interviewMichael Pascoe: Your listed investment company, Clime...

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.