Welcome to the first of many value investing insights in Cuffelinks. Montgomery is committed to investing in businesses of extraordinary quality and we are delighted to be associated with a newsletter that has the same quality commitment to its own content. I am delighted to be invited to provide our insights and I personally look forward to your feedback.
Focus on the quality of the business
Frequently, value investors focus only on the ‘value’ part of the eponymously labelled investment philosophy. Absorbed in calculations, as they inevitably become, many investors fail to step back and ask if the business is of sufficient quality to be included in a portfolio in the first place.
Equally disturbing is the focus on the index. Not only is the rise and fall of the All Ordinaries reported on a daily basis but most of the research reports examining returns available to shareholders focus on the gains and losses of the broader indices. This is folly, as you will see.
Our approach is relatively simple and it’s one we advocate for your own investing. If we aren’t happy to own the entire business for a decade, we won’t be comfortable owners of even one share for just a few minutes. In other words, because we aren’t 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.
Back in 2010 on the Sky Business network, Peter Switzer asked me whether I thought the hiring of John Borghetti – a highly regarded manager and business leader – as CEO would make me change my mind about Virgin Australia Holdings. With his exceptional experience in the industry, would I be willing to concede that the fortune of the airline had improved? With the greatest respect to Mr Borghetti, I noted that it did not matter how hard he rowed – indeed he could be an Olympic rower – the boat he was paddling had an irreparable leak. A whopping great hole in the side of the boat would stymie the efforts of even the expertise of Mr Borghetti. 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 on set.
Despite the discomfort, no apology should be required because John know that he would indeed need to produce a herculean rowing effort in order to keep the tide of the business’s economics at bay. Warren Buffett once proffered,
“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 this month, Virgin’s latest performance and trading update revealed that any CEO of an airline might have more success holding back the tide than changing the economics of the airline business. This is not a recommendation to buy or sell shares in Virgin or any airline but what I hope to achieve is an understanding of the economics of a business as it relates to the owner’s relationship with it. We will see what happened later in this story.
What are the real returns to the owner?
Exactly what does that mean? It means 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. His activities are tantamount to speculation and are as far removed from investing as night is from day.
You may also ask why any such analysis is required when dividend yields, price to earnings ratios, 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 that business are broken by the stock market itself. An individual who owns 5,000 shares of BHP does not, over any memorable period, experience what it is like to actually own BHP. The stock market 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. The shareholder receives a prospectus in the mail inviting him 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 won’t be felt until well down the road and perhaps even after the CEO and board have turned over.
Today’s story, using Virgin Australia as an example, 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 it operates in.
Going back to the beginning in 2003
Let’s suppose the year is 2003 and I ask you to consider an information memorandum to invest $184 million in a new business. I’ll run it for you. Write a cheque for $184 million and to make sure we have enough to get going, we’ll run down to the bank and borrow another $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% return on your funds. Encouraged, 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 the fact that the profit has fallen. In fact for the year ending 30 June 2012, the profit was $43 million – less than half the profit generated a decade earlier. For 2013 the guidance is expected to be a loss of approximately $30 million provided so-called ‘one-offs’ are excluded. Because you own the business outright, ‘one-offs’ feel like real losses to you so you request that I report the totals including the one-offs. OK then, FY2013 might be a loss of about $100 million.
Not good news.
The story gets worse. Recall that in 2003, you made a capital contribution of $184 million. Since then however you have made additional contributions directly in the form of capital raisings and indirectly through the retention of earnings worth more than $900 million. And remember your profits have now more than halved. Even though you have been tipping capital into this venture, the returns have been declining precipitously. That 59% return on equity is a distant memory and you are now earning less than bank interest on your money.
But just before you get too depressed, remember that money you borrowed in 2003? It was $139 million. You may have hoped that the earnings of the business have helped to pay off that debt. Well here’s a shock for you; you now owe the banks $1.7 billion. Yes, true, that is now their problem but you would have expected that borrowing money would lead to growing earnings and returns. In this case, it hasn’t.
And why? Because the business is an airline. And the economics of airlines change little … and rarely for the better.
Capital intensive, labour intensive, irrational competition, a price taker for inputs and commoditised product offerings means 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.
Beyond the numbers
Looking at businesses by studying their economics as described here has enormous and favourable implications for investors willing to consider the unconventional. This approach won’t help you pass your CFA examination but as a reliable, long-term money-making exercise, it is without peer.
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. The share price of Virgin in 2003/04 was above $2.00. Today it languishes below 45 cents.
An investor in Virgin shares would have experienced the same proportional economic calamity over a decade as the individual who owned the entire business. This is why an investor unwilling to own the whole business for ten years, shouldn’t own a little piece of it for ten minutes.
It is useful to keep in mind that the index is populated with many such businesses – large, mature but mediocre businesses that have added little or no economic value over a decade.
Now recall the popular investing advice that implores you to invest for the long term. How often have you been told to simply invest for the long term? How often have you given this advice to your own clients? Time is the friend of the extraordinary business but 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.
As Virgin-type companies, economics and share prices over the last decade demonstrate, the relationship between long-run share prices and a business’s economics is highly correlated. If you can identify businesses with superior economics, you should be able to identify those businesses that will produce superior long-run share price performances.
And do you recall the recent work by Ashley Owen published over three parts here at Cuffelinks? You can view Ashley’s report here. Ashley tested the theory that if we invested against the herd by selling some of our shares when sentiment is bullish, and buying more shares when sentiment is bearish, then we ought to be able to avoid some of the buy-high, sell-low mistakes and be better off in the long run. Ashley’s analysis revealed that doing the opposite of what the herd is doing – ie, selling in booms and buying in busts – is not actually necessary to be a successful investor. If all you do is ignore the herd and avoid buying in booms and avoid selling in busts, then you are avoiding the two most dangerous wealth destruction zones, and you are still going to be better off than probably 90% of investors and fund managers in the market.
More importantly Ashley’s analysis was conducted by looking at the index. The index is populated with businesses that are large. It is not necessarily populated with businesses that are good, and many of the index constituents harbor economic performances like Virgin.
Those who complain or suggest that the index is hard to beat cite the fact that it is always invested in the very best performing stocks. If however we remember that over the long run stock prices track business economic performance, and that the index is always invested in terribly performing businesses, then beating the index should be relatively easy.
Not only do we need to follow Ashley’s suggestion to avoid selling when sentiment is poor and avoid buying when sentiment is irrationally exuberant, but we should also avoid those businesses with poor economics and seek out those with superior economics.
Roger Montgomery is the Chief Investment Officer of The Montgomery Fund.