This article appeared in the November 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.
By Roger Montgomery, The Montgomery Fund
This is the second part of a three-part series in value investing. ASX Investor Update readers can obtain a free download of his Full Three-Part Investing Guide booklet.
Frequently, value investors focus only on the value part of the eponymously labelled investment philosophy. Our attitude at Montgomery is relatively simple and one we advocate for individual investing: if we are not happy to own the entire business for a decade, we will not be comfortable owners of even one share for just a few minutes.
In other words, because we are not in the business of betting on the rise and fall of stocks, we need the economics of the business - measured over years - to justify a purchase and estimate a valuation.
In 2010 on the Sky Business network, the business commentator Peter Switzer asked me whether I thought the hiring of John Borghetti - a deservedly highly regarded manager and business leader - as CEO of Virgin Australia Holdings would make me change my mind about the business. With his exceptional experience in the industry and his obvious ability to motivate partners, employees and suppliers, would I be willing to concede that the fortunes of the airline had improved?
With great respect to Mr Borghetti, I noted that it did not matter how hard he rowed, the business boat he was rowing had an irreparable leak. A whopping great hole in the side - a function of conditions in the airline industry such as irrational pricing and uneven playing fields - would stymie the efforts of even his expertise.
Peter replied with words to the effect: "Thanks for that Roger… coming up after the break, Mr John Borghetti." Cue uncomfortable greeting as John replaces me in the guest chair.
Despite the discomfort, no apology should have be required and none was requested - because John knew that he, like most if not all, airline CEOs, would indeed need to produce a herculean rowing effort to keep the tide of the business's economics at bay.
If there is anyone who can turn the ship around it will be John and his team, but it is worth revisiting Warren Buffett's warning for excellent managers generally: "When a management with a reputation for brilliance tackles a business with a reputation for poor fundamental economics, it is the reputation of the business that remains intact."
And Virgin's latest performance and trading update revealed that even the best airline CEOs, like John Borghetti, might have more success holding back the tide than permanently changing the economics of the airline business.
Perhaps that is why Warren Buffett also noted in 2007: "The worst sort of business is one that grows rapidly, requires significant capital to engender the growth, and then earns little or no money. Think airlines. Here a durable competitive advantage has proven elusive ever since the days of the Wright Brothers. Indeed, if a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favor by shooting Orville down."
This is not a recommendation to buy or sell the shares of Virgin or any airline, but what I hope to achieve with this column is the transfer of an understanding about how to go about uncovering the economics of a business as it relates to the owner's relationship with it.
I hope you will see that even if the business grows its equity, its revenue, its customers, the number of flights flown and the number of aircraft in the hanger, that growth is not always good.
That means that before buying any business, you must understand what the real returns to an owner are. Such an understanding, of course, need not concern the speculator or market trader who merely wants to purchase any stock that is going up. That is not investing.
You may ask why any such analysis is required when dividend yields, price-to-earnings ratios, and sales and profit forecasts are so ubiquitously offered by any number of desk-bound airline experts, all willing to encourage you to compare their understandings of load factors, passenger yields and even seat densities.
The reason only becomes obvious when it is highlighted. The nexus between ownership of a business and the economics of the business are broken by the sharemarket itself.
An individual who owns 5000 shares in BHP Billiton does not, over any memorable period, experience what it is like to actually own the business outright. The sharemarket makes sure that distracting rising and falling share prices divert the focus from profits and capital expenditure. But there's more…
Consider the company that perpetually dilutes its owners by raising fresh capital for acquisitions.
A shareholder receives a prospectus in the mail inviting them to participate by, for example, taking up an entitlement to 15,000 additional shares at a discount to the recently traded price. This clearly seems like a delightful turn of events and the shareholder gladly stumps up the cash.
But when aggregated, the additional equity may massively dilute the owners, the returns, or both, and the effects will not be felt until well down the road and perhaps even after the CEO and board have all been turned over.
The following example, which uses Virgin Australia Holdings, will attempt to do two things. First, bring the economics of a business back into the decision-making phase of investing, and second, reveal that Virgin's latest woes are symptomatic; not of one-off special circumstances, but of the unchanging structure of the industry and competitive landscape in which it is forced to operate.
Suppose the year is 2003 and I ask you to consider an information memorandum to invest $184 million in a new business. Write a cheque for $184 million and to make sure we have enough to get going, let's run down to the bank and borrow $139 million.
One year later…
After a year in business, suppose I report to you the first year's profit of $110 million. Given you invested $184 million, I suspect you are delighted with the 59 per cent return on your funds after one year. Encouraged by these early returns, let's propose you leave me to run the business for you for the next decade and you return in January 2013 to receive reports on the progress of the business.
The first piece of news you receive is that the profit has fallen. For the year ending 30 June, 2012, the profit was $43 million - less than half the profit generated a decade earlier. For 2013 the company reported a $98-million loss including "one-offs", which if you owned the business outright, feel less like one-offs and more like real losses.
That's not good news. However, the story is more complicated. You might recall that in 2003 you made a capital contribution of $184 million to kick the business off. Since then you have made additional contributions directly in the form of capital raisings and indirectly through the retention of earnings.
All up you have increased your total contribution to more than $900 million. And remember, your profits have now more than halved.
Even though you have been tipping more and more capital into this venture, the returns have been declining precipitously. That 59 per cent return on equity is but a distant memory and you are now earning less than bank interest on your money.
But before you get too depressed, remember that money you borrowed in 2003 - it was $139 million. You may have hoped the earnings of the business have helped to pay off that debt. Well, there's a shock for you - you now owe the bank $1.7 billion. You would have expected that borrowing money would lead to growing earnings and returns. In this case it hasn't.
Why? Because the business is an airline. In this example I have used Virgin Australia Holding's reported numbers. Importantly, as Warren Buffett suggested, the economics of airlines change little - and history currently suggests they rarely change for the better.
Perhaps Virgin might be the exception.
Warning signs to watch
Generally speaking, capital intensive, labour intensive, irrational competition, a price taker for inputs and commoditised product offerings. It all means that measures such as load factors, passenger yields and cost per available seat mile (CASM) are about as useful to an investor as a microscope is to an astronomer.
Looking at businesses as described has enormous and favourable implications for investors willing to consider an entirely different approach to markets and investing.
Ben Graham, the intellectual dean of Wall Street, noted that in the long run the market is a weighing machine - that price follows the economic performance of the underlying business. If we take a look at the share price of Virgin, we observe that in 2003-04 the share price was above $2.00. Today it languishes below 45 cents.
An investor in Virgin shares would have experienced an economic calamity over a decade proportional to the individual who owned the entire business. This is why an investor unwilling to own the whole business for 10 years should not own a little piece of it for 10 minutes.
Now recall the popular investing advice that implores you to invest for the long term. Time is only the friend of the extraordinary business; it is the enemy of the business with poor economics.
The longer you remain invested in a business with wealth-eroding economics, the more you will lose - be it opportunity or money, or both.
About the author
Roger Montgomery writes as Chief Investment Officer at The Montgomery Fund. Access a free download of his Full Three-Part Investing Guide booklet.
Revisit Roger's latest ASX Investment video 'Value nvesting with the experts'.
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