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Reporting season opportunities

This article appeared in the September 2012 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.

It can be a lucrative pay time for patient investors.

Photo of Roger Montgomery By Roger Montgomery, Skaffold

The reason the annual reporting season can be so enjoyable and lucrative is that it is when the inefficiencies of the analytical research process are revealed and large gains can be made. There are often results that surprise sharebroking analysts, leading to big share price rallies.

Take, for example, the day I wrote this column - August 22.

Three of our fund's four largest holdings - Seek, CSL and The Reject Shop - all reported significantly better results, setting the stage for price re-ratings. On a day the Small Ordinaries index fell three-quarters of a per cent, these three companies' share prices rallied an average of nearly 7.2 per cent.

Seek announced strong growth across all its businesses and revenue increased more than $100 million to $442 million. Net profit rose by 35 per cent. This was achieved with virtually no additional capital raised from shareholders and little in the way of debt. Return on equity was approximately 30 per cent.

The Reject Shop reported a 13 per cent increase in like-for-like net profits (and a headline 35 per cent rise) on an 8 per cent increase in sales after opening an additional 18 stores.

As an aside, analysts get all specific about the fact that 2012 had 53 weeks of selling while the year before had 52, and so prefer to adjust for the additional week. I suggest that if you owned the business outright, you would not care about such detail and wish that every year had an extra week of selling before you worked out your dividend.

The Reject Shop also reported net debt fell from $39 million to $22.4 million and, importantly, it is focused on getting the merchandising right. Operating cashflow jumped 125 per cent to $40.2 million, despite capital expenditure for 18 new stores opened and two relocations.

CSL reported a 21 per cent increase in earnings per share on a constant currency basis (headline 9 per cent), cashflow from operations grew by 14 per cent, and the board is considering a buyback of a further $900 million of shares.

In all three cases, the results exceeded analysts' estimates and that's the point - the reporting season can be a boon for patient investors who want to apply the simple principles associated with quality and value.

What to look for

There are basically three characteristics we look for when investing in Australian listed companies and it is essential to understand there are no compromises. We don't buy a little of something if it enjoys two of the characteristics. The company either ticks all the boxes or it's not considered.

Those characteristics are simply:

  1. An extraordinary business
  2. Bright prospects
  3. A cheap price.

Of course, while the characteristics are simple to understand, the strategy is not always easy to implement. That is not because you need to be a rocket scientist, but because being a patient investor is difficult when shares are moving all around you and the urging by promoters to do something, anything, is deafening.

Extraordinary businesses

The best businesses for your portfolio are those that have great economics, great prospects for sales, profits and intrinsic value (the company's true value), and great management. They have high rates of return on equity, driven by sustainable competitive advantages, solid cashflow and little or no debt. They are run by first-class managers who think like owners and treat their shareholders as such.

The factors you need to look for in a business are:

  • A high rate of return on equity driven by sustainable competitive advantages
  • Solid cashflow
  • Little or no debt
  • First-class management.

Knowing which businesses are great and which are average is the relatively easy part of investing, and because a business's economics generally change very slowly, you have plenty of time to identify the best by simply examining their historical track record.

The library of numbers is what makes the sharemarket such a convenient place to buy businesses. It is not like buying a new franchise or investing in a start-up where you really don't know how well or badly things might go. In the sharemarket you have hundreds of businesses that have been around for a decade or more. You can see exactly what you are getting yourself into.

Bright prospects

Consider your strategy carefully. Approach the shares available in the market the same way you might invest in a business. You must approach buying shares in businesses with the prospects for the next five, 10 or 20 years of the business in mind.

You are looking for a business with bright prospects for unit sales volume and earnings growth, the ability to raise prices even in the face of excess capacity, and something that has been uniquely essential to our fund's outperformance: bright prospects for intrinsic value growth.

The businesses with the best and easiest-to-identify prospects tend to be those with a demonstrated record of generating high rates of return on equity, consistent earnings and sales growth, without the need for additional capital from shareholders or banks. To find out, simply compare the growth in profits to the growth in equity and debt.

Figure 1. Skaffold Capital History - Qantas (ASX:QAN)

Skaffold capital history chart for Qantas - 2002 onwards

Source: Skaffold

Figure 1 reveals the economics of Qantas's business. [The blue line is Return on Equity, the grey bar is total shareholders' equity and the red bar is total debt.]

In 2002 it earned $439 million after owners had invested $4.2 billion and the banks had lent $4.4 billion. By 2012 the company was earnings just $58 million and while that's bad enough, owners had invested a total of $6.3 billion. In other words, an additional $2 billion had been injected into the company over the past decade and yet the company was earning significantly less. In addition to those two indicators, banks had lent an additional $1.6 billion, increasing the risk for owners.

Unless you can see the economics of the airline business changing, you would conclude that the prospects for Qantas are challenging.

Many years ago Warren Buffett wrote: "The speed at which a business success is recognized, furthermore, is not that important as long as the company's intrinsic value is increasing at a satisfactory rate."

What Buffett revealed was that you want to own companies whose intrinsic values are rising.

If Benjamin Graham (Warren Buffett's mentor) was right in his observation that price follows intrinsic value over the long run, then it's important to buy businesses whose values are rising.

Figure 2 below reveals Qantas's intrinsic value (the straight grey line) is not rising and, not surprisingly, the share price (the orange line) has been following the value down over the years.

Figure 2. Skaffold Intrinsic Value Line (ASX:QAN). AVOID?

Skaffold intrinsic value line for Qantas - 2002 onwards

Source: Skaffold

Figure 3 below, for Blackmores, reveals the kind of growth in intrinsic value we look for at The Montgomery Fund [the straight blue line is intrinsic value, the straight orange line to the right of the chart if forecast intrinsic value, and the green line is the share price].

Figure 3. Skaffold Intrinsic Value Line (ASX:BKL)

Skaffold instrinsic value line for Blackmores - 2002 onwards

Source: Skaffold

You can see that if you have the 10-year record of estimated intrinsic values and estimates for the next three years for each company, you don't need to try to predict share prices.

Cheap price

That brings us to the final step - the identification of a cheap price. For me, a cheap price is not a low price to book value, a high dividend yield or a high Price /Earnings to Growth (PEG) ratio. Nor is it a low Price Earnings (PE) ratio.

A cheap price is simply a discount to current intrinsic value.

Look at Figure 4 and the price of Commonwealth Bank shares during the GFC in 2009. The price (red line) was below the estimated intrinsic value (blue line). At the time, the shares of Australian banks were being treated just like US banks. But US banks were losing billions and were being rescued and nationalised. Australian banks were still reporting billions of dollars in profits.

Figure 4. Skaffold Intrinsic Value Line (ASX:CBA)

Skaffold intrinsic value for Commonwealth Bank - 2002 onwards

Source: Skaffold

When a company's shares are being punished because macro economic events of a temporary nature are being treated as permanent, and the price is below intrinsic value, you have the potential for outsized returns.

Patience the hardest part

You now have the basic steps required to identify the better opportunities that might also allow you to sleep more comfortably. The only remaining ingredient is patience.

Waiting until all the characteristics are present is the hardest part of investing. Fortunately, the reporting season comes around every year and because inefficiencies are often evident, a patient value investor does not have to wait very long to apply the techniques suggested here.

About the author

Roger Montgomery is from The Montgomery Fund and Skaffold. He will be running a live webinar on 19 September entitled "When to Sell" and you can register to attend. You can also apply to invest in The Montgomery Fund.

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