Call options, CFDs, debt value, equities, just a glimpse of some of the mystifying mumbo jumbo that shrouds the stock market. With many of us well under served by our compulsory superannuation and retirement, what’s the role of stocks for the beginner investor?
Audio – Roger Montgomery talks about Making good investments
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Roger Montgomery is a successful fund manager, public company chairman and, most recently, best selling investment author as well as being a bloke of great faith. He is passionate about putting successful stock market investing within the reach of everyone. Roger, on behalf of the novice investors all-around the country, thank you for joining us.
Breaking into the market as a solo investor is a pretty unsettling prospect.
Well, I think would be true if we listened to all the different advice and noise that exists in the stock market, which proves more than anything to be distracting. There are a couple of key things that you do need to know, but anyone without a stratospheric IQ can succeed in the stock market.
What is value investing?
Look, all investing is value investing. If you think of investing as the idea of laying down money today on the promise of receiving more in the future, value investing tries to actually increase the return that you get from that money in the future.
The first thing that you need to know is whether a business is a good business or a bad business. There's no point in buying something cheap if it deserves to be cheap. So, you want to buy something that is undeservedly cheap, and by definition of very high quality. And the way to identify businesses that are very high quality, and there is one arithmetic ratio that we think above all others is worthy of mention, and that is return on incremental equity. So, you're looking for businesses that generate very high rates of return on the money that's been entrusted to them. Well that's what we use to help us identify very high quality companies, and there are a number of other things, but that's the main one.
And then, ideally what we want is that very extraordinary quality business to be available at a cheap price, and there's a little formula that we use, which we have talked about on the blog and in the book I wrote called Value Able. And that formula seeks to identify a price below which you can safely say the business is cheap. And it's pretty straightforward; it's easy to explain.
And if you have a bank account with $10 million in it, for example, and let's say this particular bank account was going to be auctioned tonight on air, everybody would want to know. Well, what should I pay for this particular bank account? I don't want to get carried away. And let's suppose that $10 million bank account is generating an interest rate, and it's hypothetical of course, but it's generating an interest rate of 20 percent, which is very, very attractive.
Now, maybe neither you nor I are greedy enough to demand a 20 percent return; we'd be happy if we could get it. But, we'd be also happy if we could get a 10 percent return. So, if there's a bank account with $10 million and it's throwing out 20 percent every year in interest and it's paying it all-out, that's equivalent to $2 million of interest income. But, you and I are happy with 10 percent.
So, if we paid $20 million for that bank account when it comes to auction we will get a 10 percent return on that money because we've paid $20 million and every year we're receiving $2 million and it's equivalent to 10 percent. Now there's a little formula that as I say, I've written down, but it's simply return on equity divided by the return that we want, multiplied by how much equity is in the bank account, or how much equity is on the company's balance sheet.
So, now what we do is we turn the stock market on and we go to the auction, and the stock market is just an auction, and we decide whether or not we can get that particular bank account cheap. Now is nobody's there at the auction and people are willing to sell that particular bank account to us for $11 million or $12 million, well that's a lot less than what we valued that. Remember we valued it at $20 million. So, we know we are going to get a better than 10 percent return, we're delighted, and we'll bid for that bank account.
But, if the auction room is full and everyone is excited because interest rates are low and people are screaming from the bleachers to buy this thing and it's going for $30, $40, $50 million, well, the best thing to do as a value investor is to zip up your wallet and just wait. Because as surely as the sun rises, there will be periods of despondency and depression. And that's when you want to take advantage of low prices and great value.
So, in truth there is never such a thing as a bargain that will never come your way again?
That's exactly right. There will always be bargains because the stock market by its very nature, people who are in it are largely irrational with money, and they act emotionally, and they buy and sell shares in businesses based on things that have no bearing on that business.
So, if something's going on in the Ukraine or something's happening in France, or Italy or Germany, it doesn't affect how many buckets a variety discount retailer in Australia is selling. But, people will sell their shares because they're worried the price might fall further. And that's not investing; that's just gambling or speculation. That's betting on up or down, which is the same as betting on black or red at a casino.
Or you can treat it as a venue where you can buy pieces of some extraordinary businesses that are growing their profits in Australia, and overseas stupendously.
What do we need to know before we make that first buy?
Well you know what, and this is going to sound like a shameless plug, but that is precisely the reason I wrote Value Able in 2010; because there wasn't anything available to help people on the right track. There's a lot of misinformation. Did you know, for example that all of the economic commentary that we hear about economic growth and unemployment and inflation and those sorts of things have no relevance to stock market returns?
In fact there's a terrific study done by a friend of mine. And he looked at more than 360 years of economic data and found that when the economy grew stronger than average, half the time the stock market went up a lot and half the time it didn't. When the economy grew less than average, so it was weak, half the time the stock market went up strongly and half the time it didn't. So, it actually has no relevance, but yet we're told that we need to know all of this in order to be successful in the stock market.
And the industry I think really has done investors a disservice by making them believe that they're needed in order to navigate the stock market. It's a little bit like the terrific quote about witch doctors. A witch doctor gained fame and notoriety by prescribing two aspirin. And you have to do the rain dance and make it all sound complicated, because then the customer or the investor will think that the broker or the adviser is needed, but in reality it's pretty simple. You are just buying pieces of businesses.
Now in the short term the stock market will go up and down and prices will be volatile for the bipolar reasons I talked about earlier. But, in the long run, really good businesses will simply retain profits, so they make a profit in a year, they retain some of it, and they pay some of it out as a dividend. And as long as the retained profits are generating high rates of return and higher than you can get most elsewhere, then the value of that business will go up.
So, in a world where share prices are moving around a lot in the short term, the long-term value of businesses changes much more slowly, and it's a lot easier if you can turn the stock market off and just focus on those businesses. And there is a whole bunch in Australia that we are blessed with that generate very high returns. And that's partly because successive governments have been very lazy about industry structures and that's allowed monopolies and oligopolies and duopolies to form.
And because of that, they generate very high rates of return, and that's good for the owners of those businesses. I'll have to confess that it may not be good for their customers all the time, but it certainly is good if you're an owner of those businesses. And I've pointed out, many investors through their superannuation own pieces of these businesses.
Roger, what I'm about to ask you is almost the antithesis of what a great many people who are already in the stock market are going to want me to do. But, for those who are starting, what are the growth areas that represent real potential for people who are beginning or perhaps looking to broaden what is already an emerging portfolio?
Yes. Well I think that the health sector is going to be a growing area, and we are invested in a number of businesses. I'm looking for some other word, but biotechnology and also, I guess, health enhancing devices as well as hospitals. And the reason why they are growing is because of the aging baby boomers, which is a demographic that is very large. We've heard a lot about them, but as they approach retirement and the first of the baby boomers have already hit 65. So, as they retire and need to fund their health care they have the money to do it. And so we're going to see growth in that particular area.
Communications is another one. I always make the point that despite the fact that we're able to communicate much more easily than ever before, we are becoming worse and worse at communicating across the dining room table. But, nevertheless, it's true that communications are an area of enormous growth and opportunity.
And if you think about telecommunications and the cables that the data and the conversations around as freeways, they never shut down and the cars are never parked in the garage. People now keep their smart phones on 24 hours a day, seven days a week, and data are being transmitted to and from those devices along those freeways all the time. And somebody is receiving revenue for that. So that's another one.
Data storage is another huge area as we move toward driverless cars, as farmers start plugging in their animals and livestock to the Internet to monitor their health and whether they're pregnant, whether they are lame and those sorts of things. All that information needs to be stored and analyzed, and so data centers are another huge growth area to have a look at.
More cyclical in the short term is retailing, and there are always opportunities in investing in retailing because, invariably, the economy goes through periods where interest rates are low and employment is high or low, and that will have an affect on retailing. The market always goes too far in both directions, and when it becomes overly despondent and depressed and it thinks that we're going into a depression that's the time to buy-shares of good retailers, but not just any. And the good ones are the ones with little on their debt with very high rates of return on equity.
So, there are four things that I think I raise you to analyze, and to say their prospects are bright.
Roger, as we finish our conversation and thank you for your time, there are many listening right now who would like to explore ethical investment opportunities. Is there opportunity to ethically invest in the stock market?
Yes, there are. The difficulty is, and I've thought about this long and hard, the difficulty is it's a very personal and subjective thing. For example, you and I may agree that we don't want to invest in a logging company because we care about wombats; and that's just our personal view. Now, others might agree with that, and they too won't invest in a logging company. But, then, there are banks that are lending money to that logging company. Do you then not invest in the banks as well, because they're supporting that activity?
Where do you draw that line? So, I agree it's vital that there's a social conversation and social awareness conversation that needs to be had, but for everybody individually where they draw the line about what's acceptable and what's not will be different.
Now, there are a lot of very strong Christians in the United States that support gun ownership, and go hunting. But, others may disagree with that. So, they will be happy to own a gun manufacturer, but you and I might not. So, it's just very personal, and I don't think there is one size that fits all.
Roger Montgomery, it's been a pleasure talking with you. Thank you for clarifying the conversation around stocks, and I guess the essence of the conversation is do your homework. It's actually not that hard to do.
No it isn't. And remember, just high rates of return on equity, little or no debt, and wait for cheap prices.