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This article appeared in the December 2011 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more 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. ROGER MONTGOMERY reports.

Photo of Roger Montgomery By Roger Montgomery, www.Skaffold.com

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, you will need to be ready and will need some cash. 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 and using Skaffold (my company valuation and analysis tool for investors), I will show you how you can do the same.

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

The sharemarket in aerial view - Figure 1 

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?

Code Name Return on Equity Write-down ($m) 12-Month Share Price Return Comment Quality Score
NWS News Ltd 10.72% 713 5.99% Mastheads Written Down A3
FXJ Fairfax Media 5.53% 649.9 -42.46% Mastheads, customer relationships and goodwill written down B2
APN APN News & Media 8.14% 156 -58.55% Weak performance of New Zealand papers B3
BSL Bluescope Steel -9.02% 922 -68.90% Poor performing assets B4
LEI Leightons -13.59% 907 -35.88% Expensive airport link and Victorian desalination project C4
ELD Elders -3.08% 391 -66.92% Company cuts/writes off ties with ailing forestry business C4
GFF Goodman Fielder -11.71% 300 -62.01% Rising costs and falling prices C4
TPI Transpacific -4.22% 346.8 -30.19% Weak manufacturing and landfill divisions C5
PDN Paladin -6.99% 178.9 -68.23% Slashes book value of its Kayelekera mine C5

Source: Skaffold

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

The biggest writedowns compared to the market - Figure 2

Source: myindices

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.

About the author

Roger Montgomery is an analyst at Montgomery Investment Management Pty Ltd and was Skaffold's creator. To become a member, visit Skaffold's website.

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