Ray Dalio, arguably the most successful Hedge Fund manager in the world, manages $160b, and in his recent book Principles: Life and Work, he says:
“It’s not easy to bet against the consensus and be right … I try to find the smartest people who disagree with me and stress test my perspective … I believe that one of the best ways of getting at truth is reflecting with others who have opposing views and who share your interest in finding the truth rather than being proven right”
I am now asking myself, why since I last published my article on Linkendin, “Commodities and Forrest’s Fortescue,” has the price of Fortescue Metals (FMG) fallen over 10%? Are the opinions I hold naively wrong? Are the Analyst opinions accurate?
We do not have the ability to forecast the future, with absolute certainty, no one does. However, Warren Buffet says “Price is what you pay, and Value is what you get,” so it’s important to re-asses when we are wrong, to ask has the original Valuation fundamentally changed that would then change the price by 10%?
I will come to an updated valuation in a moment, yet since the article, a few analysts have come out with low price targets for FMG. As an example, one Investment Bank has a price target of $3.90, some 20% below last Fridays close, based on an earnings cycle forecast 5 years out using Net Present Value (NPV) techniques.
So then what is the probability that this Investment Bank will be correct and my own thesis is incorrect? To understand the rationale, one needs to look at the historical success rate of Analysts at Investment Banks. I know many analysts and some are really good friends, however the statistics show a bleak picture.
The book “Contrarian Investment Strategies” by David Dreman, has a detailed diagnostic on the success rates of Analysts. With a sample size of over 500,000 individual analyst estimates over 23 years, some key conclusions:
The average error is a whopping 44% annually;
There is only a 1 in 130 chance that the analysts’ consensus forecast will be within +/-5% for any four consecutive quarters;
For any ten consecutive quarters, the odds of fine tuning the estimates for a company within +/- 5% fall to 1 in 200,000;
… and wait for it … for meeting forecast +/-5% for 20 consecutive quarters, has a probability of 1 in 50 billion.
So the probability the forecast is correct 5 years out, is 1 in 50 billion. Or as David Dreman says, to put this into perspective, the odds are ten times greater of being the winner of the New York State Lottery than pinpointing earnings five years ahead.
So what is an alternative. The Acquirers Multiple (AM’s), developed by Tobias Carlisle, is an approach in his new book “The Acquirers Multiple,” that has a valuable way to assess companies driven by deep value techniques. Tobias says in his new book:
“The Acquirers Multiple is an industrial strength PE multiple. It’s a throwback to the corporate raiders and buyouts of the 1980s – they used it to find treasure hidden in plain sight. It compares the total cost of the business to the operating income. It assumes the acquirer can sell assets, pay out the companies’ cash, or redirect cashflows.”
The first caveat is the approach is not forecasting. As the great Peter Lynch said "Trying to predict the direction of the market over one year, or even two years is impossible."
What Tobias has however found through back testing his approach, is that companies with high AM’s % have been shown to return 18.6% compound, far outstripping the S&P500. By flipping the denominator and putting Earnings on Enterprise Value, where Enterprise Value is Market Capitilisation + Cash - Debt, you reach the Acquirers Mutiple. So taking his method and doing another scan of the ASX300 companies, to calculate all of their Acquirer Multiple’s, FMG or Fortescue is the #1 AQ in the ASX 300. I will share the % later but first what makes Andrew Forrest's company so good is:
Firstly, looking at the Economics, FMG operates in an Oligopolistic market structure, dominated by a small number of major sellers, namely RIO, BHP and Vale. Together they control over 80% of the seaborne iron ore market. The industry has high barriers to entry given the massive capital expenditure requirements for start-up; and
Second FMG has Economies of Scale. It is the lowest iron ore producer globally and although some argue pricing is at “price taker,” its revenue stream is actually at marginal revenue; rent seeking behaviour. It has EBITDA margins over 56% and historical EBITDA at over $4b. A price taker does not have high EBITDA margins, it operates at marginal cost.
To then look at the performance of FY18 YTD and where it will finish, knowing that consensus forecasts are more often wrong rather than right by Analysts, below sets out a range of valuation scenarios (detail at end):
Scenario 1 (Yellow) – Base Case, using current Spot & Futures pricing: FY USD$66.85 62fe
Scenario 2 (Green): Scenario 1, yet in H2 Discount Gap Improves
Scenario 3 (Red) - Bullish: FY USD$70.35 62fe, with Q3/Q4 +10% in Futures
Scenario 4 (Blue): Scenario 3, yet in H2 Discount Gap Improves
Scenario 5 (Brown) - Bear: FY USD$60.81 62fe, with Q3/Q4 -20% in Futures
The EBITDA below has a potential range of $4.28b (bear) to $7.51b (bull) with $5.21b the Base Case predication based on current Spot YTD results and Futures pricing.
After adjusting for the Net Profit after Tax, the Earnings per Share (EPS), second table below comes out at $0.61 (bear) to $1.07 (bull), with $0.74 the Base Case predication based on current Spot YTD results and Futures pricing.
Using then Tobias Acquirer Multiple, including Depreciation and Amortisation, which reduces the Acquirer Multiple to capture functional intensity of capital, the range comes out at +25.5% (bear) to +44.7% (bull), with +31.0% the Base Case predication based on current Spot YTD results and Futures pricing.
By comparison last year the Acquirer Multiple for FMG was +24% and within the ASX universe of 108 companies with P/E >14, P/Book >2 and Market Cap >$100m they only produce +4% Acquirer Multiples - all stretched on fundamentals.
It is important to note that really high Acquirer Multiple, as Tobias flagged are potential buyouts. The company also has $130b of EBITDA income in the ground, yet to buy the company would only be c$16.8b – consider by comparison as I remember it well in a previous life, that WES bought Coles for $20b yet has half the FCF of FMG.
Post the Acquirer Multiple, , the Dividend Yield range is a worthy build. Based on company payout guidance at the low end of the 50%-80% payout ratio, the yield before franking credits is 7.8% (bear) to 13.8% (bull)m with 9.6% the Base Case predication based on current Spot YTD pricing and Futures pricing.
Then to calculate what the “price” should be using a similar method to the great Benjamin Graham, with no assumed perpetuity growth of EPS, the share price comes out at $7.89 (bear) to $13.85 (bull), with $9.62 the Base Case predication based on current Spot YTD pricing and Futures pricing. A significant premium to last Friday’s closing price of $4.65.
I have previously written about the Regression i did using 50-year trend data in Commodity Cycles and how it indicates we are currently at the beginning of a 4-year super cycle increase in prices, however I will leave that for the prior article. What is an important build is that Commentators continue to say the “Boom is Over” but they are referencing the human labour and start-up capital requirements, they once saw. With automation now the main game (FGM has over 108 driverless trucks), and CAPEX requirements now limited, the incremental return on funds deployed is high, enabling the high EBITDA margins.
Iron Ore the input for steel that FMG provides is the foundation of economic growth and expansion. It is highly unprobable a world exists without demand for steel, as multiple economies are now in sycronished global growth: China, India, Europe and America and steel is an input for many products and industries.
What we also do know as fact is that the Chinese still have over 800m people to move into the middle class and they aim to invest over $5trillion in the One Belt One Road Initiative. If you were going to invest $5 trillion, and a key commodity you need to source is iron ore, (which Australia has in abundance and you do not), would you not seek out the lowest marginal cost? As Ray Dalio, says “Not always everything you read is the truth,” yet the Chinese since 1080 have been formidable at aspects of warfare and deception, just consider the great “Master Sun” and this quote:
“Be extremely subtle even to the point of formlessness. Be extremely mysterious even to the point of soundlessness. Thereby you can be the director of the opponent's fate.”
They will hence want the price at a level that maximises the “monopsony” return. However the forward curve has recently exploded 15% since the rhetoric of pollution crackdowns by Xi Jinping in Northern provinces and demand has not dried up.
So next time like me, you may consider that your opinions held are naively wrong, or you are deviating from your principles, consider the valuation methods by Tobias Carlisle to re-assess the facts and take comfort in the history of success in Analyst predictions.
To close these are some of the great quotes I found by Ray Dalio in his recent book:
“The most important quality that differentiates successful people from unsuccessful people is our capacity to learn and adapt to these things (values and abilities).”
“I learned that there is an incredible beauty to mistakes, because embedded in each mistake is a puzzle, and a gem that I could get if I solved it, i.e., a principle that I could use to reduce my mistakes in the future.”
“Being open-minded is far more important than being bright or smart.”
“Reality + Dreams + Determination = A Successful Life.”
“Pain + Reflection = Progress.”
Omnium Optimi
(Latin-All the best)
Please feel free to leave your feedback. I would greatly welcome it, as Ray says learn and adapt.
Scenario Calculations:
(1) = FY USD$66.85 62fe given (0.25*Q1 $70.90 Price)+(0.25*Q2 $62 Price)+(Q3,$67.50)+(Q4,$66.98). Q3 And Q4 are Platts 62fe Futures Prices
(2) Scenario 1 with Spot price trend, yet in H2 FMG improves Discount Gap
(3) = FY USD$70.35 62fe given (0.25*Q1 $70.90 Price)+(0.25*Q2 $62 Price)+(Q3,$74.50)+(Q4,$73.98). Q3 And Q4 are Platts 62fe Futures Prices
(4) Scenario 3 with Spot price trend, yet in H2 FMG improves Discount Gap to long term mean
(5) Scenario 1 with a decline in Futures Spot pricing for Q3 and Q4 by 20% (Bear Market)
Recognition:
Thanks to @frankycc and @spuza12 for the feedback before posting. Appreciate there are mutiple ways to calculate Enterprise Value, so please take this into consideration when doing your valuation.
(20min delay)