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Students of Roger Montgomery's (Buffett's) intrinsic valuation method

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Re: Students of Roger Montgomery's intrinsic valuation method

Hi all,

How people can blindly follow the advice of RM aka “Mr. -95%” is beyond me (read CCP tread for an understanding of his ‘nickname’).

To consider an investor successful, he/she needs to have a solid record built up during years, bear/bull markets in and out. (Peter Lynch, WB). Seriously, even the title of this tread is wrong, how come we can even compare Buffet’s method with the one of RM?

RM advocates buying into super-cyclical companies, (MCE, FGE) and on top of that, uses a “one size fits all” valuation metric.

Come on! Nick Scali an A1/A2? That piece of garbage! And how come BHP, the best ever company Australia has ever seen is not one?

His method needs to be amended if not scrapped altogether to take into consideration:
• The fact that some companies are cyclical
• The fact that some extraordinary companies are capital intensive

Never have been a believer myself, and never will be, I will buy the index any day than following RM advice.

Regards,
 
Mike23 said:
- ditto - when RM says with strong conviction that P/E is not appropriate to value a company when in fact his "ROE/RoR x Equity per share" is of course P/E restated - do the math. That he gets away with this beats me.
Click to expand...

I have been trying to convey this on another thread but you've described it way more eloquently than I ever could.

It is scary sometimes to read followers of this kind of valuation method say something like...

"I use ROR of 10% because it's a low risk company and if you can get 10% from a bank I'd be happy".
 
BHP and TLS as Value.able Examples

There's a lot of strident criticism of the RM "method" in recent posts, and I wonder if some folks interpret Roger's book as advocating a simple and fail-safe investing formula. i don't think he intends that, and I don't read it that way myself.

BHP is an interesting example (assuming I got my calcs right). BHP has very high ROE currently and sky-high Intrinsic Values - multiples of the current share price. I suspect the share price is not going to relect those IVs anytime soon because reality is just a little bit more complex than that! BHP share price would in theory escalate dramatically if currrent BHP returns were likely to be maintained in perpetuity. But we know commodities are highly cyclical, so that's not going to happen. A more realistic valuation needs to rest on a longer term view than the next few years of earnings.

TLS is also interesting. Its IV based on the 2011 result is in the vicinity of $2.30 (current share price around $3.05). The market anticipates improving earnings (some mix of organic growth/market share gains & NBN related cash flows I assume) in subsequent years, and if those earnings pan out, then the IV in the next couple of years could be in the $3.50 vincity.

So I think the RM valuation approach is a reasonable tool, but it cannot tell you anything useful if you don't have a good view of future earnings (underpinned by many factors, including the economy, sustainable advantage, etc.) and of other important financial parameters such as sustainability of debt, etc.
 
Roger Montgomery has also been calling a property bubble in China for years. The property boom in China is a massive part of it's growth and economic expansion. If you added this to the above posts outlook for BHP, the valuation should be lowered if you are making that call regardless of BHPs A1 performance to date.
 

True enough, RM does talk about when to "get out" in Valueable devoting 9 pages to the topic in a 250 page book (not much emphasis). I think the CCP episode taught him a lesson about portfolio weighting and when to get out but he definitely has a strong bias toward buy and hold. This can clearly be seen in his blog where he tries to calm his nervous flock about recent dramatic price falls in his A1s stemming from legitimate GFC2 fears in global markets.


Think of his blog as a free investment newsletter that allows him to spruik his brand to millions instead of a small subscriber base. He is a clever marketer and self-promoter in the internet age, no denying that.


Roger's real "pot of gold" is not a stock but rather the The Montgomery [Private] Fund. A million dollar minimum investment required mind you. Boutique funds management made him a millionaire and building up this business is where the real money is for him. Writing books and blogs promote Roger Inc. at low cost while the real money is raked in by his funds management business. Everything he does is self-serving, no altruism to be found here so your cynicism is appropriate.
 

waimate01, you lost me there. ROE as used by Roger has nothing to do with using book values, it is just a metric used (inappropriately in my view) for estimating sustainability of earnings and growth - this then factored into his cap rate based on his "power of 1.8" formula - which may be (usually is in my view) totally inappropriate for a capital intensive business. And for non-capital intensive businesses, the ROE metric will give many false positives. The formula as I have said removes necessary judgement to value a business. i.e. sustainability of earnings and earnings growth. This is all that the market is interested in in giving you a price. ROE and div payout metrics are not appropriate in my view without a first up handle on sustainability of earnings and earnings growth - as will give many false positives and vice versa. Know what you are doing is my message. I'm sure it is Roger's as well - however the failing of his book is to disguise (by his formula) the key metrics you need to assess - i.e. sustainability of earnings and earnings growth. That's all that matters!!
 

Mike, am I right in assuming from the above that you are interpreting RR in the formula as 'Rate of Return'? It's not, it's 'Required Return' - the minimum return you'd be happy to accept for your investment. It has nothing to do with the P/E ratio. It shouldn't vary from company to company or from alternative investment to alternative investment.
 

New Stratos, I doubt this is an issue with RM's understanding but rather with RM not conveying a proper understanding or educated his followers properly in this important aspect of valuations.

The cap rate (RR or RoR call it what you will) has everything (or mostly) to do with the stock you are valuing. I say mostly because a small component being the the after tax "risk free rate of return" which does vary between investors depending on their tax status. (which I don't recall RM mentioning) The investor's risk free rate is then adjusted for (i) equity specific risk premium (increase) and (ii) sustainable growth in earnings (decrease) where sustainable = 10 years+ in my books.

Both adjustments are subjective and very stock specific and nothing to do with your "personal required return".

I would almost agree with some means to take the growth factor adjustment out of the novice's hands (as has Roger tried to do via his ROE method) as small changes in growth estimates can have dramatic effects on valuations. For this reason (dramatic effects on valuations based on small differences in opinion on risk and on growth) I am very anti someone saying "an IV of a company is..." At best the IV of a company is within a range band and subject to the quality of your estimates of risk premium and growth. Whilst you should be open to ideas, you should not rely blindly on the estimates of others nor on valuation models that you do not understand.

Anyway Roger's method of adjusting RoR for growth (ROE/RoR to power of 1.8) is bogus because this is not done (taken out of the novice's hands) in a conservative manner - quite the contrary. If he admitted the bogus element and armed the audience with knowledge of what's going on and the need to review for false positive valuations (where IV is < than market) that would be a step in right direction.

I have read RM's book. I'd point you to Page 191 which says:

"... you need to apply a discount rate (this is what I have referred to as the 'investor's required return')".

Whilst RM walks a fine line in not opening himself to critique here, my note in the margin of his book was that "this will mislead the novice."

On page 192, Roger gives one paragraph to what is perhaps the most important aspect in valuing a company. He says "Finally, the investor's required return should take into account a compensation for risk - what is known as the 'equity risk premium'. If this additional rate is ,say, 4 per cent, then the investors required return is: ...." (emphasis added)

This is a very big "say"!!

The risk premium attributable to a particular company takes into account market risk being your preparedness to expose yourself to the market incl. the company's volatility in the market (beta) + sector risk + company specific risk.

Company specific risk is the risk attached to sustainability of earnings + sustainability of earnings growth (if you have allowed for this). To keep this premium low (as Buffet does by the way he selects potential investments) requires you to (1) fully understand the business; (2) have a business which has a sustainable competitive advantage relative to its peers; and (3) have management with integrity + excellent business development skills.

Versus the above-mentioned single para by Roger, there are a number of books devoted entirely to this subject to equity risk premium assessment - but not very sexy.
 

Hmm, looking at this graphic it appears that my interpretation may not be correct (or perhaps this isn't showing the numerical part of A2, but a separate measure of performance?)):
 
waimate01 said:
ROE = EPS / BV
Click to expand...

waimate01, I will reply with an example perhaps but no time right now.

Although its true that "ROE = EPS / BV" - this has nothing to do with Roger's valuation method.

As I said, as used by Roger, ROE has nothing to do with using book values, it is only a metric (used inappropriately in my view) to adjust cap rate for sustainability of earnings and growth.

This metric "ROE/RoR to power of 1.8" removes necessary judgement to value a business (sustainability of earnings and earnings growth), has a bias to penalise some valuations unfairly (capital intensive businesses) and has a bias to reward unfairly (false positives) companies with high ROE.
 

Bingo!

Hence you have people on his blog making detailed posts about how they arrived at their IV, while making little comment about other aspects of the business.
 
Re: Students of Roger Montgomery's intrinsic valuation method


His rating system is misleading at best as you rightly point out. Rating companies like FGE and MCE as A1 sends the wrong message. These companies are speculatively to a degree because they have very little track record and they highly dependent on not only winning contracts but managing those contracts. Further as you mention they are cyclical.

On the plus side at least RM is out in the public domain lifting the profile of value investing and exposing many others in the business who are complete charlatans and con men.

Using RM as your starting point if you are a new investor is not such a bad thing. The next step is to start reading more literature on valuing investing and getting to the bits that RM glosses over and get a more rounded knowledge of value investing techniques
 

Hi Mike, in discussing 'equity risk premium' (which you are interpreting as unique to each company, and I am interpreting as a general factor allowing for equities being riskier than T bonds or similar things) you've missed out Roger's very specific comments about CAPM and how he doesn't think it is appropriate to include 'beta' and why (pp191-2).

You are right there are lots of ways of arriving at a discount factor, and many books about them, but they mostly are derived from entirely different valuation models, so (arguably, obviously) are not appropriate here.

However, since we're basically taking about the Buffett approach (although in this case explained by RM), it makes sense to look at Buffett's comment, and those of his influences and other writing about him. They compare the required return - the minimum return you are willing to accept - to T Bonds or other 'good quality' low risk bonds. They usually talk about adding on a factor for inflation and your personal tax rate (eg in Graham's 'The Intelligent Investor'. Buffett and Clark in 'Buffetology' say that since in the US there have been lengthy periods of double digit inflation and tax rates over 50%, Warren Buffett usually simplifies it to requiring 15% (others claim 9% or 10%), but the main thing is - since we're trying to buy at less than IV, not at IV, it doesn't have to be perfect, we can make up for it by a separate substantial Margin of Safety.

And to be fair to Rm, the IV chapter is 39 pages out of 251, less than 16%; so it's a pity that people don't take as much notice of the other 84% where he does look at a lot of the other things which should be considered.
 
Re: Students of Roger Montgomery's intrinsic valuation method


Precisely!
And RM does mention the sources of 'his' IV formula - James E. Walter, "Dividend Policies and Common Stock Prices" The Journal of Finance, Vol. 11, No. 1 (Mar., 1956), pp. 29-41;
Warren Buffett, Benjamin Graham, and so forth - all good places to start reading.

Value Investing is not calculating an IV and paying less than that for shares. I don't even calculate the IV until I've looked at at least 9 other factors (and I'm not claiming to be a paragon, by the way!)
 

The margin of safety is used to take into account of the future variables - revenue, costs and cash flow etc. You can't double use it to compensate for a smaller discount rate. Using a 9-10% discount will have you valuing something far higher than everyone else in the market, which means you will never have the opportunity to realise the gains.

Historical market risk premium for the Australian market is 6-7% (from memory of finance lectures) so the minimum anyone should use in the current environment is 12-13%. Err on the side of conservatism, 15% is a nice round number.
 


waimate01, sorry to persist re. this but good to get off the chest so to speak, so I'll run through an example of where I'm coming from.


Example of RM valuation model and recon. to P/E method (EPS/RoR)


Assumptions:






(a) earnings

$6,875​
k



(b) equity (book value)

$25,000​
k



(c) # of shares

21,000​
k



RoR (or RR or whatever you wish to call the cap. rate)
(say)
12.0%​




EPS (a) / (c)

32.74​
cents per share


ROE (a) / (b)

27.5%​











RM valuation model

ROE/RoR x equity per share


(where pays all earnings as dividends)

27.5%/12% x $25m/21m shares



1.5833 x $1.19 cents per share




$2.73











restating

ROE/RoR x equity per share



=
(earnings / equity) / RoR x equity / # of shares

=
(earnings / # of shares) / RoR



=>>>
EPS / RoR (i.e. P/E ratio)




32.74 cents per share / 12%




$2.73





As you might expect any valuation must go to capitalisation of a future earnings earnings stream and this is precisely what RM valuation model does. (i.e. it is a disguised PE - capitalising EPS)


There is a fundamental issue with this basic formula (acknowledged by RM) in that PE values an annuity using the cap rate which means the earnings are achievable over an infinite period. Granted the first 30 years of infinity account for most of the value in PV terms, however you still need to have a 30 year outlook.


If a company pays out all earnings as dividends the RM valuation model decides for you that the company cannot / is not entitled to any "earnings growth" adjustment. I'd like to decide that thank you. Bogus #1.


Secondly, if the company retains its earnings (dividend payout ratio of NIL) then the RM formula decides for you that the company has wonderful sustainable earnings growth into the future and is entitled automatically to a cap rate adjustment for acount for this growth. Bogus #2. No input by you or any reality check.


The higher is ROE, the higher is the premium payable for sustainable earnings growth (per RM model to power of 1.8 of ROE/RoR) notwithstanding that this might be a low capital intensity business with an average or dare I say it a negative earnings growth outlook.
Let's use above same assumptions on the basis that the company retains all its earnings.


RM valuation model

ROE/RoR x equity per share

(where retains all earnings)

(27.5%/12%)^1.8 x $25m/21m shares


4.449 x $1.19 cents per share



$5.30










What has changed to the fundamentals of the earnings power of the business? Not much say I. But the value (purely based on dividend retention policy) increases valuation per RM model by 94%.


We have already established that RM's formula does no more than apply a cap rate to EPS in a disguised manner. So for an investor who has dilligently considered an appropriate 12% RoR for a company based on his or her analysis of a suitable risk premium to be applied to earnings, the RM model discards this (without telling you) and applies a cap rate of 6.2% in this instance - equivalent to bluest of blue chips which was obviously not your assessment in picking a RoR of 12%.


solving for cap rate given the EPS which we know:

cap rate = ​

EPS / $5.30
=>>>​

.3274 / $5.30


6.2%


This is based on an ROE of 27.5%.


What happens if your assessment of fundamentals is unchanged, still deserving of a RoR of 12% by your earnings outlook assessment - and the ROE for this company happened to be 55%? Close your eyes and go for the supersonic valuation ride. Sorry to put a dampener on this forum. I think the ideals of sharing knowledge are great - but not with eyes wide shut which appears to be by design by the undisclosed mechanics of the RM valuation model.
[FONT=&quot]
I regard myself as a value investor and would far rather be see analysis and discussion about company's earnings power sustainability and growth leading to an educated risk + growth premium assessment with eyes wide open. My objection to RM is goes to this objective of the value investor (RM follower) being defeated.[/FONT]
 
skc said:
The margin of safety is used to take into account of the future variables - revenue, costs and cash flow etc. You can't double use it to compensate for a smaller discount rate.
Click to expand...

Actually, that's what I've been restraining myself from saying with regard to people (including Roger) who want to double up by building an MOS into their RR.


I entirely agree 9 or 10%, like I keep seeing people use, is just silly. I use 15%, but that's me, it's not necessarily 'right'
 
New Stratos said:
I am interpreting as a general factor allowing for equities being riskier than T bonds or similar things ....
Click to expand...

humbug

New Stratos said:
you've missed out Roger's very specific comments about CAPM and how he doesn't think it is appropriate to include 'beta' and why (pp191-2).....
Click to expand...


humbug


New Stratos said:
.. but they mostly are derived from entirely different valuation models, so (arguably, obviously) are not appropriate here.
Click to expand...

humbug - all valuation models (incl. RM) do the same thing - discount an earnings stream - the judgement is only in an approriate cap. rate - which by defninition requires your judgement on risk in sustainable earnings and on earnings growth.


New Stratos said:
Warren Buffett usually simplifies it to requiring 15% (others claim 9% or 10%) ...
Click to expand...

humbug


New Stratos said:
... but the main thing is - since we're trying to buy at less than IV, not at IV, it doesn't have to be perfect, we can make up for it by a separate substantial Margin of Safety.
Click to expand...

humbug ... you won't have a chance to buy (or you'll stay in too long with a false positive sense of security) if your IV calc. is grossly excessive.


New Stratos said:
... And to be fair to Rm, the IV chapter is 39 pages out of 251, less than 16%; so it's a pity that people don't take as much notice of the other 84% where he does look at a lot of the other things which should be considered.
Click to expand...

humbug ... notwithstanding that you've read the other 84%, if you decide to follow his model, it is the IV calc. which will mainly dictate your investment decision.
 
New Stratos said:
I entirely agree 9 or 10%, like I keep seeing people use, is just silly. I use 15%, but that's me, it's not necessarily 'right'
Click to expand...

New Stratos, sorry the example I posted did not format right - but if you can follow you will see my point. If you have selected a conservative 15% (assume based on a dilligent risk premium assessment), how do you feel when that is stripped from you (by RM model without your knowldge) and a much lower cap rate substituted because of div. policy or ROE - both of which may have little or nothing to do with sustainable earnings or earning growth?
 
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