I wrote this blurb to clarify some thoughts that flowed from thinking about Roger Montgomery's value investing methodology. I applied the RM methodology (as far as I understood it) to TGA because it is the stand-out investment I have in terms of performance and relative value to my total portfolio. I have also some of the words below in the TGA thread of this forum.
Because TGA was rarely mentioned in the financial media, and it was illiquid, I worried that my affection for TGA might have been mistaken on the same basis that one does not pick up a $50 note, because were it a $50 note, somebody else would have picked it up earlier! As an investor (not trader) I now ignore much of what is said or written by those who presume to know about investing on the ASX, and instead I look for the unheralded performers that are under valued, which can be fairly small companies.
Seeing that RM classed TGA as an A1 stock, over Easter I decided to see how TGA's “intrinsic value” pans out using RM's methodology, and these figures are set out below. The results coincide reasonably well with my own crudely calculated intrinsic value of TGA, which was also the case with other stocks, so I conclude that although I do not agree 100% with RM's views, most of the differences are semantic (language pedantry). For instance, if RM says a share's intrinsic value is $1 today (Y1), $2 in Y2 and $3 in Y3, I am sure that nobody would for $1 give me a thus-worded IOU that allowed me to opt to take $3K in Y3, because people would ascribe a higher present value to the IOU than the Y1 “intrinsic value”. There is no problem using words in a specific way – for instance, economists use the word “utility” to have a unique meaning that does not accord with Mr Everyman's use of the word.
Also, RM denigrates using PER, and yet a target PER is the reciprocal of the RR (required rate of return), and one can arrive at the same conclusion using target PERs, just as one gets the same arithmetical result dividing by 2 as one gets multiplying by .5 (the reciprocal of 2). To elaborate, if one could get a no-debt share with a long-term ROE of 15% for a PER of 6, one would buy the share, and likewise if one used RM-style logic because the following mathematics using ROE = 15% and RR = 10% would show it to be priced below “intrinsic value” with a good margin of safety:
* If equity per share is E, and the ROE is 15%, then the EPS would be 0.15E.
* If RR is 10%, and the EPS = DPS, then the RM factor is 15% divided by 10%, or 1.5
* The RM “intrinsic value” would be 1.5 times E, or 1.5E
* Consequently, for a PER of 6, the market price for an EPS of .15E would be .9E
* One could consider buying because 1.5E > .9E with a margin of safety
If one did not think about ROE and intrinsic value, and one wanted an RR of 10% for a stock of this quality, one would use a target PER equal to the reciprocal of 10% (1 divided by 10%), which is 10. With the market PER being 6, one would buy the stock because 10 > 6. The margin of safety would be the same, because, not surprisingly, the ratio of 1.5E to .9E is the same as the ratio of 10 to 6.
RM's ROE-centric approach has the advantage of pushing one towards quality shares, but it can throw up companies (e.g., financial planning firms) that rely on skillsets rather than capital, where senior staff may be able to walk off with both the skillsets and many of the customers, and the same applies to firms with business models that are easily replicated – e.g., The Reject Shop (TRS).
I am not comfortable with the factors that RM uses for zero-dividend shares – I think they are too high. I have not attempted to retro-calculate these factors, but I suspect that RM's calculation of them assumes that all the earnings can be employed at the current high ROE, and that the alternative use to which an investor can put the money is at the bank deposit rate, as opposed to superb alternative investments in the ASX, particularly if the funds are within a no-tax-pension-paying SMSF environment, as is the case for half of my total TGA holdings.
TGA's figures for YE 31/03/2011 and YE 31/03/2012 could be improved soon, because TGA should come out with the YE 31/03/2011 preliminary report on 24 May 2011, and this should provide a better basis for YE 31/03/2012 than my guesstimates below, where I guesstimated:
* 31/03/11 equity by adding for H2 the increase for H1;
* 31/03/12 equity by adding 50% of the estimated earnings;
* 31/03/11share # by adding the performance rights # to the 30/09/11 #;
* 31/03/12 share # by simply adding a further 1.5 million shares;
* YE 31/03/11 earnings by taken the mid point of the forecast $22M to $23M; and
* YE 31/03/12 earnings by adding $3M to YE 31/03/11 earnings,
and I assumed the payout ratio is a consistent 50% and an RR of 10% was suitable for TGA (an A1 company), plus I arrived at the RM factor for zero dividends by primitive interpolation from the table on page 184 of RM's book “VALUABLE”.
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . YE 3/2009 . . YE 3/2010 . . YE 3/2011 . . YE 3/2012
Earnings YE 31/3 . . . . . . . . . . . . . . . . . . $12,320K . . . $19,495K ,. . $22,500K . . .$25,500K
Equity - start of year . . . . . . . . . . . . . . . . $66,162K . . $69,262K . . $81,767K . . . $94,791K
Equity – end of year . . . . . . . . . . . . . . . . $69,262K . . $81,767K . . $94,791K . .. $107,541K
Average Equity . . . . . . . . . . . . . . . . . . . . $67,712K . . $75,514K . . $88,279K . . $101,166K
Earning/Average Equity . . . . . . . . . . . . . . . 18.19% . . . 25.82% . . . . 25.49% . . . . 25.21%
Shares . . . . . . . . . . . . . . . . . . . . . . . . . . 128726K . . 129441K . . . 130737K . . . 132237K
Av Equity per shre . . . . . . . . . . . . . . . . . . $0.5260 . . .. $0.5834 . . . $0.6752 . . . $0.7650
EPS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9.57c . . . . . 5.06c . . . . 17.21c . . . .. 19.28c
RR (required rate of return) 10%
Assume Payout Ratio 50%
RM's factor where DPS=EPS . . . . . . . . . . . .. 1.8195 . .. . 2.5816 . . . . 2.5487 . . . . 2.5206
RM's factor where no div . . . . . . . . . . . . . . . 2.9447 . .. . 5.5210 . . . . 5.3929 . . . . 5.2833
Factor (average above) . .. . . . . . . . . . . . .. . 2.3821 . .. . 4.0513 . . . . 3.9708 . . . . 3.9020
Intrinsic Val (Factor x av equity per share) . .. $1.253 . . . . $2.363 . . . . $2.681 . . . . $2.980
Remember, in the table above the words “intrinsic value” are used in RM's time-static way, whereas it is normal to consider the time-value of money when estimating value for a point in time. This is why one needs to guesstimate a string of “intrinsic values” to get a feel for whether one should invest or not. Also, I am a tad apprehensive of the row of numbers for “RM's factor if no dividend” - too high, maybe.
If one simply dreamed up conservative PERs for each of RM's classifications A1 to C5 for an EPS=DPS setting, and another for a no-dividend setting, one could quickly arrive at a list of investment candidates by comparing the market PER to this list. For TGA, one could simply assume that a share of this quality should enjoy a PER of say 14.5, which to err on the conservative side is an average PER, and arrive at 17.21 cents x 14.5 = $2.50 as an intrinsic value. TGA is better than average, which is why RM classes it as an A1, so one could use a higher target PER and get a higher value – e.g., 17.5 would give $3.01. In my view, TGA is worth somewhere between $2.50 and $3.00.
RM's views helped me consolidate my own investing approach, and to a degree, thanks to his book, ROE is central to my stock-picking approach now, but more for “soft” reasons than as the core of an arithmetical exercise. As I wrote earlier, some businesses thrown up via the RM methodology require little capital, and hence they can generate high ROE, but if managers can walk off with a slice of the client base and the intellectual capital between their ears, things can quickly go awry. This perhaps is why Fiducian (FPS) does not excite me, although it has high ROE. lowish PER, good dividend yield, no debt, low Aspect Earnings Model, et cetera - although I would look at it again if I had the readies to invest, and I have invested in SGH which has a similar risk of senior staff walking away with a chunk of the business, rather than sharing the loot with pesky shareholders, particularly the Chardonnay socialists who floated SGH and gave themselves fat salaries and millions of share as quid pro quo for the original legal practice.
I do not comprehend the Aspect Earnings model as well as I would like to, but if it is less than unity, then at least somebody reckons the share is worth considering. In a different but similar vein (easy replication of business model), when I walked through Tuggeranong Mall in the ACT last year, I noticed that more than one Asian-owned-and-staffed business competing with The Reject Shop (TRS) had popped out of the woodwork, which is part of the reason why I opted for Cash Converters (CCV) at a SP of 63 cents instead of TRS or JBH.
Because TGA was rarely mentioned in the financial media, and it was illiquid, I worried that my affection for TGA might have been mistaken on the same basis that one does not pick up a $50 note, because were it a $50 note, somebody else would have picked it up earlier! As an investor (not trader) I now ignore much of what is said or written by those who presume to know about investing on the ASX, and instead I look for the unheralded performers that are under valued, which can be fairly small companies.
Seeing that RM classed TGA as an A1 stock, over Easter I decided to see how TGA's “intrinsic value” pans out using RM's methodology, and these figures are set out below. The results coincide reasonably well with my own crudely calculated intrinsic value of TGA, which was also the case with other stocks, so I conclude that although I do not agree 100% with RM's views, most of the differences are semantic (language pedantry). For instance, if RM says a share's intrinsic value is $1 today (Y1), $2 in Y2 and $3 in Y3, I am sure that nobody would for $1 give me a thus-worded IOU that allowed me to opt to take $3K in Y3, because people would ascribe a higher present value to the IOU than the Y1 “intrinsic value”. There is no problem using words in a specific way – for instance, economists use the word “utility” to have a unique meaning that does not accord with Mr Everyman's use of the word.
Also, RM denigrates using PER, and yet a target PER is the reciprocal of the RR (required rate of return), and one can arrive at the same conclusion using target PERs, just as one gets the same arithmetical result dividing by 2 as one gets multiplying by .5 (the reciprocal of 2). To elaborate, if one could get a no-debt share with a long-term ROE of 15% for a PER of 6, one would buy the share, and likewise if one used RM-style logic because the following mathematics using ROE = 15% and RR = 10% would show it to be priced below “intrinsic value” with a good margin of safety:
* If equity per share is E, and the ROE is 15%, then the EPS would be 0.15E.
* If RR is 10%, and the EPS = DPS, then the RM factor is 15% divided by 10%, or 1.5
* The RM “intrinsic value” would be 1.5 times E, or 1.5E
* Consequently, for a PER of 6, the market price for an EPS of .15E would be .9E
* One could consider buying because 1.5E > .9E with a margin of safety
If one did not think about ROE and intrinsic value, and one wanted an RR of 10% for a stock of this quality, one would use a target PER equal to the reciprocal of 10% (1 divided by 10%), which is 10. With the market PER being 6, one would buy the stock because 10 > 6. The margin of safety would be the same, because, not surprisingly, the ratio of 1.5E to .9E is the same as the ratio of 10 to 6.
RM's ROE-centric approach has the advantage of pushing one towards quality shares, but it can throw up companies (e.g., financial planning firms) that rely on skillsets rather than capital, where senior staff may be able to walk off with both the skillsets and many of the customers, and the same applies to firms with business models that are easily replicated – e.g., The Reject Shop (TRS).
I am not comfortable with the factors that RM uses for zero-dividend shares – I think they are too high. I have not attempted to retro-calculate these factors, but I suspect that RM's calculation of them assumes that all the earnings can be employed at the current high ROE, and that the alternative use to which an investor can put the money is at the bank deposit rate, as opposed to superb alternative investments in the ASX, particularly if the funds are within a no-tax-pension-paying SMSF environment, as is the case for half of my total TGA holdings.
TGA's figures for YE 31/03/2011 and YE 31/03/2012 could be improved soon, because TGA should come out with the YE 31/03/2011 preliminary report on 24 May 2011, and this should provide a better basis for YE 31/03/2012 than my guesstimates below, where I guesstimated:
* 31/03/11 equity by adding for H2 the increase for H1;
* 31/03/12 equity by adding 50% of the estimated earnings;
* 31/03/11share # by adding the performance rights # to the 30/09/11 #;
* 31/03/12 share # by simply adding a further 1.5 million shares;
* YE 31/03/11 earnings by taken the mid point of the forecast $22M to $23M; and
* YE 31/03/12 earnings by adding $3M to YE 31/03/11 earnings,
and I assumed the payout ratio is a consistent 50% and an RR of 10% was suitable for TGA (an A1 company), plus I arrived at the RM factor for zero dividends by primitive interpolation from the table on page 184 of RM's book “VALUABLE”.
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . YE 3/2009 . . YE 3/2010 . . YE 3/2011 . . YE 3/2012
Earnings YE 31/3 . . . . . . . . . . . . . . . . . . $12,320K . . . $19,495K ,. . $22,500K . . .$25,500K
Equity - start of year . . . . . . . . . . . . . . . . $66,162K . . $69,262K . . $81,767K . . . $94,791K
Equity – end of year . . . . . . . . . . . . . . . . $69,262K . . $81,767K . . $94,791K . .. $107,541K
Average Equity . . . . . . . . . . . . . . . . . . . . $67,712K . . $75,514K . . $88,279K . . $101,166K
Earning/Average Equity . . . . . . . . . . . . . . . 18.19% . . . 25.82% . . . . 25.49% . . . . 25.21%
Shares . . . . . . . . . . . . . . . . . . . . . . . . . . 128726K . . 129441K . . . 130737K . . . 132237K
Av Equity per shre . . . . . . . . . . . . . . . . . . $0.5260 . . .. $0.5834 . . . $0.6752 . . . $0.7650
EPS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9.57c . . . . . 5.06c . . . . 17.21c . . . .. 19.28c
RR (required rate of return) 10%
Assume Payout Ratio 50%
RM's factor where DPS=EPS . . . . . . . . . . . .. 1.8195 . .. . 2.5816 . . . . 2.5487 . . . . 2.5206
RM's factor where no div . . . . . . . . . . . . . . . 2.9447 . .. . 5.5210 . . . . 5.3929 . . . . 5.2833
Factor (average above) . .. . . . . . . . . . . . .. . 2.3821 . .. . 4.0513 . . . . 3.9708 . . . . 3.9020
Intrinsic Val (Factor x av equity per share) . .. $1.253 . . . . $2.363 . . . . $2.681 . . . . $2.980
Remember, in the table above the words “intrinsic value” are used in RM's time-static way, whereas it is normal to consider the time-value of money when estimating value for a point in time. This is why one needs to guesstimate a string of “intrinsic values” to get a feel for whether one should invest or not. Also, I am a tad apprehensive of the row of numbers for “RM's factor if no dividend” - too high, maybe.
If one simply dreamed up conservative PERs for each of RM's classifications A1 to C5 for an EPS=DPS setting, and another for a no-dividend setting, one could quickly arrive at a list of investment candidates by comparing the market PER to this list. For TGA, one could simply assume that a share of this quality should enjoy a PER of say 14.5, which to err on the conservative side is an average PER, and arrive at 17.21 cents x 14.5 = $2.50 as an intrinsic value. TGA is better than average, which is why RM classes it as an A1, so one could use a higher target PER and get a higher value – e.g., 17.5 would give $3.01. In my view, TGA is worth somewhere between $2.50 and $3.00.
RM's views helped me consolidate my own investing approach, and to a degree, thanks to his book, ROE is central to my stock-picking approach now, but more for “soft” reasons than as the core of an arithmetical exercise. As I wrote earlier, some businesses thrown up via the RM methodology require little capital, and hence they can generate high ROE, but if managers can walk off with a slice of the client base and the intellectual capital between their ears, things can quickly go awry. This perhaps is why Fiducian (FPS) does not excite me, although it has high ROE. lowish PER, good dividend yield, no debt, low Aspect Earnings Model, et cetera - although I would look at it again if I had the readies to invest, and I have invested in SGH which has a similar risk of senior staff walking away with a chunk of the business, rather than sharing the loot with pesky shareholders, particularly the Chardonnay socialists who floated SGH and gave themselves fat salaries and millions of share as quid pro quo for the original legal practice.
I do not comprehend the Aspect Earnings model as well as I would like to, but if it is less than unity, then at least somebody reckons the share is worth considering. In a different but similar vein (easy replication of business model), when I walked through Tuggeranong Mall in the ACT last year, I noticed that more than one Asian-owned-and-staffed business competing with The Reject Shop (TRS) had popped out of the woodwork, which is part of the reason why I opted for Cash Converters (CCV) at a SP of 63 cents instead of TRS or JBH.
