This article appeared in the December 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.
See this leading value investor's top 10 holdings and why Roger believes that price follows value.
By Roger Montgomery & Tim Kelley, Montgomery Investment Management
As I write, the S&P/ASX 200 Index sits at 4361, some 35 per cent below its late 2007 peak, and it is five years on from the start the GFC. There have been some profound changes to the Australian sharemarket in that time.
As well as the more obvious effects, such as the terrible damage to retirement savings and the demise of several prominent corporate names, there have been some important changes to the psyche of the market. One significant development has been a marked shift in investor attitudes towards risk generally and the merits of equity investing in particular, on which I want to focus.
An ability to learn from our mistakes is central to success in many fields. Einstein's definition of insanity was doing the same thing over and over again and expecting different results. When applied to the woeful performance of the past five years, a natural drive to avoid past mistakes has prompted a reappraisal by investors of their participation in equities:
- those who might previously have sought share exposure in excess of 100 per cent using margin loans now have a significant part of their capital in cash
- annuity-style products have surged in popularity, helped by advertising that plays on investor fears
- capital has flowed apace into hybrid securities that offer no prospect of equity upside, plenty of equity downside risk, but present lower perceived risk than ordinary shares.
In light of market experience, it comes as no surprise that investors today approach equities with trepidation. To continue do otherwise would be indicative of … insanity.
The problem with this logic is that it is may be completely wrong. Insanity per se is not a helpful part of an investment process, but a capacity for independent thought definitely is. The ability to disagree with popular opinion, where that disagreement is based on sound reasoning and analysis, can be a powerful contributor to long-term investment success.
The crystal-ball season
As we approach 2013, we will start to see opinion coalesce around the prospects for the market over the coming 12 months, and a range of market commentators will offer views on where they think the index may stand at year's end.
I can't say with any confidence what the market will do over the next year, and I expect that the number of people who can is getting smaller and certainly smaller than the number of opinions published. However, I do have a perspective on the longer-term merits of the Australian market.
What I can say with some confidence is that in the long run, markets follow value. That is, if you invest at a time when valuations are broadly favourable, you can reasonably expect a tailwind. If you invest when valuations are stretched, you will face some headwinds.
The recipe is simple: The higher the price you pay, the lower your returns.
It follows that an objective assessment of value is a good foundation in framing an attitude towards equities. With that in mind, we have been doing some analysis to better understand the value currently on offer in the Australian market.
In looking at the question of whether the market is cheap at present, we found the answer interesting.
Your attention please
Before we proceed, there is a short safety demonstration. We have a single-minded focus in our investing and this affects the way we approach the analysis and the way you should interpret it. In particular, we are interested only in the highest-quality companies listed on ASX: those with strong balance sheets, good economics and vibrant financial performance. We ignore businesses that do not meet these criteria, and care is needed in extending our conclusions to the market as a whole.
Table 1. The Montgomery Fund, Top completed holdings
|Company name||Montgomery score||Return on equity (%)||Net debt/ equity (%)||Price/ earnings (X)|
|Credit Corp Group||A1||23.5||(2.3)||12.1|
Source: Montgomery Investment Management
Let's move on to methodology. In looking for investment opportunities, we employ automated computer models that gauge the quality, performance and value of every company listed on ASX. These models are completely consistent and objective - each company is valued the same way every time, with no emotional bias.
For the purposes of working out how effective the models are, they can also be applied retrospectively; that is, to estimate the value of a company at a nominated earlier point in time using the information that was available at that date (including any broker forecasts as they were at the time).
By going back in time we can see whether the models worked and for the purposes of this discussion, see what conclusions might have been made.
We have structured an analysis as follows:
- We selected a group of companies that have held reasonably consistent quality and performance scores over an extended period. These included some larger, well-known companies such as Woolworths, Cochlear and Commonwealth Bank, as well as a number of worthy smaller companies.
- At six-month intervals starting in 2002, we calculated the intrinsic value of each company (where possible) and compared the value of an equally weighted portfolio of these companies with its market price. The result is an indication of whether the group was cheap or expensive at each point in time.
This approach has the benefit of consistency. At each point in time we are analysing the same group of companies, all of which are steady performers, with the same weightings and in a uniform way.
A drawback is we cannot extend the analysis as far back as we would like. Few companies maintain consistently high quality over multiple decades, and the further back we go the more gaps appear in the electronic databases that feed the models. It would be fascinating to see what the numbers would have looked like in 1987, but the data is lacking. Even where the data is complete, the results are approximate at best.
The output from this work is a chart that compares the estimated margin of safety - the gap between market price and our estimated value - for the portfolio across the different time periods, as set out below. To make it easier to understand, we inverted the chart. For reference, we have also set out the S&P ASX 200 Index over the same period.
Generally speaking, when the market is expensive, the margin of safety is low or even negative. Because the chart is inverted, this shows up with the red line appearing in the top half of the graph. Generally, when the market is estimated to be relatively "cheap", the red line will appear in the lower half of the graph.
Exhibit 1: Estimated value
Source: Montgomery Investment Management
Exhibit 2: S&P ASX200 index
Source: Montgomery Investment Management
Interpreting the results
A number of observations emerge from Exhibit 1. First, if we focus just on the post-GFC period, one legitimate view is that prices are expensive relative to March 2009 and September 2011. Notwithstanding a slight pullback in early November, the valuation metrics now are less favourable than at any other time since 2008, with the exception of March 2010. As shown in Exhibit 2, March 2010 did not prove to be a good time to invest. Prices today are the dearest they have been since 2008.
On a longer-term view, the picture is different and contradictory. Although current valuations seem expensive compared with recent history, they appear favourable in the context of the full 10-year span. Before the GFC, the cheapest point in the time series was 2003 and that proved to be a very good time to buy. Today's valuation is better than it was then, suggesting the prospect of considerable growth from here, for those with a long-term view.
Alert readers will point out that the world has changed a lot since the GFC, and the prospects for economic growth have dimmed considerably, hence lower valuations today are entirely justified.
There is certainly some merit in this reasoning, but within limits. The mood of the sharemarket is quite sensitive to near-term economic growth prospects, but underlying valuations are more stable, particularly for the consistent performers our company selection models throw up. The value of these businesses is governed less by next year's earnings growth and more by what they may achieve over a decade or more. Our ability to predict economic conditions over the relevant timeframe is limited, to say the least, and so it should not greatly influence an assessment of intrinsic value.
The conclusion that we lean to is that, although the best opportunities presented by the GFC may be behind us, this does not mean the market should now be declared expensive.
Positioning for 2013
If you have followed our thoughts over the years you will know that our unique approach to investing helps to identify some extraordinary opportunities, and collectively these have served investors in both The Montgomery Fund and The Montgomery [Private] Fund well.
With the sound of the GFC still ringing in investors' ears, a natural response has been to seek shelter in fixed interest or other perceived safe investments, and to remain there until a recovery has clearly presented itself. The problem with this approach is that you will pay a much higher price for a cheery consensus. For those that do venture into equities, the comfort of a high dividend yield has been preferred to aspirations for total return.
At Montgomery Investment Management, we place ourselves very much in the cautious investor category, but we think this means understanding and measuring risk, rather than retreating from it. If we can find sufficiently attractive opportunities, our preference is to be on the front foot in pursuit of them.
For 2013, our approach can be summed up in a few key principles:
- first, fixed-interest returns are simply not good enough for anyone with a medium to long-term outlook. After inflation and taxes, a long-term investment in fixed interest guarantees a poor outcome
- second, the future returns on equities will be determined more by value than by recent past performance. In this regard, a fall in prices should prompt increased, rather than decreased, focus
- finally, for enterprising investors, the market currently offers a lot of possibilities. It is possible to find good-quality companies whose value is not fully appreciated, and our job is to find them.
About the authors
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