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Value opportunities

This article appeared in the April 2013 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.

This leading value investor gives his view on whether the Australian sharemarket is cheap or expensive; provides tips on how to beat the market return; and lists three high-quality companies worthy of further investigation.

Photo of Roger Montgomery By Roger Montgomery, The Montgomery Fund

When I wrote in last December's ASX Investor Update about the prospects for 2013, The S&P/ASX 200 index was at 4361 and about 35 per cent below its peak reached in late 2007. We were as bullish as we had ever been so I hope you were paying attention.

(Editor's note: Watch Roger's ASX Investment talk on value-investing principles).

Although you needed to read my entire article to understand the reasons for the enthusiasm and bullishness at the Montgomery office late last year, the message was simple:

"Today's valuation is better than it was then, suggesting the prospect of considerable growth from here, for those with a long-term view … It is currently possible to find good-quality companies whose value is not fully appreciated."

The Montgomery [Private] Fund's biggest position over the past six months has been SEEK. Figure 1 below shows its recent price performance. The reason to display it is not to boast, but rather to help answer an important question: should you be investing in shares now?

With the S&P/ASX 200 index now sitting at 5117 (at time of article submission), having risen 17.3 per cent since last November, and with many stocks we like having risen substantially, there are probably only two questions to be asked.

For those invested: should I take profits?

For those who did not hear the bells ringing in November letter: is it too late to buy?

Figure 1.  SEEK Price Chart

Seek price chart - March 2012 to March 2013

Source: Bloomberg

To begin answering these questions, I'll start with the big-picture fundamentals. The Australian economy looks pretty good. I don't mean the economist's view of the economy, but the coalface view.

Speaking with an owner of many major shopping centres, I discovered that retail tenant sales turnover has been improving since October. Gerry Harvey told me in March that sales for February were just as good as January, if not better.

VFacts car sales numbers are through the roof. New car sales in February were up 5.2 per cent year on year, and year-to-date sales to March were tracking 8.2 per cent ahead of the same time last year.

On top of all that, some bank-published reports have revealed improving consumer confidence.

The official data indicates that Australia is growing at close to trend rates, there is no sign of inflation pressures, and housing construction is reviving.

Market risks

So what are the risks? One of the big risks, we think, is in the resources sector. Look at the long-term chart of iron ore in Figure 2 and you will immediately notice the very long period that prices traded at less than US$20 per metric tonne (mt).

Indeed, for two decades between 1983 and 2004, prices never traded above US$20/mt. Then, between December 2004 and February 2011, iron ore prices surged from US$16/mt to US$187/mt. This rally, of course, triggered a very large mining investment and construction response.

Figure 2.  Chart of China imports iron ore fines, 62% FE spot (CFR Tianjin port), US dollars per dry metric tonne

Chart of China imports iron ore fines - February 1998 to February 2012

As prices started rising, an increasing number of new mine and mine extension projects were commissioned. Even those that might have previously been unprofitable were commissioned and a mining investment boom began.

The long lead times between commissioning and ore production ensure that the supply response will be some years hence, but it will come. And just as product is about to enter the supply chain, prices are falling.

In the first half of the 2013 financial year, lower commodity prices (as well as a higher dollar) cut profits for BHP Billiton to $US5.7 billion. This was a massive 43 per cent lower than a year earlier excluding writedowns and down 58 per cent including writedowns.

Rio Tinto fared worse, reporting a full-year net loss for 2012 of almost $US3 billion after recognising writedowns.

The impact of any further declines in the price of iron ore will spread well beyond the miners. Mining services companies will be particularly hard hit as less work means greater competition for fewer projects, driving margins lower.

One of the highest-quality mining services companies is Monadelphous - a company that has increased earnings per share every year by an average 37 per cent per annum over the past decade. At this year's profit announcement the company reported it expected revenue growth to slow in the 2013-14 financial year, describing it as a "year of consolidation".

Is the market cheap or expensive?

With a basic picture of 2013's areas of opportunity and risk laid out, one of the next possible steps is to look at the market generally and decide whether it is expensive or cheap. But assessing whether value exists in the market is different to predicting its direction.

Just because the market is assessed to be cheap does not mean it will not get cheaper. Similarly, a finding that the market is expensive does not mean a crash is imminent.

At The Montgomery Fund we believe an objective assessment of value is a good foundation in framing an attitude towards equities.

At the end of last year I noted we had conducted some analysis to better understand the value currently on offer in the Australian market.

Part of our investment style - which I believe you should consider for your own investing - is we believe that a true valuation must be completely independent of the price. A valuation should be used to compare the price. If the valuation has price as an input, you are simply comparing price to some other form of price.

This is possible in a supermarket, where the price in one store can be compared to another. But in the sharemarket there is only one price. Therefore, it must be compared to something else, and I propose comparing it to "value" or "worth".

It follows, then, that the least informative commentary about whether the market is expensive or cheap is that which observes the market is well down from its highs. Not only could profits have changed since then, but so could the components of the index and even their weighting.

To be clear, I don't see much need to forecast the sharemarket and you will not find me publicly suggesting the S&P/ASX 200 will be at such and such a level by some future date.

You can be a successful investor in the long run without being a successful market or economic forecaster. Instead, what we do is estimate future intrinsic values based on company profitability, justified by fundamental values. Unlike forecasting the entire market, and all the possible influences, including sentiment, it is possible and practical to assess an individual business.

Then, from the compilation of facts, an estimate of past, present and future valuations are possible - and something we introduced to Australia.

Obviously, it is not possible to be precise - by its very nature intrinsic value is an estimate - but it is possible to produce a reasonable range of probabilities that are rational.

In the first example (Figure 3 below), Skaffold simply appropriately weighted and aggregated the valuations of the biggest 200 companies. The aggregated valuation is then plotted against the S&P/ASX 200.

Figure 3 reveals the sharemarket to be a little expensive. The thick stepped line represents Skaffold's estimate of intrinsic value in the past and into the future.

You can see that over the long run there is a good correlation between price and value. Over the long run, price tends to follow value.

Currently, Skaffold's intrinsic value for the ASX 200 Index is rising but the market appears to have moved a little ahead of value. For any further gains in aggregate share prices to be sustained, intrinsic values would also need to rise further. For this to occur, we would need to see further earnings upgrades. If price gains occur and valuations do not correspondingly rise, the risk of a setback is heightened.

Figure. 3.  ASX 200 Price versus Value

Chart comparing the ASX 200 index price and intrinsic value since 2003
Source:  Skaffold

Speaking with analysts in March, I realised that a common theme in the stockbroking community is that the big-cap blue chip companies are now expensive. Their conclusion, therefore, is to start scouring the smaller companies.

However, with the Montgomery [Private] Fund having significantly outperformed the market over the past two years by investing in smaller highest-quality companies, we can assure you that market prices for smaller companies do not now appear in aggregate to be cheap.

Indeed, in our experience the smaller companies rallied in advance of the big-caps - the latter being fuelled by the chase for yield.

Choosing the best stocks

Beating the market returns requires a disciplined focus on only the highest-quality companies.

By highest quality we mean those with strong balance sheets (look at to find out more), good economics and vibrant financial performance. We ignore businesses that do not meet these criteria, so some care is needed in extending our conclusions to the market as a whole. This means that if we discover the market looks expensive, it could be that lesser-quality issues may still have a long way to run.

The first step was to select a group of companies that have held reasonably consistent quality and performance scores over an extended period. By automatically and objectively rating every company from A1 to C5, we are able to avoid many of the issues that befall inexperienced investors. Recent collapses such as Gunns, Hastie Group and Becton were all rated C5 and therefore sub-investment grade.

Among those we did include were some of the larger, well-known companies such as Woolworths, Cochlear and Commonwealth Bank, as well as a number of worthy smaller companies.

Every six months 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 analysed the same group of companies (all of which are steady performers) with the same weightings and in a uniform way.

The output from this work is Figure 4 - 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.

Figure 4. Portfolio safety margins

Chart that compares the estimated margin of safety for a portfolio across different time periods
Source: Montgomery Investment Management

Generally speaking, when the market is expensive, the margin of safety is low or even negative. Because the chart is inverted, this displays as 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.

What the graph in Figure 4 shows is that the market for quality companies is, today, more expensive than it has been at any time since the GFC. But if we extend the analysis to include the period before the GFC, we find that it is not as expensive as it can get and there may be significant upside still to come.

In essence, what we believe is that the higher-quality companies our investors are invested in are more likely to upgrade their earnings in coming months than not. As a result, their intrinsic values could rise and further share price gains for these very highest-quality companies are quite possible.

I am not presenting a broad-based bargain basement bin, but selective high-quality companies such as these three: Codan, The Reject Shop and Ainsworth Gaming* may be worth further investigation.

About the author

Roger Montgomery is the founder and Chief Investment Officer of The Montgomery Fund and a director of Skaffold. *The Author's associated entities holds shares in the companies listed.

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