Roger Montgomery, the chief executive of ASX-listed Clime Capital, is one of the most outspoken value managers in the market. A believer in the Warren Buffett rule that owning shares is the same as actually owning companies, Montgomery thoroughly researches a stock before committing. Once committed he is prepared to invest heavily in the company. Montgomery's approach has paid big rewards, underpinning a successful investment company. Eureka Report subscribers will be familiar with Montgomery through his campaign against companies paying out too much money in dividends. (See our feature from September, A pox on dividends.) As a value investor, Montgomery is now preparing to stop paying dividends to his own shareholders; he believes return on equity should pay for itself. However in today's interview, Montgomery also reveals that high conviction bets can test investors when they do not work out as planned. Clime's investment in Credit Corp has not paid off. In fact the stock has dropped sharply. What next for the value investor? See below. The interview Michael Pascoe: Your listed investment company, Clime Capital, has an unusual portfolio at present because of the large amount of cash it holds, yet it’s been very successful. Why.  Roger Montgomery: We have a very simple philosophy for investing; that is, we want to buy a few great businesses when they’re cheap and we don’t make any strategic decisions about cash. So we’re not saying we think the market’s going up, or we think the market’s going down. The cash we’ve got is a function of finding great businesses. If we find one, we buy a meaningful amount, which then means we don’t have 1–2% of the portfolio in anything. They’re large positions and then if we can’t find anything, the safest place to have your money is in cash rather than a second-rate investment. The reason we’ve done well is that the businesses we have bought shares in, their performance has been exceptional and the share prices have reflected that. Obviously it’s a very concentrated portfolio. Does that make it a more risky portfolio though? The traditional response that you’ll get from an academic or a larger fund manager will be yes, it does make it riskier because you’ve got larger positions in a handful of companies; and if you think about stocks then the short answer is yes, it makes it riskier. However, my view is that when most people talk about risk, they refer to volatility – they talk about the change in the share price. I’m not interested as much in the change of the share price on a daily, weekly, monthly or even yearly basis. What I’m more interested in is whether the business that I’ve bought is increasing in value over time. Once you start focusing on the underlying business and you believe strongly that the value of that business is going to be higher in five years’ time, then I’m really not that interested in how volatile the journey is to get to that point. I’ve got a lot of cash so, as a net buyer over the next five years, I actually don’t want the share prices to go up. When you say you look for a stock with intrinsic value, how do you actually decide that? Well the first thing is we need to stop talking about stocks. What we need to do is talk about businesses. We’ve just come back from a visit with Jetset Travelworld. We bought some Jetset shares 40% lower than where they are today and we just went and had a visit. One of the last questions that we’ve got in our pad of 17 questions we take with us each time is: would I want to own this business outright? If I’m not willing to own the whole business, given its competitive pressures and its position and its industry, do I really want to own a little bit of it because I think the shares are going to go up? One is investing … buying businesses and owning them is investing. Buying stocks, expecting the price to go up, that’s speculation, and we’re in the business of investing. So the first thing we do is conceptually understand that we’re buying businesses and we’re owning them for a long time. We’re not trading stocks; rather we've come up with a unique way of valuing businesses. Well you’d better tell me about it then. It’s based on a fairly simple principle. To make the numbers easy, let’s say you’ve got a tax-exempt Commonwealth bond giving you, say, a 14% tax-free return. You then look at corporate Australia and corporate Australia is generating a 14% return on equity. These are hypothetical numbers, of course. Then let’s assume you’re paying 50% tax on your dividend and corporate Australia is paying all of its profits out as a dividend and there’s no franking on those dividends. So the end result to you as an investor in corporate Australia would be an internal rate of return of 7%, which is half the return that the tax-exempt Government bond is doing. So what would you pay for corporate Australia? No more than 50¢ for every dollar of equity. That’s what it’s worth. Now you can reduce that to a formula and the formula would be return on equity divided by your pre-tax required return, multiplied by equity per share – and that is the basic formula for valuing a business that pays 100% of its earnings out as a dividend. Now there are some other bells and whistles because companies don’t pay all their earnings out as dividends – they retain and compound some – so that return on equity part of the formula has some adjustments to it but that’s effectively the formula. Now what that formula does is turn on its head 25 to 30 years of valuation theory. Back in the 1960s Miller & Modigliani, two mathematicians, came out and said in a paper called Dividend Irrelevance that it doesn’t matter whether a company pays out its earnings as a dividend or not it doesn’t change the value of the business. Well that only is true under one assumption: that the return you want for your investment is the same as the return on equity the business is producing. Which is another whole philosophical debate about dividends. I know you’re not a fan of dividends. Well I’m a fan where the company isn’t generating a high rate of return on equity, they should pay it all out, but if they can get 20% a year every year they shouldn’t pay any of it. If they can reinvest it at 20%, that’s going to be worth more to me long term than this one. I don’t want to get too side-tracked on the dividend argument, but Clime Capital pays out dividends. Yeah. Well that’s going to change. We’ve got an AGM tomorrow (November 15). We’re getting a lot of push from our shareholders, saying, ‘We understand the theory, don’t give us the dividend’. So in the annual report I said, ‘Let me know whether you want the dividend or not’, and I haven’t had a single shareholder say they want the dividend. Every shareholder who’s written to me said, ‘Keep the money’. But your share price has dropped a bit lately, is that why? No, after we talked about that, the share price went up. The share price has dropped because one of our holdings has dropped in price substantially and we’ve ended up buying more of that particular holding. Which one’s that? Credit Corp. Which is one of your two biggest investments. Second largest. It was the largest but now second largest, thanks to a 50% drop in the share price. Now let’s talk about that for a minute. The company has a $2 billion face-value book of debt ledgers that it’s collecting. It’s hired 130 people recently. Management thought they’d take three months to start collecting about $1000 a day on the ledgers that they’re employed to work on. It looks like now they’re going to take five months to get to that point. They’re currently collecting about $600 a day, not $1000. You’re employing them, you’re paying them a salary, they’re getting to the point where they’re earning that, but it’s taking two to three months longer than what you thought. Cost to the business is going to be about $9 million at the EBIT level. Shareholders have dumped the stock. Why? They’re annoyed because the company gave guidance only a few months ago about what the profit figure for 2008 would be, so they’re emotionally saying, ‘Look, there’s something wrong in the business, something we’re not being told’. First reaction: sell it. Great. Now I also think the company probably structured their announcement poorly. They could have actually put some other information in there about how the business was tracking which may have mitigated some of that sell-off but I’m happy they didn’t because it means that the share price has dropped 50%. All our new investors and all of that cash that we’ve got can now be employed at a cheaper price in the same business. The reality is that that business will take a little bit longer to get to the point we thought it would get to but it will still get there. And that’s the difference. The share price is now what it was two and a half years ago when the debt ledger was half the size it is today. So we think that is an obvious opportunity. Do you set prices for companies and if the market falls to that price, you buy? Yeah. We’ve got a program called StockVal, which we use to value companies. We follow about 400 companies. The prices are updated twice a day and all of those 400 companies [are checked] in a split second for what’s cheap compared to what they’re worth. When something gets to our valuation we may buy. Let’s say we decide that we want a company to be 10% of our portfolio. We may buy a third when the price hits our valuation. If it drops to 5% below the valuation, we’ll buy another third. If it drops below more than 10% below the valuation, we’ll fill the position and it becomes a 10% holding and we start at that point. Given that system then, why wasn’t all your cash used up in the middle of August when the market briefly tanked thanks partly due to the stupidity of the SFE and the ASX. Wouldn’t that have triggered a big buy program? We did put a lot of the cash in and then what happened was that our expectations for returns over the next two years were given to us on a platter in 10 days and so we took a lot of profits. There were some examples … I’d rather not name them … but there were some examples where … Oh go on, name one. … there were some examples where they went from being 5% undervalued on August 16 – and I won’t forget the date for a long time – to 30% above their value in 10 days. Now we expect companies that generate a 15% return on equity to get to that point in maybe two or three years so the value would get to that price in two or three years’ time. Well for us, we’ve learnt vicariously from Warren Buffet’s experience with Coca-Cola that when you get that substantial a premium over your valuation sometimes it’s worthwhile taking the profits and protecting the capital. The risks to a decline in the market are serious at the moment. We’re not trying to predict where the stockmarket’s going to go but there are very real risks of an adverse surprise anytime you wake up over the next 18 months. We’re starting to see some of that now. I think it makes sense to have that cash. The other reason we didn’t invest more was the things that were very cheap on that day, we already owned. We didn’t want to add any more. How much cash did you get in on the 16th. About half of the cash that we had, we invested on that day and then 10 days later took it out again. Your biggest single holding is The Reject Shop. What attracted you there, what did you look for? Oh that was a classic one. That was a gift. We had a business that had a $50 million market capitalisation. It was trading about $2.40 at the time. It had Barry Saunders running it. Barry Saunders is ex-Woolies, K-Mart, Target and the Coles Myer board. A brilliant retailer. Learnt a lot from the Woolies experience and from Wal-Mart in the United States. So he was a guy who was clearly punching above his weight, was managing a $50 million business. That’s the first thing that we liked. The second thing that we liked, it was a business that had $11 million of equity generating a 40% return on its equity with terrific growth prospects. It had a business where it’s average unit sales number was about $9 so we thought, ‘Well, if the economy was to turn down, they’d probably do better, relatively speaking’. And then what we liked was that all of the press at the time was focusing on Miller’s Retail and the Warehouse Group, both businesses were doing poorly. There were a couple of articles that came out and said, ‘Look, anybody can go and get a container load of junk from China and set up a shop in George Street or Pitt Street and sell it for $2. So this is clearly a business with no competitive advantage, no barriers to entry’. I thought, hang on a sec, here’s a business doing 40% return on equity and you’re saying that there’s no competitive advantage? It’s got no debt either. And I’m buying this thing on 2½ times equity and it’s generating a 40% return on equity. For me that was just a no-brainer, so we put about 10% of the fund into that business and we had no trouble accumulating shares. It went over four years from generating 40% on $11 of equity to 16% return on $30 of equity, still with no debt, a 50% increase in stores and it can double in size again; 60% return on equity and the share price went from $2.40 to $14 a share. We’ve had investors, that became 45% of their portfolio and when we called them to say look, ‘It’s starting to get just a little bit big, we wouldn’t mind taking some profits and diversifying your portfolio slightly’. They refused. They said no, no, we’re very happy with it. Don’t worry about it. We’ll pay the tax in time. Now obviously investors can look at the Clime Capital portfolio and see the companies you like. Obviously the ones you don’t hold a lot of now, the assumption must be you would like to hold more of at a price. Correct. People have to be very careful about coat-tailing us, though, because we could change our mind at a moment’s notice. We could have met with the company today and decided what we thought was a competitive advantage doesn’t really exist. We’ve got a better handle on it now than we did and we may sell it and if they copy our portfolio, our portfolio tomorrow may be different. |
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