Valuing Companies Part 1

Without going into enormous lengths, I thought I would talk a little this week about my process in deriving intrinsic valuations of companies I consider for investment.

Like most value-based investors, my methods draw heavily in most cases from using discounted cash-flow (DCF) analysis.  I have heard using DCF described as more art than science, where the cash flows can be accurately forecast, this is not the case, but in the case of forecasting earnings for companies, this is rarely the case.  Calculating intrinsic valuations based on blue-chip companies are generally easier than when focussing on the small end of the market.  The big 4 banks for example or ASX20 companies like Woolworths, Origin, Telstra, Brambles or AMP are quite stable and can be extrapolated forward with some confidence. Others in the ASX20 might be a little more troublesome, CSL for example has had meteoric (but slowing) growth, picking future growth and a suitable multiple is troublesome.  QBE as an insurer can be hard to assess and the miners (BHP, RIO & NCM) can be harder to predict because of commodity prices and currencies across multiple countries of operation.  These are the 20 biggest public companies in Australia and the market still misprices them regularly.  I have been a long-term bear on Telstra, though their price is much fairer now.  I have been for a good while bullish on QBE. QBE have struggled a little over the last couple of years with the strong AU$.  Putting the currency aside, it’s an outstanding business, run by able and shareholder-oriented management, trading a good measure under what I would consider their intrinsic value.  Despite this, it takes the recent announcement by QBE of an acquisition, which in terms of the size of the company is far from material and is unlikely to change EPS going forward by more than about 1% and since then, their share price has run up 10.5% (at time of writing).  Go and search globally and see how many insurance companies of comparable size and security you can find that are currently 1. Yielding over 7%, 2. Trading at a multiple of 13x or less, 3. Have doubled their EPS in the last 5 years, 4. Have a combined ratio of consistently less than 90% and 5. Provide a return on equity of 20%.  If you find such a company, I’d like to hear about it.  That said, as always, I state, despite being clearly undervalued, I maintain, far more deeply undervalued companies exist in the smaller end of the market.

DCF, coupled with consideration of underlying asset values and myriad other qualitative factors helps me arrive at my assessment of a company’s intrinsic value.  The ability to completely independently assess intrinsic values has proven critical to defending and then substantially growing my family’s assets through the recent downturn.  I will not go into too much more detail than that (I will expand a little next week).  Plus the methods I use are something of a proprietary knowledge of mine, which we will share with others through the establishment very shortly of EGP Fund No. 1.

What led me to decide to talk about valuations was my fairly recent purchase of a tiny parcel of shares in a company called Astron (Ticker code - ATR).  I have been following this company since 2007, when they sold their business in China and started to move from being an end user of mineral sands products to a mineral sands producer.  When a company completely changes its direction, the market is usually understandably cautious.  If you scour through the companies at the smaller end of the market, it is not difficult to find companies that went from being technology focussed around 2000, to becoming pharmaceutical or biotech companies after the ‘tech wreck’, that have again morphed into mining exploration companies since the mining boom started.  Astron are different.  For starters, they hold a bank balance of $166.5m in cash.  The market capitalisation of the company (at time of writing) is $160m.

Basically, when you buy $1 of ATR, you are buying $1.04 of cash.  What you get ‘for free’, are substantial Chinese business interests/contacts and a JORC resource nearly half the size of Australia’s largest Mineral Sands producer Iluka resources (ILU – a $3.94b company), or only marginally smaller than Mineral Deposits Limited (MDL – a $315m company), a Senegalese prospect at a similar stage of development, on the point of preferred placement, I concur with Dorothy of Oz, “There’s no place like home”.  ATR face challenges, it will cost about $300m to develop the Donald Mineral Sands into production, but given their good cash balance and relationships with big players such as POSCO (third largest steel manufacturer in the world), it would seem pretty likely that the project gets off the ground.  To my mind, the fact that ATR is trading up over 30% on its 12-month lows is evidence the market frequently gets it wrong (i.e. they traded at less than 2/3’s of the cash they held).

I hold only 7.5% of my family holdings in ‘speculative’ stocks – everyone needs a little excitement in their lives.  I think by ATR meeting my definition of a speculator, you get some comprehension of my idea of risk management.  By the way, if anyone has a $100,000 term deposit, I would be happy to buy it from them for $96,100, which is the virtual equivalent of buying ATR, except I don’t get substantial mineral and business potential thrown in for free. – Tony Hansen 21/02/2011.

Shareholders Best Interests Part 2

Before I start, I want to add a caveat on comments I make when describing/valuing companies.  About 3 months ago, in my post here, I described the big 4 banks as having 2 classes, with WBC & CBA representing better value than ANZ & NAB.  Since then, the share prices of CBA & WBC (including dividend to WBC) have appreciated by 14.04% and ANZ & NAB have appreciated (including dividends to both) by 4.97%.  Under these circumstances, you must be sure to note the time when comments were made allow for any share price movements in the intervening period.  To clarify my position here, I would say that despite their combined $275b girth, you could now throw a blanket over them in valuation terms.  I would say it is improbable that the 4 will outperform the indices over the longer term (5 or more years).  I would be disinclined to single one out, but with a gun to my head, I would probably nominate WBC as most likely to lead the pack over the medium to long term.

Back to best interests… For Australian listed companies (who earn a substantial proportion of their profits at home), another routinely mishandled (by management) area is franking credits.  Franking credits are worthless to the companies that own them, but enormously valuable to the majority of shareholders, in particular retail holders with a marginal tax rate of less than 30% and super funds.  The most commonly cited franking credit hoarder is HVN (Harvey Norman), whose franking credit account held about $620m, or about 58.5 cents per share.  In order to pay out this full balance in the form of a fully franked dividend, they would need to pay about a $1.36 dividend.  This seems hardly practical based on a share price of $2.97 at time of writing, so obviously another tack needs to be found.  I suspect that Gerry Harvey had expected that his forays into foreign markets would solve this problem.  That is to say with a substantial proportion of profits earned overseas, the balance would be eroded by continuing to pay fully franked dividends.  These ‘International Profits’ have evidently been harder to come by than expected, though in time this choice may work out.

One outstanding recent example of a clever application of capital management, which successfully found a way of returning substantial franking credits to shareholders, whilst still enhancing shareholder value was this recent initiative by WOW (Woolworths) here. Now granted, Woolworths are facing some headwinds in the way of a rejuvenated Coles and weaker retail conditions, but you would be hard pressed to find an ASX50 company that has used capital management to better effect for its shareholders over the last 10 or so years.  To contrast, about 3.4% of WOW share price sits in the franking account, whereas about 19.7% of HVN share price is in the franking account. I stress, these credits are worthless to the companies, but invaluable to many shareholders.  I have no financial interest in WOW (or HVN) by the way.

To explain the benefits of the WOW plan, I will lay it out in brief. At the time the share-price was trading at about $29.80, the buyback was conducted at a 14% discount ($25.62), so shareholders who elected not to participate were immediately benefited by having a portion of the shares eliminated at below market cost to the company.  Those who elected to participate received $3.08 in capital component (so if you’d bought your shares at $15.08, you had a $12 per share capital loss to use against future gains).  They then received the remainder as a $22.54 per share fully franked dividend, which of course, carried a $9.66 franking credit.  This means holders who took this option received $35.28 (18.4% above market prices) in total value.  This was obviously chiefly beneficial to shareholders in lower income tax brackets and superannuation funds, but as I pointed out, longer-term shareholders also benefited by eliminating shares at a discount to prevailing market prices, thereby strengthening, or concentrating their shareholding.

Another recent example of cleverly returning capital to shareholders was in the recent special dividend by FFI Fresh Food Industries (disclosure – my wife has a small holding of FFI).  They announced a fully franked 50 cps special dividend, with a new DRP at a large 10% discount, virtually forcing all shareholders to participate, but when a management can average an 18.1% return on equity through the GFC, you have reason to believe they will be able to put the additional equity to work at reasonable returns.  They put about 1/3 of their franking balance where it belonged (in shareholders hands) and substantially improved liquidity on a small and fairly illiquid stock.  This type of owner oriented action is what I scour the bourse for, and it usually comes in situations like FFI, where the board and senior executives are substantial owners, take salaries that are eminently reasonable and consistently act with the best interests of shareholders at front of mind.  If you enjoy reading annual reports (there are only a few of us), I can commend you to this one (FFI’s) as it displays, in my opinion a clarity and directness in communication that you see too infrequently with leading Australian corporations - Tony Hansen 14/02/11

Shareholders Best Interests Part 1

To many people, the biggest issue with regard to CEO’s and Board’s of listed companies acting outside of shareholder interest is ‘Executive Remuneration’.  I admit I have never been a particularly strident critic in this area.  By this I mean that though I do think CEO pay packets tend to be higher than justifiable, I respect the market mechanism that makes the decisions and I am mindful that on a global scale Australian CEO’s are generally in the lower percentile bands for remuneration (for companies of comparable market cap).  If shareholders become agitated enough, there is change. There are many flaws in this area, but I don’t agree it is as out of control as people (mostly the popular press) think.  If there is one aspect of executive pay that does make my blood boil, that is the re-pricing of options.  If a CEO makes an agreement about their pay, there should be no prospect of re-pricing the terms of that agreement at a later date, if conditions turn out to be more challenging than was thought at the time of negotiation.

For Australian listed companies, my number one bone of contention is capital management.  In a well-run and profitable established business, substantial cash flows will be produced and the decision as to what to do with these funds (in combination with strategy) is probably the CEO and board’s greatest responsibility.  Invariably, CEO’s will default toward the prospect of mergers and acquisitions (M&A), and it is in this area the greatest folly usually occurs.  Integrating two businesses, if done well can substantially enhance results, for even when a full price is paid for a business, there are usually substantial savings to be garnered through eliminating duplicated functions.  However, there is substantial evidence that the majority of M&A fail to generate anywhere near the expected benefits.

The reason CEO’s still default to M & A, despite the difficulties is often ‘empire building’. Empire building is a human instinct and is usually very powerful among the type of individuals who run corporations.  It is not only the empire building instinct, but a dose of self-interest, caused by the fact that a CEO who runs a $500m corporation that earns $2 per share in profits will inevitably have a larger pay packet if he grows his company to a $2b company, even if it still only earns $2 per share.  This is where the board must do its job and ensure the incentivisation of executives enhances earnings per share, but pays minimal interest in growth for growths sake.

One outstanding recent example of a clever capital management strategy, which caused me to choose this blog topic is the “Bonus Share Plan” – BSP announcement described here in the announcement by CWP (Cedar Woods Properties).  I should disclose here that my wife owns shares in CWP.  Disregarding my opinion that they represent very good value (even though their share price has nearly doubled in the last 6 months), the reason I like this announcement is because of the flexibility it gives shareholders in how they receive their funds from the business.  You can either use the BSP to add new shares to your original cost base, which is what you would do if you were in an Income Tax bracket that was higher than the corporate tax rate.  Alternatively you can take the dividends or use the Dividend Reinvestment Plan, in which case you would receive the franking credits, which you would obviously do if your shares were in a super fund, or you were in a tax bracket below the corporate rate.  It would require considerably more explanation here just why this sort of option is a massive boon for shareholders, but suffice it to say this sort of shareholder-oriented action periodically strengthens my faith in corporate Australia.

The thing I found singularly most upsetting at the lows of the financial crisis was the dearth of share buy-backs and opportunistic acquisitions by those companies that had been foresightful enough to retain cash (rather than having every penny of leverage their permissive lenders would allow).  Boards and CEO’s seem to have a perverse need to have their decisions justified by a buoyant market, when of course the best results would be achieved when moods are more subdued. - Tony Hansen 07/02/11

Analysts Top Picks

I am frequently critical of the funds management industry, as I pointed out in my post, routinely, when you factor fees into the equation, over 80% of managers fail to beat the most suitable benchmark.  The key reason for this is fees & charges, of course, but it at least warrants consideration of how useful the advice of brokers/analysts in general is.

I found this article on the US version of the MSN-Money website.  It ably demonstrates the issue I have with broker recommendations, which in-turn reflects on the fund management industry.  It points out that the 10 stocks analysts hated most routinely beat the 10 stocks analysts loved best.  In thinking about this article, you may decide a contrarian position is likely to be more profitable.  I tend to often agree, but my opinion is most ably captured in the quotation from A. A. Milne (Author of Winnie the Pooh):

 

"The third-rate mind is only happy when it is thinking with the majority. The second-rate mind is only happy when it is thinking with the minority. The first-rate mind is only happy when it is thinking.”

Rather than trying to think with the majority, or the minority, I try hard to be completely objective when examining an individual stock for investment purposes.  This can be hard to do with very popular stocks that get a lot of coverage, but it can definitely be done.  By far, however, the easiest way to ensure your analysis of a stock is not ‘coloured’ by others opinions, is to spend much of your time examining stocks in the area of the market that analysts and the financial press virtually ignore.  The very best discoveries are there and await the inquiring mind.  I thought it might be worth having a look at some highly regarded analysts selections for 2011 in Australia. To have Goldman Sachs Picks for 2011 are attached.

For those of you who couldn’t bother opening the link, the picks were (same order as the article, I’m not sure if it was a preference order):

1. AMC – Amcor.  Amcor over the last 5 years have reported earnings per share (EPS) of $2.04.  Over the 5 years prior to that, they reported $1.96.  To my way of thinking, for a company to justify a P/E multiple 17.17, which is about 20% above the market, they must show better historical performance, or brighter future prospects.
2. BHP – BHP Billiton.  It’s hard not to expect, barring a major collapse in the world economy, that BHP will do better than the broader market over the next few years.  But it must be remembered that BHP are the 4^th biggest company in the world (By Market Cap) and as well as they do, many smaller, more nimble companies will do better.
3. JHX – James Hardie.  I am agnostic here; lumpy sales and earnings, in a difficult business make analysis difficult.
4. NWS – News Corporation.  I have been a long-time bear on NWS, however, they have migrated their business substantially away from newspapers and can probably be expected to marginally outperform the market over the coming years now they are trading on a more sensible P/E multiple.
5. QAN – Qantas.  I say no to airlines as a general stance.  Qantas are one of the best in the world, but as a long-term investor, best avoided.  If they ever divest their frequent flyer program, then the rest of the business should be strongly avoided.
6. AIO – Asciano.  Trade on too high a multiple due to ambitious forward earnings expectations.  Hard too imagine them beating the market over the next few years.
7. CPU – Computershare.  At $10.10, there is probably a lot more upside than downside in the longer term with CPU.  If the next couple of years (as generally expected) turns out to be strong for M & A, they will do better than the broader market.
8. LLC – Lend Lease.  $10,000 invested 5 years ago here would now be worth $7861.  LLC have been a huge disappointment, nothing tells me they are likely to do much better than the broader market over the next few years.  I don’t think they will under-perform as badly as they have historically either.
9. OST – Onesteel.  I like OST, they have been an historically excellent performer, with management that acts generally in shareholders best interests.  I do not like their industry. Chinese, Korean and Indian steelmakers have considerable competitive advantages & input prices will squeeze margins.  Still, likely to out-perform over the medium term.
10. WPL – Woodside.  Hard to bet against the energy industry.  I think over the medium to longer term, WPL will do well.

 The 10 selections are not terrible, and depending on how well the best 2 or 3 go, could even slightly outperform the market.  But going back to my earlier point, the safest route for anyone who can ably analyse the future prospects and financial reports of a company is to look where less people have already looked (i.e. outside the top 150 or so companies). You are less likely to find a gem looking under a rock where dozens have already looked; you need to find the rocks that haven’t been looked under.

The most important thing is to deeply and critically analyse any potential investments regardless of popular opinion, or invest with someone who is properly incentivised to do just that.  To do anything else would be to risk being known by another A.A. Milne quotation as “A Bear of Very Little Brain” – Tony Hansen 31/01/11.

The Importance of Benchmarking

The S&P/ASX200 TR index (my preferred benchmark) finished calendar 2010 at 34,518.53 points.  If you are a market follower, you will have heard many commentators saying the market was down in 2010.  This is a mistake often perpetrated on an unsuspecting market by an (in my opinion) uninformed ‘commentariat’.

The S&P ASX 200 did finish calendar 2010 down 2.57% on its 2009 finish, however the S&P/ASX200 TR index finished up 1.57%.  How is this? Well this simply means that dividends accounted for 4.14% of the total return for the ASX200 in calendar 2010.  This is not a new phenomenon, Australia is, and has been for some time one of the highest dividend paying share markets in the world.  The difference between the Price (S&P/ASX200) & Total Return (S&P/ASX200 TR) index over the last 3 years was 4.19%, over the last 5 years, it was 4.40%.  By way of comparison, US markets return less than 2% annually on average to investors as dividends.

Given the comparatively high Australian dividend returns, it is all the more important we consider them when deciding how our market has performed.  I consider the ASX200 (and the All Ordinaries and other ‘price’ indices) to be completely invalid measures when it comes to benchmarking, because when it comes to measuring returns, if dividends aren’t part of your ‘return on investment’, then what are they? Whether you choose to reinvest the dividends or not is your choice, but they must make up a part of your performance measure.

In my opinion in the area of performance measurement, there is no more important concept than benchmarking.  Imagine I were a pretty fast 100 metre runner (I’m not), had I beaten everyone I’d ever raced, and my best time was an extremely impressive 10.3 seconds, were it not for benchmarking, I’d possibly consider myself one of the fastest men alive.  Based on all recent evidence, this would be a reasonable conclusion.  Benchmarking, however tells me that my best time, a 10.3 second 100m dash would not be fast enough to have qualified for the most recent Olympics and therefore, there must be many who are faster than I.  Benchmarking myself against, for example the Australian 100m girls under 14’s record would also be unsuitable.  To be a valid performance measure, a benchmark must be 2 key things. Firstly, a valid measure of performance and secondly, nominated in advance of the performance occurring.

When it comes to benchmarking performance for Australian Equity fund managers, unless they are operating in a specific sector, such as listed property, or resources, the only suitable benchmarks will be the accumulation indices, either ASX200/ASX300 or All Ordinaries.

A quote I like that demonstrates the importance of benchmarking is made by Warren Buffett: “one must avoid the error of the preening duck that quacks boastfully after a torrential rainstorm, thinking that its paddling skills have caused it to rise in the world. A right-thinking duck would instead compare its position after the downpour to that of the other ducks on the pond”.

Believe it or not, since 1980, on a dividend-reinvested basis (over calendar years), the total return indices have exceeded 20% on 11 occasions (greater than 1 in 3 years). They have exceeded 40% on 5 occasions (nearly 1 in 6 years – though the last time was 1993). In these years, it is possible for investors to be substantially duped if their fund manager does not benchmark to an appropriate index.  An uninformed investor whose fund manager has grown his portfolio by say 38% could be compared to Buffett’s duck if the market has advanced by say 44%.

Believe it or not, some funds (though not many) use the ASX200 (rather than the TR index) as their benchmark.  This immediately gives them over a 4% advantage, so they could take a hefty annual management fee, track the benchmark closely and still report above benchmark performance.  Worse still are the ‘absolute return’ funds, without naming names, I have seen examples of these that charge 2.5% p.a. management fees, have a benchmark of 0% (they don’t even give you CPI) and charge 25% ‘out-performance’ (is beating 0% really outperformance?) fees, they comfort you by not charging fees until any capital losses (in years they decline) have been recouped. Given that the Australian market has advanced about 12.5% p.a. over the last 30 or so years, such a fund, had it exactly matched the benchmark returns would have left you with a return of about 7.5% over time. Over 30 years, $1 invested at 12.5% p.a. will become $34.24, whereas invested at 7.5% p.a. it would become $8.75, the difference would be in your fund managers pocket, so take care when investing in managed funds (or super for that matter). Now the weekly readership is growing, anyone with anything they would like me to address specifically is welcome to contact me by e-mail: tony@eternalgrowthpartners.com - Tony Hansen - 24/01/2011.

The Importance of Buy & Hold

In mid-March 2008, when the market was down 25.85%, I was quietly confident that there shouldn’t be a huge amount of downside left after such a substantial decline.

Now, you will note from the above statement, I don’t rate much in the forecasting stakes – the market went on to fall roughly as far again over the ensuing 12 months.  What I can lay claim to is some solid results in the stock-selection stakes.  I found Credit Corp Group (ticker - CCP), they seemed to tick a lot of the boxes I seek, reasonably long and consistently profitable trading history, high return on equity, averaging over 25%.  Their only issue would seem to have been that they were far too heavily leveraged at a time when such leverage was frowned upon due to seizing credit markets.  A quick perusal of their business and their cash flows, however, indicated that if they committed seriously to paying down their debts, they could do so in pretty short order – they did and they have (cut by roughly 2/3 in the next 2 years).

So I bought a small parcel of CCP @ 66 cents 14/03/2008 (it is not a big holding, today they make up less than 4% of the family portfolio).  In pretty short order, they hit 99 cents (up 50% on purchase price), and then they bottomed at 39 cents on 28^th January 2009 (down 40.91% on my purchase price).  All this indicates is that it was a volatile period; those of you in the market then will already know this.

In any case – as at the time of first drafting this post (20/12/10), CCP is priced at $4.05 and they have returned me 14 cents in dividends since purchase.  So they represent $4.19 of value to me today, which equates to an annualised return of 95.83%.  I don’t point this out to gloat; I have made a couple of purchases that worked out better & a great many that did not nearly so well (doing not nearly so well as 95.83% can actually be quite satisfactory).

In truth, the point I want to make regards the ‘buy & hold’ ethos.  I make the point as follows – In order to maintain my annualised growth of 95.83% on my original 66-cent purchase price, CCP will need to grow my investment by 63.25 cents per year (.9583 x 0.66).  This means that to get to 20/12/2011 still carrying my return of 95.83% pa (on original purchase price), I need CCP to finish the year at about $4.68 (including dividends).  Now this only represents a return of 15.62% from their current position. This is only a little more than 3% above the historic market (S&P/ASX200 TR) return, and entirely possible from this company.

Year	Price	Growth
20/12/10	$    4.05
20/12/11	$    4.68	15.62%
20/12/12	$    5.31	13.51%
20/12/13	$    5.95	11.90%
20/12/14	$    6.58	10.63%
20/12/15	$    7.21	9.61%
20/12/16	$    7.84	8.77%
20/12/17	$    8.48	8.06%
20/12/18	$    9.11	7.46%
20/12/19	$    9.74	6.94%
20/12/20	$   10.37	6.49%

The table set out to the left further demonstrates this proposition stretched out for the next 10 years.  You will see that by the 10^th year, the required return (assuming a smooth return of 95.83% per annum on my original investment) is only 6.49%.  I can go out today and get a 6.5% return from any number of places, so that will be eminently achievable.

Though I haven’t included the next 10 years of the table, I can assure you it gets more impressive, by the 20^th year all I need in order to continue to grow my starting capital by 95.83% annually on its original value is to grow my holding by only 3.94%.  Clearly, if 3.94% is all the return I expect, I may start to move some of this capital elsewhere, but you see the power of the notion.  This is a demonstration of one of the most powerful parts of share investing, the power of the ‘free leverage’ afforded by uncrystallised capital gains. Tony Hansen - 17/01/2011.