, Fleetwood, GUD Holdings, REA Group, Thorn Group, Carsales.com, Blackmores, Cochlear and Reckon extraordinary?

Re-read Part Two of Value.able then come back and share your insights. Go right ahead and share whatever you know or think, but only about the companies in the  above list.

Just as your portfolios need a clean out, so does my Insights blog.

Please refrain from posting any banter as comments on this post. Just your highest quality thoughts only.

1) Please keep your comments to the format below and we will build a useful library of insights.

2) Do not post any questions to me or other bloggers at this post.

Here’s the format to follow:

COMPANY NAME

Insights: If you work in the industry or have before, or perhaps you work for one of the companies or a competitor. Do you have a special or unique insight. ONLY comment if your insights are of the genuine industry variety.

Extraordinary prospects: Why does the future look bright for this business? Or if you don’t believe the future will be as extraordinary as the past, why not?

Competitive Advantage: What sets this business apart from its competitors? Don’t debate other’s comments, just post your own thoughts without reference to others.

Debt: How has management managed capital? What is your evidence?

Cashflow: Track record of cash flow?

The Value.able community, Graduates and I look forward to reading your insights.

Posted by Roger Montgomery, author and fund manager, 11 May 2011.

Posted in A1, Insightful Insights, Value Investing, Value.able

62 Comments Leave a Comment

How do your Easter holiday homework results compare?

Your Easter holiday homework was published mid morning on Thursday 14 April. Two hours later Andrew correctly completed the cash flow component – well done Andrew.

Many Graduates have posted comments here (and sent even more emails to me) asking why Telstra made the cut. Then there’s Aristocrat with all that debt, Fortescue’s recent capital raisings, The Reject Shop’s declining Return on Equity, Coca-Cola’s dwindling competitive advantage…

I’m passing the mic to Rob, a member of the Value.able Post-Graduate elite:

“Roger usually gives us homework which contains a mix of stocks. As he said he used his discretion to come up with 14. He also said 
“This homework is not about finding cheap stocks – it is about understanding businesses, return on equity, debt, cashflow and identifying extraordinary prospects”.
The only way for us to achieve this is to look at some B3s such as Telstra, and as Andrew said early the odd “basket case”.
Working through the good and bad can be eye opening but you do need to examine all the stocks to compare how they fair according to the criteria mentioned in the above quote.”

And from Chris B:

“It has been my opinion for a while that it is kind of hard (and almost pointless) trying to assign an estimated value on a business unless you have done a lot of research about the business in question first…”

Leon was the first Value.able Graduate to post his answers, quite late in the evening on April 15. Whilst Leon’s valuations don’t match my calculations exactly, they are close. Remember your primary aim is to buy extraordinary A1 businesses at BIG discounts to your estimate of their Value.able intrinsic value. A difference of twenty cents is neither here nor there if the business is worth $8 and you can buy shares for $5!

The Results

Assignment One: Calculate the 2010 Value.able intrinsic value and 2011 forecast Value.able intrinsic value – download the results

Assignment Two: Re-read Value.able Chapter 9 on Cashflow (from page 152) and analyse the cashflow of each company using the balance sheet method – download the results

Here are Andrew’s insights on the Cashflow homework:

“Based on a simple look, Retail Food group has the best cash position of the three followed by the reject shop and then loads of daylight and then Aristocrat.

However on further digging for RFG I can see that the 85,852 worth of borrowings are now a current liability and therefore will be due in the next 12 months. They do not appear to have the assets or the cash generating abilities to service this and will therefore probably need to raise capital in some form.

Aristocrat is a basket case where cash flow was declining and borrowings rising. Doesn’t take a genius to see what is going to happen here. ROE might be high but it is debt fueled. Kind of get the feeling that Aristocrat is about as lucrative as gambling on one of their machines in the pub.

Therefore the last one standing and my pick of the three overall is actually the reject shop. It is generating positive cashflow and should be able to adequately meet its future needs.

Thank you to all who participated and if your answers where close… well done! It is vital that you continue to practice your technique. With repetition you’ll get to the point where you can simply ‘eye-ball’ Value.able intrinsic value.

Before I sign off, I would like to officially welcome Alex, Yong-Chuan, Matty, Leon, Andrew, Geoff, Justin, Peter and Margaret to the Value.able Graduate Class of 2011. If I have omitted your name, please accept my apologies. I am delighted to welcome you as a Graduate. Please send your photo with Value.able to roger@rogermontgomery.com for inclusion in the 2011 album.

For those wondering, the woman screaming in fright was looking at the stock market on Friday!

Posted by Roger Montgomery, author and fund manager, 3 May 2011.

Posted in A1, Company Valuation, Insightful Insights, Value Investing, Value.able

172 Comments Leave a Comment

Who asked for Easter holiday homework?

My team tell me that this year’s combination of Easter and Anzac Day has produced a once-in-a-lifetime succession of public holidays. I have encouraged them to use the time wisely – practicing Value.able intrinsic value calculations. In addition to spending precious time with family and friends, I encourage you to do the same.

We have an extraordinarily generous community of Value.able Graduates here at the blog and on my Facebook page.  Special thanks to Ashley, Kent B, Lloyd, Rob, Matt R, Steve, Andrew, Gavin, Ken, William (Bill), Greg, John M, Ron, Joab (whom we will miss dearly – please keep in touch), Jonesy, Brad, Ann, O’Reilly, James, Trav, Omar, Michael, Costas, Emily and Anthony.  If I have left anyone out please let me know. Thank you for sharing your wisdom with our community!  I am sure there are many others who are delighted to help recent Graduates.

Before I reveal your Easter homework, here are a couple of links you may find helpful:

Webinar – I guide you, step-by-step, through a valuation

Data sources – The Value.able community’s guide to finding the data you need to calculate your own valuations.

Now to the homework…

I began with 1847 businesses and removed the 1168 that didn’t make any money last year (put $0 into the Value.able formula and you will get $0 out). That cut out 63 per cent of the Australian market… a useful first filter.

Then I applied the following criteria;

1) ROE > 20 per cent: (Chapter 6 – The ABC of Return on Equity)

2) Debt/Equity Ratio < 50 per cent: (Chapter 8 – Debt Is Not Always Good)

And then I refined the list further as follows;

3) 2011 forecast Earnings and Dividends are available: (Chapter 5 – Pick Extraordinary Prospects)

4) Must achieve one of the following Montgomery Quality Rating (MQR) – A1, A2, A3, B1, B2, B3: (Part Two – Identifying Extraordinary Businesses)

That left 255 stocks as the subject of your holiday homework. Using my discretion, I reduced the list to 14: The Reject Shop (ASX:TRS/MQR:A2), West Australian Newspapers (ASX:WAN/MQR:A2), Computershare (ASX:CPU/MQR:A2), Mermaid Marine (ASX:MRM/MQR:A3), Flexigroup Limited (ASX:FXL/MQR:A3), Cedar Woods Properties (ASX:CWP/MQR:A3), SAI Global Limited (ASX:SAI/MQR:B2), Fortescue Metals Group (ASX:FMG/ MQR:B2), Coca-Cola Amatil Limited (ASX:ASX:CCL/ MQR:B2), Retail Food Group (ASX:RFG/ MQR:B3), Telstra (ASX:TLS/ MQR:B3), McMillian Shakesphere (ASX:MMS/ MQR:B3), Bradken Limited (ASX:BKN/ MQR:B3) and Aristocrat Leisure Limited (ASX:ALL/ MQR:B3).

This homework is not about finding cheap stocks – it is about understanding businesses, return on equity, debt, cashflow and identifying extraordinary prospects. Effort calculating intrinsic value should only be exerted once you’re satisfied the business is extraordinary.

If you are keep to improve your investing with some useful examples, your holiday homework is as follows:

1. Download the 2011 Easter holiday homework worksheet – click here.

2. Calculate the 2010 Value.able intrinsic value and 2011 forecast Value.able intrinsic value (populate into the worksheet)

3. Then answer the following questions and perform the following tasks:

A. Of the 14 companies, list those demonstrating a rising value over the next twelve months.

B. The stocks of which companies, if any, are offering a margin of safety?

Important things to note:

  • For consistency, use 10% Required Return
  • 2011 Forecast Earnings Per Share and Dividends Per Share numbers are included in the Easter holiday homework spreadsheet. Use these numbers.
  • You will have to get the 2010 ending equity (which is also the 2011 Beginning equity – from the annual reports)

If you need some guidance about how to calculate future valuations you can also read this post.

For those seeking a real challenge, re-read Value.able Chapter 9 on Cashflow (from page 152) and analyse the cashflow of each company using the balance sheet method. Click here to download the Cash Flow homework worksheet. At Montgomery Investment Management we only invest in businesses with strong cash flow. I will produce the cash flow analysis for The Reject Shop (TRS), Retail Food Group (RFG) and Aristocrat Leisure (ALL) after Easter.

My team and I wish you a happy Easter. I really do hope you have an enjoyable and rewarding break and that you enjoy the tasks I have set for you. I look forward to reviewing your results after the break.

Posted by Roger Montgomery, author and fund manager, 14 April 2011.

Posted in A1, Company Valuation, Insightful Insights, Value Investing, Value.able

403 Comments Leave a Comment

Will David beat Goliath?

I am deviating from my regular style of post, handing over the stage to Value.able Graduate Scott T. Scott T has taken up a fight with conventional investing by tracking the performance of a typical and published ‘institutional-style’ portfolio against a portfolio of companies that receive my highest Montgomery Quality Ratings. I reckon in the long run the A1/A2 portfolio will win, but let’s not get ahead of ourselves.

Over to you Scott T…

In December 2010, a large international institution released their “Top 10 stockpicks for 2011”. Click here to read the original story.

I thought it would be interesting to compare the performance of these suggestions against an A1 and A2 Montgomery portfolio.

So I imagined this scenario…

Twin brothers in there 30’s each inherited $100,000 from their parent’s estate. One was a conservative middle manager in the public service; he had little interest in the stock market or super funds and the like, so he decided to go to an internationally renowned, well-credentialed and highly respected firm to gain specific advice. Goldman Sachs advised him of their top ten stocks for 2011, so he decided to achieve diversification by investing $10,000 in each of the ten stocks he had been told about.

His twin had a small accounting practice in a regional Queensland and was a keen stock market investor. Specifically he was a student of the Value Investing method, and liked to think of himself as a Value.able Graduate. He too thought diversification would be a suitable strategy so decided to invest $10,000 in each of 10 stocks that were A1 or A2 MQR businesses and that were selling for as big a discount to his estimate of Value.able intrinsic value as he could find.

For this 12-month exercise, running for a calendar year, we shall assume that neither brother is able to trade their position. One brother has no inclination to, and his regional twin is fully invested, and more inclined to hold long anyway.

For the companies who have declared dividends in this quarter, most are now trading ex-dividend, but only 2 or 3 have actually paid. Dividends will be picked up in Q2 and Q4 of this study.

Now after just 3 months let’s look at the how the two portfolios have performed…

Institutional Bank Top 10 Picks for 2011


Montgomery Quality Rated (MQR) A1 and A2 Companies

We will visit the brothers again in 3 months on 30/6/2011 to see how they are fairing.

All the best

Scott T

How has your Value.able portfolio performed compared to the ASX 200 All Ords?

Posted by Roger Montgomery, author and fund manager, 6 April 2011.

Posted in A1, Company Valuation, Insightful Insights, Value Investing, Value.able

92 Comments Leave a Comment

Why idolise the iPad2?

It’s an amazing story… Man creates computer. Man overcomplicates computer. Man strips back computer and creates a brand that has revolutionised the way we are entertained.

Did you know Apple has sold over 300 million iPods and iPhones over the past decade? That’s 300,000,000 products. According to the World Bank, in 2009 the world’s population stood at 6,775,235,741. The World Bank also notes that 80 per cent of the world’s population lives on less than $10 per day. Of the remainder, every 4th man, woman and child has purchased an Apple products in the last decade. Not a bad competitive advantage, (postscript: but perhaps not a sustainable one?)

Apple is also infiltrating the way we work. The Montgomery office is all Mac (and for your information, we have never had to call an IT professional to fix anything). Our iPhones are synced with our iMacs and our MacBooks synced with our iPhones.

You have heard the stories of Apple fans setting up camp on the footpath outside Apple’s flagship store on Sydney’s George Street. Australians don’t do that for coal or iron ore.

And don’t forget the accessories market. There’s no special concessions for development partners. Privately held companies that manufacture the sleeves, cases and connectivity devices that enhance our Apple experience don’t get hold of new devices until we do – on launch day.

Apple has the X-factor. Its product is unique. Its experience is unique and there is an almost religious fervour toward the brand. Competitors don’t stand a chance. The result? High, durable rates of return on equity and a rising Value.able intrinsic valuation – an A1 business.

Return on Equity is just one of dozens of metrics I uses to produce the Montgomery Quality Rating (MQR). Re-read Chapter Eleven, Step C on page 188 of Value.able for the Value.able ROE calculation.

Who is the Aussie equivalent? The Australian market may be much smaller than the US, but there are a handful of extraordinary businesses, A1 businesses. And its worth finding tem. They may not be listed yet. They may not even have launched yet…

Posted by Roger Montgomery, author and fund manager, 29 March 2011.

Postscript: The data used to calculate intrinsic value is available here: https://www.apple.com/investor/

Posted in A1, Company Valuation, Value Investing, Value.able

187 Comments Leave a Comment

Who makes your A1/A2 small cap list?

Time was a rare commodity on Peter’s show last night. Whilst I managed to list a few A1 and A2 small cap stocks that I consider make the Value.able grade, there just wasn’t time for details. So, as promised, I have put together a quick precise of two stocks (in boring businesses) I listed last night.

Remember: DO NOT rush out and buy shares in any company I discuss with Peter or any other media outlet (or here at the blog) without conducting appropriate research and seeking personal and professional advice FIRST!

These insights are not a solicitation to trade any security. I may own shares in the companies mentioned. I cannot predict share price directions – they could all fall by 80% or more after you buy. Finally, I am under no obligation to keep you updated with any change of my view, my estimate of the Value.able value of the company or my Montgomery Quality Ratings (MQRs).

Before I begin, here are the highlights from last night.

Zicom Group (ZGL)

In 2007, the first reported results after purchasing the Zicom Group, the company earned $6 million on equity of $21.6 million (ROE 27.7%).  Since then another A$8 million has been raised from owners and profits have risen to A$8 million. Return on additional capital is 25%.

In the HY11 results, the company announced a profit A$7 million. Revenue grew from $47.75 million in the previous corresponding period to $71 million. A buyback of $4 million shares occurred in the half.

Company forecasts are for a full year profit of $12.9 million, which would representing a return on equity of 18%. Growth in equity is exceeding growth in profits, however the ‘growth’ has been through retained earnings.

Zicom has four divisions; Offshore Marine Oil & Gas (43% of revenue, makes winches and ROV’s/oil rig boom to help – think winches on ships that lift ROV’s off deck and into water), Construction Equipment (39%, concrete mixers/marginally profitable & foundation equipment), Precision Engineering & Automation (14% constructs automated production lines, ink cartridges for HP, semi conductor and medical devices and associated components) and Industrial and Mobile Hydraulics (4%).

ZGL’s order book stands at $83.2 million, up from $68.9 million. Cash flow was negative $10 million, however $5 million was spent seeding two start-ups and another $5 million was spent on acquisitions ($700k of PP&E and $4 million on buying back shares).

Click here to read Roger’s latest insights on Zicom, published 6 April 2011 in Alan Kohler’s Eureka Report.

Codan Limited (CDA)

Codan Limited designs and manufactures a diversified products range for the international high-frequency radio, satellite and metal detection markets (think Minelab metal detectors).

Shares on issue are virtually unchanged from a decade ago and borrowings, which surged from $2 million in 2007 to $73 million in 2009, fell to $52 million last year and another million in the latest half year.

CDA’s 2007 profit of $11 million fell to $8 million in 2008, then rose to $24.4 million last year. The company forecasts profit of $20-$22 million in 2011 (optimistic analysts believe this figure will be higher, circa $24 million).

Since 2001, CDA’s profits have increased by 10.13 per cent per annum, from $10.268 million to $24.472 million

To generate this $14.2 million increase in profit, shareholders have put in equity of $21.859 million and left in earnings of $23.150 million (32%). The company has also borrowed $8.615 million net, in addition to the $43.483 million of debt held in 2001, resulting in current debt outstanding of $52.098 million and a net debt to equity ratio of 46.66 per cent.

Return on Equity is the best measure of economic performance, and CDA has averaged 31.02 per cent since 2001. Recently, CDA generated a return on equity of 37.94 per cent.

Finally, I also mentioned a small number of small cap stocks that are high quality and appear to be trading at a discount or close to my estimate of intrinsic value at the moment – Forger Group, ThinkSmart and Matrix Composites and Engineering. Here is my list:

Over at  facebook.com/montgomeryroger Unc Dev’s list includes Thorn Group, Reckon, Iress, Nick Scali and Fleetwood. Shuo nominated PFL and Kristian proposed FSA, SWL & RQL. Which stocks make your A1/A2 small cap list?

Posted by Roger Montgomery, author and fund manager, 25 March 2011.

Posted in A1, Company Valuation, Insightful Insights, Value.able

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When to sell? Matrix and other adventures in Value.able Investing

In August 2010 Matrix Composites & Engineering was trading around $2.90. Thirty days later the share price was at $4.48. Today MCE is trading at just over $9.00 and has a market capitalisation of more than half a billion dollars. It’s no longer just a little engineering business. Like the Perth industrial precinct of Malaga in which its headquarters are based, MCE is growing rapidly (according to Wikipedia there are currently 2409 businesses with a workforce of over 12,000 people in Malaga. The 2006 census listed only 28 people living in the suburb).

But has MCE’s share price risen beyond what the business is actually worth?

Stock market participants are very good at telling us what we should buy and when. When it comes to selling, it seems silence is the golden rule.

If you receive broker research, take out a report and turn to the very back page – the one beyond the analyst’s financial model. You will often find a table that lists every company covered by that broker’s research department. Now look to the right of each stock listed. What do you notice?

Buy… Buy… Hold… Buy… Buy… Accumulate… Hold…

What about sell?

There aren’t many companies in Australia worthy of a buy-and-hold-forever approach. And if you have invested in a company with a previous BUY recommendation, the luxury of a subsequent Ceasing Coverage announcement by the analyst is not helpful.

So then, when should you sell? It is a question I have been asked, to be honest, I can’t remember how many times. Because I have been asked so many times, it’s a question I answered in Chapter 13 of Value.able – a chapter entitled Getting Out.

Value.able Graduates will recognise a sell opportunity. Yes, it is an opportunity. Fail to sell shares and you could eventually lose money.

Of course, any selling must be conducted with a certain amount of trepidation, particularly when capital gains tax consequences are considered. But not selling simply because of tax consequences is unwise.

We pay tax on our capital gains because we make a gain. Yes, its difficult handing over part of our investment success to the Tax Man for seemingly no contribution, but without success our bank balance would remain stagnant forever.

When then should you sell? In Value.able I advocate five reasons. For now I would like to share with you a possible reason.

Eventually share prices catch up to value. In some cases it can take ten years, but in the case of Matrix, it has taken far less time for the share price to approach intrinsic value.

One signal to sell any share is when the share prices rise well above intrinsic value.

There are no hard and fast rules around this. And don’t believe you can come up with a winning approach with a simple ‘sell when 20% above intrinsic value’ approach either.

What you MUST do is look at the future prospects. In particular, is the intrinsic value rising? I believe it is for Matrix (and I am not the only fund manager who does – you could ask my mate Chris too).

Here’s some of his observations:  Risks associated with the timing of getting Matrix’s facility at Henderson up and running are mitigated by keeping Malaga open. And Malaga is producing more units now than it was only a few months ago. Matrix could also produce more units from Henderson than they have suggested (the plant is commissioned to produce 60 units per day) and I believe the cost savings will flow through much sooner than they say. Recall the company has indicated Henderson could save circa $13 million in labour, rent and transport costs (see below analyst comment). Excess build costs are now largely spent and if the company can ramp up to 70 units a day, HY12 revenue could double.

Why do I believe this? Because a recent site visit for analysts suggested it. As one analyst told me: “Production of macrospheres has started from Henderson with 7 of the 22 tumblers in operation. This is a good example of the labour savings to come as it’s now a largely automated process – there were only 3 people working v >20 on this process at Malaga.”

(Post Script:  My own visit to WA at the weekend revealed a company capable of producing just over 100 units per day – Henderson + Malaga)  Moreover, the sad events unfolding in Japan will force a rethink on Nuclear.  If nuclear energy – recently hailed as a green solution to global warming – reverts to being a relic of an old world order, demand for oil will increase.  Oil prices will rise.  Deep sea drilling will be on everyone’s radar even more so.

And the risks?  Well, one is pricing pressure from competitors. This is something that needs to be discussed with management, but preferably with customers!

Some Value.able Graduates may be reluctant to place too much emphasis on future valuations. Indeed I insist on a discount to current valuations. If it is your view that future valuations should be ignored, then you should sell.

Personally I believe one of my most important contributions to the principles of value investing is the idea of future valuations. Nobody was talking about them at the time I started mentioning 2011 and 2012 Value.able valuations and rates of growth. They are important because we want to buy businesses with bright prospects. And a company whose intrinsic value is rising “at a good clip” demonstrates those bright prospects.

If you have more faith and conviction that the business will be more valuable in one, two and three years time, you may be willing to hold on. I am currently not rushing to sell Matrix, however I do hope for much lower prices (buy shares like you buy groceries…)

I cannot, and will not, tell you to sell or buy Matrix and I might ‘cease coverage’ at any time. As I have said many times here, do not use my comments to buy or sell shares. Do your own research and seek and take personal professional advice.

What I do want to encourage you to do is delve deeply into the company’s history, its management, their capabilities, recent announcements and any other valuable information you can acquire.

And in the spirit demonstrated by so many Value.able Graduates, feel free to share your findings here and build the value for all investors.

When the market values a company much more highly than its performance would warrant, it is time to reconsider your investment. Looking into the prospects for a business and its intrinsic value can help making premature decisions. Premature selling can have a very costly impact on portfolio performance not only because the share price may continue rising for a long time, but also because finding another cheap A1 to replace the one you have sold, is so difficult.

Posted by Roger Montgomery, author and fund manager, 18 March 2011.

Posted in A1, Company Valuation, Resources, Value Investing, Value.able

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Are relationships more important than cars?

In last weekend’s Weekend Australian, Terry McCrann wrote an excellent piece explaining the possible nature and motivations behind the relationship between Murdoch, Stokes and Packer. ‘Hiatus after Packer’s bombshell’ was both enlightening and entertaining. I quote:

“From the day Stokes seized control of the West Australian Newspapers boardroom three years ago, it was always a case of when, not if, he would move to join it with his Seven Network.

“There was the sheer irresistibility of the gains to be extracted from such a me…There was also the requirement to provide an exit to … the KKR private equity group…There was also the need, and indeed opportunity, to solve a couple of Stokes’ tax issues…It also preserves liquidity in the enlarged WAN-Seven, which becomes the premier listed media vehicle in Australia. That will enable KKR to be taken out in due course and, when it does, further cement the stock’s appeal…”

“It also highlights – and partly explains – a missing piece in the Stokes media set. The merger doesn’t bring together all of the Stokes media interests.

“Left out is the Stokes holding company’s 23 per cent stake in – what do you know – Packer’s Consolidated Media Holdings. And it has linkages into the Packer partnership with Rupert Murdoch’s News Corporation in Foxtel and Foxtel Sports.

“Its absence could be explained by the complication it would have brought to the merger proposal. Also, its inclusion would have given Stokes more shares in the merged entity. That would have rendered the new company less tax and investment efficient.

“But it’s an absence that raises the question of whether there is a Stokes shuffle part deux – or trois if you count the Seven-WesTrac deal. And that brings Packer and his partnership with the other Murdoch, Lachlan, back into the building.

“He walked out of the Ten boardroom because Lachlan poached budding TV star James Warburton from Stokes’ Seven to be chief executive of Ten. In the most public, and indeed shocking, way Packer signaled his disagreement with that, and to Stokes that it was not his doing.”

Relationships it seems, matter. And so they should.

In the end, it is not cars, boats and planes that bring joy, but the quality of the relationships you develop.

This week I read that Carsales.com.au had been sold out of Nine Entertainment Co, the rebadged PBL Media (which is owned by CVC Asia Pacific).

Reading Terry’s article caused a rumour I heard last year to become louder in my mind. The rumour was that a group of customers of Carsales.com.au (ASX:CRZ, MQR:A1, Value.able Margin of Safety; -24%) were thinking of leaving to start a rival that would be funded by News. You could understand News’ interest, given it is losing the online automotive classifieds race to Drive (Fairfax) and Carsales.

If this is true, and if Terry is also on the mark with the intimacy of the relationships amongst Australia’s media barons, both individual and corporate (excluding Fairfax), then it would be reasonable to assume that the status quo should be maintained until after Carsales had been spun out of the former PBL, finding itself completely owned by institutions and private investors.

Now that hurdle is out of the way, let’s see if Carsales does lose any major customers.

Posted by Roger Montgomery, author and fund manager, 10 March 2011.

Posted in A1, Company Valuation, Media, Value.able

95 Comments Leave a Comment

Peter Switzer interviews Matrix CEO Aaron Begley

Peter Switzer called me earlier this week. He was travelling to Perth and asked me to recommend a CEO to invite on his show. Matrix CEO Aaron Begley instantly came to mind.

Value.able graduates will recall I discovered Matrix a long time ago. It was the first business to achieve my coveted A1 Montgomery Quality Rating (MQR). I have written about Martix in Money magazine and here at the blog, and also shared my insights with Peter on the Sky Business Channel.

Here are the highlights of Peter’s recent interview with Aaron Begley.

I often meet with CEOs and advocate you do the same. Attend AGMs and EGMs, or better yet, call the company. If management isn’t willing to speak to shareholders, that’s a fairly good indication to me of what they think of their owners.

Aaron and the board of Matrix check all the boxes I seek in Value.able companies. Re-read Chapter 6 of Value.able for more of my thoughts. And to watch another CEO interview, click here.

Posted by Roger Montgomery, author and fund manager, 4 March 2011.

Posted in A1, Mining Services

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Is CSL a master of share buy backs?

When a company buys back its shares, the announcement is often accompanied by reports suggesting either 1) the company has no other growth options towards which it can employ equity capital or, 2) the company has great confidence in its future and other shareholders should be following its lead rather than selling out to the company itself.

Back in 1984, in his Chairman’s Letter to Shareholders (a source of information I have quoted frequently here and in Value.able), Warren Buffett observed:

“When companies with outstanding businesses and comfortable financial positions find their shares selling far below intrinsic value in the marketplace, no alternative action can benefit shareholders as surely as repurchases.”

Note to CFOs and CEOs: “shares selling far below intrinsic value in the marketplace.”

It is just as important for the CEO of a public company to be buying shares only when they are below intrinsic value, as it is for Value.able Graduates building a portfolio.

Buying shares above intrinsic value will destroy value as surely as buying high and selling low – something many Australian companies became all to expert at during the GFC as they issued shares in their millions at prices not only below intrinsic value, but below equity per share.

One question to ask is if companies are engaging in buy backs today, why weren’t they when their shares were much, much lower? The answer of course may be that they may not have had the capital back then. A recovery from the lows of the GFC has not only occurred in the prices of shares trading in the market place, but also in the cash-generating performance of the underlying businesses themselves.

Irrespective of the circumstances, a company now buying back shares that had previously issued them at the depths of the GFC is having a second crack at wealth destruction.

I am pleased to report that not all companies are following the crowd. Some larger companies, including BHP, RIO and Woolworths, have announced buy backs at or slightly below my estimate of their Value.able intrinsic values.

Webjet, Customers, Coventry Group and Charter Hall Retail REIT have all announced buy backs and Bendigo/Adelaide Bank is engaging in one to reverse the impact of shares issued through their DRP.

As I wrote yesterday (Is there any value around?), value is becoming much harder to find. Companies are expensive, even my A1s. Whilst any Value.able valuation is merely an estimate, the absence of a large Margin of Safety, combined with the announcements of buy backs, does not inspire my confidence.

In the US, share buy backs historically peak at market highs. Think back to the first half of 2007 and in 1999 and 2000 – two periods that investors may have wished they’d sold shares back to the companies – are also periods during which buy backs peaked.

Share buy backs are a very public demonstration of management’s capital allocation ability, or lack thereof.

Whilst Warren Buffett is regarded as the master of share buy backs, he has often sited another capital allocator as the real genius – the late Dr. Henry Singleton, the founder and CEO of Teledyne.

When the inflation-devastated stock market of the 1970s had pushed shares to the point that some suggested ‘equities were dead’, Henry Singleton bought back so many shares that by the mid 1980s there were 90% less Teledyne shares on issue. Here’s a para from the web: “In 1976, the company attempted, for the sixth time since 1972, to buy back its stock in order to eliminate the possibility of a takeover attempt by someone eager for the cash reserves the company had accumulated. Altogether, Teledyne spent $450 million buying back its stock, leaving $12 million outstanding, compared to $37.4 million at the close of 1972. With many of the company’s divisions showing stronger results and fewer shares outstanding, Teledyne’s stock increased from a low of $9.50 per share to $45 per share, becoming the largest gainer on the New York Stock Exchange.”

Who is Teledyne’s Australian equivalent?

One iconic Aussie business (it achieves my second highest MQR – A2) immediately springs to mind. In 2009 this business issued shares at a high price to fund a $A3.5 billion acquisition. But things didn’t quite go to plan… the US Federal Trade Commission intervened and the shares slumped. What did management do? They used the cash raised from the share issue to buy them back. Amazing!

Fast-forward twelve months and this business has nearly $1 billion in cash in the bank and no debt. If it keeps using its own cash and that being generated, and buying back shares at the present rate (and assuming the share price doesn’t change of course), it will have bought back all its shares in seven years. A Value.able business… what do you think?

Yes, if not for management’s decision to buy back shares ABOVE intrinsic value.

Unfortunately CSL’s share price may not be as high in seven years as it could have been, had management chosen to buy back its shares below intrinsic value.

If you own shares in a company engaging in a buy back, ask yourself whether value is being added to the company? Value is generated when the shares being purchased are available at prices below your estimate of its Value.able intrinsic value.

If management are overpaying, inappropriate capital allocation practices may be the only addition to the future prospects of the business.

Posted by Roger Montgomery, author and fund manager, 1 March 2011.

Posted in A1, Company Valuation, Health Care, Value Investing

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Is there any value around?

Two themes seem to be gaining traction amongst Value.able Graduates at the moment.

1. Value is becoming harder to find (yes, I agree), and

2. Questions related to share buybacks have increased remarkably

This afternoon I will address the growing problem of finding value (and save buybacks for another day).

As I scan the market for great quality businesses trading at large discounts to my estimate of their Value.able intrinsic value, I am finding fewer and fewer opportunities. And when it comes to ‘small caps’, the prospects are few and far between.

On Peter Switzer’s show last Thursday a caller asked me what was good value in the small cap space. I define ‘small cap’ as anything between $300 million and $2 billion (below that is micro caps and nano caps). The fact is, only four or five of my highest Montgomery Quality Rated (MQR) businesses (think A1, A2, etc) are cheap. And most of them you already know about.

Forge and Matrix Composite are still below rising intrinsic values (more on those soon), and Cabcharge and ARB Corporation are just below intrinsic value. The remaining value is in much smaller companies and of course, the risk when investing in this space can be much higher.

Many Value.able Graduates have commented that investing in these micro and nano cap stocks is akin to scraping the bottom of the barrel. Whilst I tend to agree, I also believe that when it comes to investing, little is more satisfying than discovering an extraordinary business beyond the reach of the managed funds that have self-imposed restraints and must only invest in the top 200 or 300 companies.

There is merit in the concept of investing in small businesses that have the potential to become large. And there are profits to accrue when they do. Before you dismiss this idea, keep in mind that many of the large companies dominating Australia’s competitive landscape today were once small. Admittedly, in many cases they were small while they were buried in private ownership or private equity ownership, but in some examples they were small and grew to be large whilst they were listed. Can you think of a few examples? The Value.able community has shared a few here at my blog.

Given Australia’s small population, the big businesses that dominate the investment landscape are mature and have to make smart decisions and continually reinvent themselves to continue to grow. Think about Harvey Norman. Its failing is not in the fact that the economy is slow or that consumers can buy cheaper goods overseas. Its failing is that it is a tired old concept that has lost its mojo. The company has failed to change and failed to reinvent itself. Its own failure has seen it fall victim to the JB Hi-Fi’s and the buy-online-from-overseas-cheaper.com merchants of the world.

So whilst scouring for smaller companies may seem like bottom-fishing, there is merit in catching the smaller fish. And for those investors who prefer to stay clear, patience, bank bills and term deposits are the solution.

Far better is it to be in the safety of cash than in inferior investments, such as companies trading at premiums to intrinsic value.

Forewarned is forearmed. And to be forewarned, don’t miss out on your copy of Value.able. As I told Peter last week, there aren’t too many Second Edition copies left.

Posted by Roger Montgomery, author and fund manager, 28 February 2011.

Posted in A1, Company Valuation, Insightful Insights, Value Investing

153 Comments Leave a Comment

Is your stock market still turned off?

At this time of year, well-meaning articles on the subject of how to invest in the year ahead abound. Indeed I have contributed to the pool of wisdom in my recent article for Equity magazine titled Is your stock market on or off?.

Value.able Graduates know to turn the stock market off and focus on just three simple steps. Even if you have read Value.able, or joined in the conversation at my blog, its not just me that believes they’re worth repeating. Ashley wrote about the article ‘More of the same stuff for the Value.able disciples but the more you read it the more you will practise it’ and from David ‘‎’twas a good refresher indeed!’.

Step 1

The first step of course is to understand how the stock market works. Once you understand this, turning it off is easy. And you do need to turn of its noisy distraction.

Step 2

The second step is to be able to recognise an extraordinary business (Go to Value.able Chapter 5, page 057).

I have come up with what are now commonly referred to by Value.able Graduates as Montgomery Quality Ratings, or MQR for short. Ranking companies from A1 to C5, my MQR gives each company a probability weighting in terms of its likelihood of experiencing a liquidity event.

Step 3

Finally, the third step is to estimate the intrinsic value of that business. Use Tables 11.1 and 11.2 in Value.able.

Three simple steps. If you get them right, you too can produce the sorts of extraordinary returns demonstrated and published, for example, in Money magazine.

The key is to buy extraordinary companies. To save you some time, I would like share a current list of companies that don’t meet my A1 rating. Indeed these are the companies that receive my C4 and C5 ratings, the worst possible. Avoiding these is just as important as picking the A1s because even diversification doesn’t work when your portfolio is filled with poor quality companies or those purchased with no margin of safety.

Whilst the eleven companies listed above are low quality businesses, they won’t necessarily blow up. This is not exhaustive, nor is it a list of companies whose share prices will go down. It is however a list of companies that I personally won’t be investing in.

If your first question is what are the chances of loss?’ then my C5 rating represents the highest risk. But of course risk is based on probability. And a probability is not a certainty. Nevertheless, I prefer A1s and A2s. More on those lists another time.

Posted by Roger Montgomery, author and fund manager, 3 February 2011.

Posted in A1, Insightful Insights, Value Investing

271 Comments Leave a Comment

Will your portfolio repeat its 2011 performance?

If you are new to my stock market Insights blog, welcome. And to the Value.able community, thank you for your many comments and encouraging words. It gives me great encouragement and motivates me to hear how your investing and returns have improved as a result of reading Value.able and the collection of comments posted by Graduates here at my blog. Thank you also for spreading the word and purchasing additional copies for family and friends.

Taking a look back over the stocks we discussed last year, it appears the Value.able approach to investing in the highest quality businesses, with a true margin of safety, has been doing quite well.

In addition to the blog, I also wrote about many of the stocks that achieve an A1 Montgomery Quality Rating (MQG) in my Value.able stocks for Money magazine over the last six months of 2010.

The stocks are listed in the table below. The column titled ‘Gain’ demonstrates you can do well without exposing yourself to lots of risk – for example the risk that is inherent in speculative stocks.

The returns exclude the dividends received, which would obviously boost results materially. The correct comparison therefore is the All Ords price index rather than the All Ordinaries Accumulation Index. Since 30 June 2010 the All Ordinaries has risen 12%. That is a stark contrast to many of the returns produced by the high quality businesses listed above.

The returns stand even higher above the Index when the selection is ranked by those that I regarded as offering the greatest margin of safety at the time the stock was mentioned: Oroton (up 37.5%), ARB Corporation (up 29.8%), JB Hi-Fi (bought and then sold the next month (up 5%), Monadelphous, Forge, Decmil and Matrix (up 44%, up 59%, up 35%, and up 37% respectively). The average, six month, price-only return of these businesses is 34.8%. And some of these A1 businesses, a margin of safety still exists.

If you are new to value investing you will, when searching around, find many commentators, portfolio managers and investors who may disparage value investing generally. They may question the method of calculating intrinsic value or even dismiss the valuations produced, but quite seriously, the proof is in the eating. And the returns offered have been nothing short of mouth watering.

But six months is NOT enough to hang your hat on, as Tony and Adam recently pointed out on my Facebook page. So if you have been an investor in any of these companies, following a conversation with your adviser of course, remember that the change in price over a year or two shouldn’t excite or concern you. It’s the change ahead in the Value.able intrinsic value of the company that matters.

If you haven’t already purchased your copy of Value.able, I commend it to you. It will change the way you think about investing in the stock market for the better, and as the many independent comments elsewhere here on the blog can attest, it may also materially improve your results. Value.able is available exclusively at www.rogermontgomery.com

Posted Roger Montgomery, author and fund manager, 2 February 2011.

Posted in A1, Company Valuation, Insightful Insights, Value Investing, Value.able

173 Comments Leave a Comment

Who made the Value.able grade?

The Value.able class of 2010 is indeed all class.

Your nominations for the A1 stocks to watch in 2011 are fine examples of the sorts of companies that I eagerly seek for my own portfolio (with the exception of the odd recalcitrant student who diverged from the lessons learned).

I haven’t yet decided which will be revealed on Sky’s Twelve Shares of Christmas special tonight at 7pm, although the shortlist may be obvious from the numbers presented in the table below.

If we presume that all A1s have equally bright prospects – they don’t – then the job of picking the top stock comes down to the one that offers the highest return when combining the discount to intrinsic value and the prospective change to intrinsic value over the next two or three years.

One difficulty with such a simplistic approach is that firstly, varying degrees of certainty about the future cloud the picture. I have also used consensus numbers to produce the valuation changes and these are notorious for being optimistic at precisely the wrong points in the business cycle.

To avoid this dilemma for the purposes of the exercise (but perhaps not for the purposes of investing), I could elect to go with the choice that received the most recommendations. The winner of that contest would be a tie between Matrix Composite & Engineering (MCE) and Forge Group (FGE) and the equal runners up would be Oroton (ORL), ARB Corp (ARP), Cash Convertors (CCV), Cellestis (CST) and CSL (CSL). The remaining contributions include Acrux (ACR), BHP (BHP), Bradken (BKN), Centrebet (CIL), Coca Cola (CCL), Decmil (DCG), Euroz (EZL), Fleetwood (FWD), Focus Minerals (FML), FSA Group (FSA), Hunter Hall (HHL), iCash Payment Systems (ICP), Industrea (IDL), JB Hi-Fi (JBH), QBE (QBE), REA Group (REA), Resource Equipment (RQL), Seek (SEK), Seymour White (SWL), Sirtex (SRX), Speciality Fashion Group (SFH), The Reject Shop (TRS), ThinkSmart (TSM), Thorn Group (TGA) and Woolworths (WOW).

Whilst I have identified a universe of A1 companies trading at discounts to intrinsic value that have slipped under your radar, the objective of the exercise was to ask for your picks and now that I have the list, choose a winner I must.

On tonight’s Summer Money program on Sky Business at 7pm I will reveal the ONE stock that you have selected as the relatively best prospect for 2011. It won’t be Roger Montgomery’s pick. It will be the top pick by the Insights Blog Community –  the Value.able Graduate Class of 2010!

Posted by Roger Montgomery, 16 December 2010.

Posted in A1, Company Valuation, Value Investing

114 Comments Leave a Comment

What are your Twelve Stocks of Christmas?

CONTRIBUTIONS ARE NOW CLOSED.

I have an assignment for you.

Before we start, two things…

1. If you are looking for a gift that keeps on giving in 2011, give your loved ones a copy of Value.able. To guarantee your gift makes it into Santa’s sleigh, you must order before 5pm next Monday, 13 December.

2. Put Thursday 16 December @ 7pm in your diary. Sky Business has invited me to appear on their Summer Money program.

Within Summer Money, Sky is running a series called The Twelve Stocks of Christmas and I have been asked to present one of the twelve stocks. What I would like to do is let everyone on Sky Business know about you – the Value.able Graduate class of 2010!

You have been instrumental in contributing to the knowledge and awareness of value investing and I would like to say thank you by reviewing your suggestions on air.

So, what will it be? You can nominate one of the companies we have already discussed. More points can be earned by contributing a company of which you have industry-level knowledge. Think about your industry or business:

- Who is the strongest [listed] competitor in your industry?

- Who would you like to see out of business because they are an emerging threat?

- What are their competitive advantages, their opportunities for growth and why do you think they will sell more of their product or services in the future or at higher prices?

- Perhaps they are out of favour in the share market, but you believe it’s a case of a temporary set back being treated like a permanent impairment?

I encourage you all to post your contribution. There are just two rules:

1. One stock (your best pick) per Value.able Graduate. The more detailed your information, the better; and

2. Ideas must be submitted by Wednesday 15 December

Before the live show at 7pm next Thursday, 16 December, I will run my valuation eye over every suggestion and give each my Montgomery Quality Rating (MQR). But the list will be yours – a contribution from the Value.able Class of 2010.

Whilst only one stock will make it to the show, EVERY SINGLE STOCK  contributed on this post with sufficient supporting detail will be subsequently listed in my final pre-Christmas post for 2010, complete with MQRs, current valuations and prospective valuations (I have decided to called these MVEs – see below).

Embrace this opportunity to practice what you have learned over the past twelve months, and get the official Montgomery Quality Rating (MQR) and Montgomery Value Estimate (MVE) for your favourite stock. You never know, your stock may just be the one I contribute on national television to The Twelve Stocks of Christmas.

Post your suggestion here at the blog by Wednesday 15 December 2010.

I look forward to reviewing your insights and hearing what you think of your classmates’ suggestions. Simply click the Leave a Comment button below.

Posted by Roger Montgomery, 9 December 2010.

Postscript: thank you for your kind words and birthday wishes. I’m thoroughly enjoying my time away and am very much looking forward to reading and replying to your comments when I return to the office next Monday.

Postscript #2: Steven posted his own Value.able 12 Days of Christmas at my Facebook page last Friday – brilliant!

On the twelfth day of Christmas,
My independent analyst’s blog gave to me
12 A1s humming
11 valuations piping
10 C5s a-sleeping
9 forecasts prancing
8 capital raisings milking
7 floats a-sinking
6 CEOs praying
5 golden A1s!!
4 C5 turds
3 emerging bubbles,
2 editions of Value.able
And a market leader with a high ROE!

Here is Steven with his daughter Sophie.

Roger, you were good enough to sign my book…

“To Steven, Your guide to avoiding the dogs you told me you were so worried about, RM”.

Here I am reading Value.able to my little two year old Sophie at bedtime, holding her toy dogs. The moral of the story for Sophie? Roger shows dogs make fun toys and pets but must be avoided at all costs when investing in great businesses!”

Steven

Posted in A1, Company Valuation, Insightful Insights, Value Investing, Value.able

159 Comments Leave a Comment

Has 2010 been a good year for Value.able investing?

Christmas is about sharing and joyful memories. With just 18 days to go, I thought it would be educational, if not insightful, to share the performance of some of the securities Value.able Graduates have discussed here at my blog.

Does the Value.able approach to investing, as advocated some of the world’s leading investors, have merit?

First Edition Graduates may not be surprised by the results posted below. The higher quality businesses, those scoring A1 and A2 Montgomery Quality Ratings (MQRs), and those at larger discounts to intrinsic value have, in aggregate, beaten the index. Some have trounced it. And with the exception of QR National, the companies that were labeled as poor quality (C4 and C5 MQRs) and overpriced, have under-performed. Some of the maturing higher quality companies (think JB Hi-Fi) have indeed performed.

The following tables present some of the blog posts and the stocks that I have listed, mentioned or discussed in them. I have consistently suggested investigating an approach that seeks the highest quality businesses and prices that offer the biggest discounts to value.

Whilst the results are short-term (therefore nothing should be taken from them), they are nevertheless encouraging. The approach advocated in Value.able is worth investigating.

Many Value.able Graduates have suggested I start a newsletter or a stock market advice service. Thank you for the encouragement. I do enjoy the cross pollination of ideas and look forward to 2011 attracting even more investors to the patient and rational approach shared here at my blog.

Here are the tables (DO YOUR HOMEWORK AND RESEARCH. ENSURE YOU ARE COMPREHENSIVELY INFORMED. SEEK AND TAKE PERSONAL PROFESSIONAL ADVICE).

Do these three companies represent the last of good value? Oroton, JB Hi-Fi, DWS, Cogstate, Cash Converters, Slater & Gordon, ITX, Forge, Decmil and United Overseas

Which 15 companies receive my A1 status? CSL, Worley Parsons, Cochlear, Energy Resources, JB Hi-Fi, Navitas, REA Group, Carsales, Mondaelphous, Iress, Fleetwood, ARB, McMillian Shakesphere, Sirtex, Oroton.

Is Apple an A1? What A1 companies does Roger Montgomery think are the best value right now? Apple, Forge and Decmil.

Where are my valuations Roger? Cabcharge.

JBH’s years of fast growth has slowed.

What do you think of the QAN, JBH and ITX results Roger? Qantas and ITX

Telstra profits will continue to drop

Who is in front of the reporting season avalanche? Navitas, JB Hi-Fi, Cochlear and Matrix.

Part II: What else has the reporting season avalanche uncovered? Ross Human Directions, Monadelphous, Forge, Carsales, DWS, Finbar, SMS Management, CSL, Consolidated Media, Integrated Research, McMillian Shakesphere, Count Financial, Domino’s Pizza, The Reject Shop, Credit Corp, Chandler Macleod, Primary Healthcare, Slater & Gordon, Noni B, Embelton and Tamawood.

Retailing Maturity – Roger Montgomery now has reservations about JB Hi-Fi.

Part III: The avalanche is over – where should you be digging for A1s? Lycopodium, REA Group, Fleetwood, K2 Asset Management, Acrux, Hunterhall, Macquarie Radio, Blackmores, ISS Group, Thorn Group, GUD Holdings, Webjet, Kresta Holdings, Kingsgate, Fiducian and Euroz.

Foster’s turns down $2b bid.

How does cash flow through Decmil?

Part IV: Where should you focus your digging?

Will Roger Montgomery invest in QR National?

I thought the performance of Fosters after the wine bid was knocked back was interesting, but only another year or two will confirm whether the opportunity to add value was passed up. Some higher quality businesses also underperformed the market, thanks in part to deteriorating short-term prospects rather than deteriorating quality.

Remember to look for bright long-term prospects. Of course, in the short-term prospects will swing around – that is business, but longer-term prospects of businesses with true sustainable competitive advantages tend to win out.

Keep an eye on the blog before Christmas as I will be posting a couple of very handy lists (and possibly some homework) before the annual Montgomery Family Christmas break.

Posted by Roger Montgomery, 7 December 2010.

Posted in A1, Company Valuation, Insightful Insights, Value Investing, Value.able

40 Comments Leave a Comment

How many of your Chips are Blue?

If you are new to the stock market, I believe it is possible that you have been lulled into a false sense of security. I say this because I regularly hear well-meaning advice that goes something like this; “just buy a portfolio of blue chips and hold for the long term”

But what is a blue chip? Here are some of the definitions I have found around the place:

“a common stock of a nationally-known company whose value and dividends are reliable; typically have high price and low yield; blue chips are usually safe investments”

“A blue chip stock is the stock of a well-established company having stable earnings and no extensive liabilities. Blue chip stocks pay regular dividends, even when business is faring worse than usual. …”

“A large company. Blue chip shares are generally lower risk. FTSE 100 constituents are generally considered blue chips”

“Shares of companies that are considered to be particularly solid and with a high capitalisation level. Their purchase is presumably associated with minor risk when the Stock Exchange falls”

And my new favourite definition;

“Blue Chip is the third album by Acoustic Alchemy, released under the MCA Master Series label in 1989, and again under GRP in 1996.”

Clearly there is only rough consensus around what a ‘blue chip’ actually is, but I get the distinct impression that a lack of understanding about what truly constitutes ‘high quality’ has meant the resultant definitions are clumsy at best. And if advisors can’t define quality/blue chip with some consensus, then its quite possible new investors are plunging into a blind-leading-the-blind situation.

Here at my Insights blog, I don’t talk about blue chips. Why? Because they don’t exist. There is no such thing.

I define quality through my A1-C5 Montgomery Quality Ratings (the MQRs) using a raft of measures and scenarios, combined with measures of the financial relationship a company has articulated over the years with its shareholders and its competitive position.

Warren Buffett once observed that time is the friend of the wonderful business but the enemy of a poor one. You don’t want to put the shares of a bad business, even if it’s a big one, in the bottom drawer and forget about them. Long term buy-and-hold investing then should only apply to the truly high quality companies – A1 companies.

To that end I would like to share with you an early Christmas gift (until Value.able arrives under your Christmas tree).

One of the definitions noted above and a commonly held one is that blue chips have to be large companies. Companies that inhabit the S&P/ASX 50, for example, may be considered Blue Chips. Putting aside for a moment the fact that there are plenty of large companies that have gone to the wall, it is possible to re-rank the so called Blue Chips – the large capitalisation companies – and find out if any are more blue than the rest.

So in the pursuit of ‘blueness’, below you will find all companies with a current market capitalisation of more than $10 billion sorted by my MQR (followed by Safety Margin for good measure). I have also included my current expected (annual) rate of change in Value.able Intrinsic Value over the next three years and thrown in dividend yields because I know how adored they are.

Of course, all of this is purely didactic and not intended as advice. YOU MUST SEEK AND TAKE PERSONAL PROFESSIONAL ADVICE. Also remember that I do not know what share prices are going to do, they could all halve or double and my MQRs andValue.able Intrinsic Values could all change tomorrow, possibly by a lot. They could go up or down and I am under no obligation to keep you updated. So please DO NOT RELY ON THE INFORMATION PROVIDED.

Having made that clear, and I am not joking about such serious matters, here is the list:

So its seems not all blue chips are entirely blue. As one of my friends – who likes to occasionally catch the amber light – says, “there’s still a bit of green left!”

Lumping all large companies into the ‘Blue Chip’ camp may not lead you to secure returns. Indeed, it could more likely see you merely lurch from one crisis to the next. If that is an experience you would like to change or avoid, then understanding the factors that indicate good quality is vital.

Value.able Graduates would have read the chapters about identifying extraordinary businesses in my book. If you haven’t yet secured your copy of Value.able you can do so at my website, www.rogermontgomery.com.

Posted by Roger Montgomery, 26 November 2010.

Posted in A1, Blue Chips, Company Valuation, Insightful Insights, Value.able

144 Comments Leave a Comment

Which bank?

Everyone from the media, to politicians and litigation funders have been busy bashing our banks over the head. Led by a possibly tipped-off/advised Joe Hockey, this particular attack seems to have legs. Have you been distracted by the noise?

Not me, I have been busy looking at the latest set of financial results from ANZ, NAB and WBC and comparing them to my CBA benchmark.

I have spent many hours and analysed many industries and their KPI’s and for the banks I will simply say that CBA and WBC are currently my two highest quality banks (based on the Montgomery Quality Rating). WBC gets an A1 MQR (up from an A5!), CBA is an A2 (up from an A4). They’re also the biggest.

My salient facts for the big four are shown below.

While ANZ appears to be the cheapest and the most tempting, I continue focusing on the goal of filling the portfolio with only the best businesses. So it may prove a better option to exercise patience and wait for wider safety margins. With the latest round of bank bashing and China announcing further tightening measures, I may not have to wait long.

Between now and then you will read many views about the size of each bank’s reported profits, why they have too much power, why they should cut this fee or stop doing this and that. But keep in perspective that no matter what is written or said, they provide many services and functions that are vital to capitalism.

Another important couple of things to remember is that they collectively have 92% market share and don’t provide all (or any!) of their services for free. ATM Fees… Debit Card Transaction Fees… Annual account-maintenance fees… Monthly Account keeping Fees… Minimum Balance Fees… Wire Transfer Fees… Overdraft Protection Fees… Overdrawn fees… Dishonour Fees… Clearance Fees… Statement Fees… Voucher Fees… Periodical Payments or transfer fees… Stop payment fees… Recent Transaction List Fee… Overseas transaction fees… Electronic banking fees… Interest fees… Establishment Fees… Deferred establishment fees… Over the limit fees… Currency conversion fees… Annual Fees… Deposit Fees… Withdrawal Fees… Online-banking fees… Teller fees… the list goes on, there’s even “late” payments fees for paying your credit card too early.

As you might know there are four basic sources of competitive advantage – something Buffett is primarily focused on – they are: economies of scale, the network effect, intellectual property rights and high switching costs. The four biggest banks enjoy both economies of scale and the benefits of high switching costs. It is personally more taxing for a client to change banks than the benefits that inhere from switching. And so very few people switch. As I have often said, if you live on an island with a long swim to anywhere else, then owning a bank is not a bad idea. They can charge you to put your money in, charge you to take your money out and even charge you to find out how much money you have.

For me, being active in the share market can bring on-line brokerage fees, telephone order fees, custody fees, software fees, transfer fees, late settlement fees, margin lending fees etc…

No matter where you turn, the banks are entrenched in my daily life.

And where do all of these fees, along with net interest income and trading profits go? Into wafer thin 1% margins. Yes, our banks rely on massive volumes. WBC has $620b of assets. A 1% return on those assets equates to a profit of $6.2b – roughly what they reported in their full year result.

They are also some of Australia’s highest leveraged businesses shouldering enormous risks (albeit controlled) to generate that return. If you have ever heard that ‘X’ bank has a tier 1 risk weighted capital ratio of 8%, generally this means that the bank is holding only $8 for every $100 that a customer has borrowed. Being highly geared, it is therefore in the bank’s interest to ensure that everything in our economy ticks along.

By far the biggest variable expenses for banks are bad debts. During the GFC when bad debts increased dramatically, do you remember what happened when things turned ugly? Those wafer thin profit margins disappeared like the last Mars Polar Lander. The impact on NAB’s profits, for example, was dramatic with profit in 2009, $2 billion lower than the year before.

With these risks in mind it seems a tad irrational to quibble over the enormous profits being earned, particularly when they are largely returned to Australians. Shareholders receive 70%-80% of profits in fully franked dividends and the Australian public receive 30% of pre-tax profits via tax payments to the government.

On the other side of the coin is the very real fact that these are mature businesses. As Value.able Graduate Richard Quadrio mentioned in his comment here on the blog yesterday, banks can only increase their profit by either lending us more or charging us more. The former depends on our appetite, which may be slowing. That leaves the latter.

In my mind, they have the power to keep increasing prices but the legislators now need to be convinced that they should be allowed to in return for wanting to continue lending and perpetuating the GDP growth dream.  Paralysed by these competing forces, I go back to what I know – investing, and ask; which bank is the best? For me that’s the only question – which bank?

Posted by Roger Montgomery, 11 November 2011.

Posted in A1, Banks, Financials

114 Comments Leave a Comment

Have you been getting your daily dose?

If only it worked that well all the time!

Last Thursday evening (4 November) on Peter’s Switzer TV I listed, amongst other companies, Credit Corp and Forge Group as two I would have in the hypothetical Self Managed Super Fund Peter challenged me to set up that day.

Why did I nominate CCP and FGE? Both receive my A1 or A2 MQR and both have been trading at a discount to their intrinsic value.

If you are a regular reader of my blog you would have read my insights for some months on these companies. And if you saw today’s announcements, you can imagine why I am a little happier than usual.

Credit Corp’s previous 2011 NPAT guidance was $16-$18 million. Today the company announced FY11 would likely produce an NPAT result of $18-$20 million.

Forge Group’s announcement states “The Board wishes to advise that the company forecasts net profit before tax for the half year ending 31st December 2010 to be in the range of $25-$27 million. This represents an improvement on the previous corresponding period (pcp $19.04m) of up to 42%.”

As I fly to Perth for a presentation and company visit, I am encouraged that several of the companies Value.able graduates mentioned in our lists are also hitting new 52-week highs. In a rising market that lifts all boats, it is perhaps unsurprising, but nevertheless it should be an encouragement to Value.able graduates and value investors that companies like FLT, DCG, MIN, FWD, FGE, CCP, NCK, DTL, MCE, MTU and TGA have all hit year highs – some of them yesterday. More importantly those prices are perhaps justified by their intrinsic values.

Of course I am not here to predict where those prices will go next, because I simply don’t know. Short-term prices are largely a function of popularity and the market could begin a QE2-inspired correction, an Indian infrastructure-inspired bubble or a China liquidity-inspired bubble tomorrow. I have no way of telling and instead, I focus on intrinsic values and only pay cursory attention to share prices.

So, as I always say, seek and take personal professional advice before taking any action and remember that 1) I don’t know where the share price is going 2) I am under no obligation to keep you up-to-date with my thoughts about these or any company, my Montgomery Quality Ratings or my valuations and I might change my views, values and MQRs at any time so don’t rely on them and 3) I may buy or sell shares in any company mentioned here at any time without informing you.

And so I remind you one more time. Please seek and take personal professional advice and always conduct your own research.

Posted by Roger Montgomery, 9 November 2011.

Posted in A1, Company Valuation, Insightful Insights, Value Investing, Value.able

155 Comments Leave a Comment

Are you drowning in a sea of complexity?

I don’t know if you have noticed but some of my recent posts and comments have been getting a little technical. I am sorry about that, I get a bit carried away sometimes.

Of course on this blog, I am not alone. Joab’s brilliant heads-up on the forthcoming changes to the treatment of leases and the impact on the financial statements is exactly the sort of thing that excites those of us who make investing a full time occupation.

In this field it’s easy to want to prove how much detail one can accumulate about a company or what one knows about valuations or credit analysis. Then of course debates and polite but pointed arguments begin about whose mousetrap is better.

Yet for most of us, it’s a storm in a tea cup, and meanwhile someone has made a million dollars quietly accumulating a few shares in the recently listed company XYZ Ltd.

In most cases there is one pearl that counts and the rest is noise. Our job is to find the pearls. Of course with so much rubbish to sift through it can be challenging to pluck up the enthusiasm to even start searching. For many investors, time is of the essence and short cuts are needed.

Well, I am here to deliver. But this not a post about buying the next hot uranium or gold explorer – tips I do receive and some I even regret missing sometimes. Today’s post is about a shortlist of A1 companies, their proximity to intrinsic value, my expected change in those intrinsic values and the associated net debt to equity ratios.

Why? It’s about getting back to basics.

Investing is simple. Not easy, but simple. Much work went into the classification process to come up with my A1, A2, C5, etc Montgomery Quality Ratings using, for example, industry specific KPI’s to ensure that future sweat was reduced.

And recently one Value.able Graduate Ken, reinforced my resolve to keep it all very simple. Ken D wrote:

Hi again Roger,

Out of curiosity, last week I constructed 2 hypothetical portfolios: 1) with your A1 stocks in equal proportion; and 2) the same with your A2 stocks. I have attached some numbers. I was impressed by the average past performance (i.e. investment performance) from both portfolios and also noted quite a difference between the A1 and A2 portfolios (attached). I doubt whether the result is fortuitous. Without asking you to outline your ranking process, I was wondering whether the strong past performance might be expected as a direct result of criteria used in the A1, A2 classification process – e.g. reference to historical earnings growth for instance, or perhaps more interestingly, a product of the inherent quality of the business as measured by current performance measures.

Ken

In answer to Ken’s question and for everyone’s benefit, remember Ben Graham’s quote about short-term voting machines and long-term weighing machine? Over longer periods of time, price follows intrinsic value and because my Value.able method of calculating intrinsic value is related to the performance of the business, one should expect price to follow performance. Over time A1 businesses should do better and a portfolio filled with just A1s purchased at big discounts to intrinsic value, should, in theory, do best.

Ken looked at all the A1s that I had mentioned on the blog and went backwards (I’ll ignore survivor bias for now) to have a look at the annual returns a portfolio of A1s would have produced.

While there is more refinement required, the early results are impressive. Over the last ten years Ken’s portfolio of 16 A1 company stocks returned 24 per cent, per annum. The same 24 per cent per annum result was produced with a portfolio of 23 stocks over five years and there were 31 A1 stocks in the last year that combined, returned 31 per cent.

Thanks for putting in the time Ken.

With all that in mind, here is my latest list of A1 companies, their proximities to intrinsic values and a few other salient stats.

What I would like to see as comments here are your thoughts or insights about any of these companies. Go right ahead and share whatever you know or think. But only about the companies in the list. Keep the comments to the topic set and we will build a useful library of insights. Just click the Leave a Comment link below.

Posted by Roger Montgomery, 3 November 2010.

Posted in A1, Company Valuation, Value Investing, Value.able

304 Comments Leave a Comment

Carsales.com.au is an A1 business, but is it cheap?

Each Wednesday I write my ValueLine column for Alan Kohler’s Eureka Report. Usually I post a link to my article the following day here at the blog. This week Alan has generously allowed me to republish my insights. Visit the Eureka Report website, www.eurekareport.com for more details about Alan’s newsletter.

ValueLine: Carsales.com

Ever noticed that the biggest and best online businesses are lists? Lists of websites, lists of houses, lists of flights, lists of jobs, lists of hotel rooms … even lists of people!

The business of curating and providing lists can be an extremely lucrative one because there is no need for a warehouse or a manufacturing plant. Nor is there a need for inventory and there is potentially very little maintenance spending required.

But because anyone with access to a server and knowledge of a programming language can imitate the business model, what is needed to be successful is a sustainable competitive advantage. More about that in a moment.

Last year nearly one million cars were sold in Australia; this year the figure is expected to be even higher. Of Australia’s adult population of 19.3 million, 5.3% buy a new car every year. Excluding January sales (when everyone is on holidays) and June sales (with end of financial year run-outs) about 85,000 new cars are sold each month.

That’s a lot of new cars being bought, and one suspects that just as many second hand-cars being sold too. One company leveraged to this industry without having to buy stock, lease a showroom or pay the wages of mechanics is Carsales.com (CRZ).

After a decade of business under private ownership, Carsales.com was floated at $3.50 a share in September 2009 in one of the most highly anticipated listings of the year. As is often the case with such floats, very few retail investors were able to get an allocation.

Today Carsales (CRZ) is Australia’s largest online list of cars, with about 205,000 units available for sale as of June this year.

For the year to June 2010, Carsales reported a profit of $43.2 million, which was $16.8 million less than listed car dealership Automotive Holdings (AHE). Automotive Holdings reported a profit of $60 million but required $1 billion of assets and $376 million of equity to produce it.

By way of comparison, Carsales required just $114 million of assets and $89 million of equity. Automotive Holdings generated a return on assets of 6.5%; Carsales’ figure was 39%.

If they were your assets, which return would you prefer?

For every dollar of sales, Automotive Holdings generates earnings before interest, tax, depreciation and amortisation (EBITDA) of 3.8¢. Carsales generates EBITDA of 52¢ from every dollar of sales.

If you could own one of these businesses, which would you prefer?

Carsales dominates Australia’s online lists of cars, capturing roughly half the market. Its next nearest competitor is the Newscorp-owned Carsguide with 93,000 cars for sale at mid-August, followed by the Trading Post with 69,000 cars.

For the full year to June 2010, Carsales’ revenues increased by 28%, with operating costs rising by less than 12% and net profits increasing by over 41%.

One of the keys to sustaining this kind of performance is a competitive advantage and while many conventional reports cite brands and systems as sources of competitive advantage, Carsales’s advantage comes from what is known as the network effect.

This is arguably one of the strongest sources of competitive advantage and it is evident when the value of a service increases for both new and current users as more people begin to use that good or service.

Think about it like this.

As more people list their cars/jobs/properties on a website, more people visit that website because it has the more cars listed. As more people visit the website, it justifies more people listing their cars there and this virtuous circle continues to work in favour of the dominant site, until an unbridgeable moat exists between Carsales.com and the other brands.

In an effort to break the cycle, one of Carsales’ competitors offered vendors the opportunity to list their cars for free but even that failed to put a dent the growth trajectory of Australia’s leading car classifieds website.

Carsales enjoys the same benefits of the network effect as Seek (SEK) does in job ads, REA Group (REA) does in real estate and Wotif (WTF) does in accommodation. This network effect is as visible and obvious as it is entrenched for Carsales.com and investors looking to buy a wonderful business would be hard-pressed to find many more attractive (for more of Roger’s thoughts on web-based businesses, click here).

Now the reality is that Carsales’ largest shareholder, PBL Media, owns 49% of the company and at some point that stake will be sold. But investors fearing the overhang should be less concerned by who buys and sells the shares and more concerned with whether the intrinsic value of the company is rising or not.

Carsales’ intrinsic value is rising. My forecasts suggest intrinsic value will rise 19% for each of the next three years and, let me assure you, there are few companies that can even promise that.

But a rising intrinsic value is just one of the characteristics the ValueLine portfolio seeks. The other is a discount to today’s intrinsic value. And that is the only test that Carsales.com. does not pass.

Carsales.com is an A1 business with a strong competitive advantage that is generating excellent returns on assets but, according to my calculations, its intrinsic value is $3.77. If we compare this to yesterday’s closing price of $4.72, it is approximately 25% overvalued.

In 2012, my estimated intrinsic value for Carsales rises to $4.65 and in 2012 to $5.24, but disciplined value investors need to make sure that everything lines up perfectly to pursue a successful investment strategy.

Carsales is not currently trading at a discount but it is a great business to keep in mind, should the market temporarily change its mind.

Posted by Roger Montgomery, 7 October 2010

Posted in A1, Company Valuation, Value.able

48 Comments Leave a Comment

Part IV: Where should you focus your digging?

While everyone else seems to have moved on from reporting season, I’m still digging my way through a mountain of analysis. I am almost done.

Based on the amount of comments contributed here at my blog it seems you have enjoyed reading my insights as much as I have enjoyed sharing them.

Before I get into what I have uncovered from last week’s filings, congratulations are in order. Gavin was the first Value.able Graduate to correctly pick the three companies I omitted from Part III’s second table – congratulations Gavin. Gavin picked all three despite there being thousands of companies listed on the ASX and only having six pieces of financial data. Amazing!

Congratulations are also in order to Mike and Pat, who picked all three. Great digging fellow Value.able Graduates!

The missing companies are ARB Corporation (ARP), Wotif.com (WTF) and Mineral Resources (MIN).

As always, please undertake your own research and seek and take personal professional advice before you go rush out and buy anything.

I also wanted to say a big thank you to all who have posted comments. Our Value.able investing community has benefited greatly from your contributions and insights and I am excited by the great sense of community that you have developed. I must say a special thank you to our regular contributors – the quality of your comments are amazing, and more importantly, respectful and non-judgmental. Keep them coming!

If you haven’t yet posted a comment, now is a great time to start. The Value.able community is here to share ideas and help each other. If something is on your mind, I guarantee there is someone else with a similar question. So please contribute as much as you can or ask as many questions that you may have.

Now onto my lists – despite all my digging, there is only one new entrant into my A1 Montgomery Quality Rating this week. With three companies experiencing rating declines, on a net basis we actually lost two A1s. You can see them below.

Dominion Mining (DOM) had the largest rating decline, from an A1 to an A3. It still displays high quality metrics – with $16m in cash on the balance sheet and no debt (just watch out for those capitalised exploration expenditures), but my Montgomery Quality Rating declined. Why?

As you know, I tend to shy away from commodity businesses. It is not that they are difficult to understand, but rather difficult to forecast with a great deal of confidence – forecasting how much they will produce and when, their cost of production and/or project establishment and development costs and then ultimately, what price they will get for their production. There are simply too many variables that management can get wrong and many that are completely out of their control.

To this point I proffer Dominion (ASX: DOM), which in the most recent financial year, despite a higher average gold price, saw production slip from 98,755 ounces to 80,570 and cash production costs blow out from $438 to $697 per ounce. The combination of lower production and lower efficiencies transformed a highly profitable business into a barely profitable one in the space of 12 months. Now that’s operating leverage!

Indeed if you took all of the hitherto-labelled ‘resource evaluation and mine development expenditure’ expenses straight to the Profit and Loss account as opposed to the Balance Sheet, DOM would have made a loss of several million.

Given the many variables and accounting flexibility, if exposure to this sector is your goal, perhaps your focus could move from those who ‘look for’ and ‘produce’ to those who ‘service’ – the suppliers of the picks and shovels and those engineering businesses that install, maintain and replace all the picks and shovels. In my opinion, there are fewer variables and the economics haven’t changed since the days in 1851 when a gold rush in Ballarat saw 10,000,000 grams of gold delivered to Melbourne’s Treasury.

Back to my A1’s… the only entrant this week is Centrebet International (CIL). Remember that this is in addition to the 30 revealed so far in my previous posts – Part I, Part II and Part III. My A1’s now total 31.

CIL is in the business of online wagering and gaming and appears to have carved out a niche in Australia’s multi-billion dollar gambling market.

Take a look below and you will also see those companies that have achieved an A2 Montgomery Quality Rating since my previous blog post. The average ROE of this group is an impressive 23.39% (albeit around half that of my A1’s) with an average gearing level of -36.05%. There are plenty of Balance Sheets here reflecting a net cash position.

Combine my A1s and A2s (78 in total) published in the past couple of weeks and you have an excellent starting point from which to begin your own digging (by doing your own research and seeking independent personal and professional advice).

I will also mention that I may own any of the above companies and that I may buy or sell at any time – even tomorrow, and I am under no obligation to keep the list up to date in any way, shape or form. Before you do anything, YOU MUST conduct your own research and I insist you obtain independent personal and professional advice considering your needs and circumstances.

Value.able gives you the simple steps to follow to estimate a value for each company yourself and some thoughts to consider in regards to qualitative factors, such as competitive advantage. If you are not already a Value.able Graduate, why not?

Also remember that the share price may halve tomorrow. DO NOT buy shares in any company simply because I like it or own it – that is not investing, that is speculation. Speculating that I am right is not investing. That is the exact opposite of the value investing doctrine I espouse.

Reporting season will soon be a distant memory and the media, analysts and ‘investors’ will start to think about other things… the economies of the US, China and Europe will start to tickle the minds of idle analysts and commentators, but your focus should remain on great quality companies trading at very big discounts to intrinsic value.

Posted by Roger Montgomery, 15 September 2010.

Posted in A1, Company Valuation, Insightful Insights, Value Investing

147 Comments Leave a Comment

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