ASX Fair Value 13 November 2011

Fair value range is defined by the value based on consensus earnings forecasts [4,322], and value based on earnings adjusted for leading economic indicators [4,095]. Currently the ASX (XJO/S&P500) is sitting right in the middle at 4,204. The fair value range is narrow, with a range of only 5%.

Dow Jones Fair Value November 2011

Current Assessment: the Dow Jones is approximately at fair value, with some downside risk.

This Dow Jones Composite Value Index is an aggregation of the 30 companies that make up the Dow Jones Industrial Average.

The aggregation is an approach which effectively combines all companies and treats them as if they were a single entity. Once that is achieved, it is possible to view the Dow companies in totality; measuring:

• combined value versus price – to help determine likely market movements up or down
• the primary valuation technique is on the basis of profitability and does not consider PE ratios, which I believe to be ineffective
• earnings trends, including incorporating leading economic indicators to measure against consensus earnings estimates
• profitability, cash flows, debt levels and financing activities, free cash flows (fundamental stats)
• sentiment indicators are included to provide an additional view of direction or risks
• two value metrics are used: valuation based on consensus earnings forecasts and valuation based on the earnings indicator using economic indicators

Value is a moving target. It is my view that markets are relatively efficient in aggregate over the medium term, but are not efficient at all times over all time-frames. It is also my view that markets are frequently relatively inefficient on an individual company basis over the short to medium term.

Value is a moving target – it is not static. Given that the economy and financial markets are dynamic and constantly forward-looking, value should change frequently. The reason for this is that I judge value not on what happened in the past, but what is happening in the future. Therefore expectations of earnings, and the probability of those earnings being met, are vital to driving perceptions of current value.

Note that this is not a value versus growth perspective. There is no such thing. Prices should generally move towards value, but value can be increasing or decreasing at any point of time. Therefore, there should not be such a thing as a ‘value investor’ or ‘growth investor’. Value is a consideration of what price should be paid on the basis of value heading either upwards or downwards. Situations where price materially diverges from value are likely to be bubbles on the basis of price. From an investment point of view, it is generally the right idea to invest at prices below value and sell at prices above value (with a margin), whilst having consideration as to whether value is increasing or decreasing.

Two companies out of the 30 are excluded – namely the banks JP Morgan and Bank of America. The reason for this is that they skew the fundamental data and reduce clarity of the dynamics of the other companies that are included.

IBM Releases Results - Tech Companies in the US looking good?

With results out from IBM, I thought I'd have a look at the state of the big US technology companies:


From Zero Hedge:

Putting the cherry on top of an ugly day for bulls comes global tech vanguard IBM, which did not use the DVA wildcard and still saw its earnings beat already reduced expectations of $3.22, printing at $3.28... but... it did miss the consensus top line of $26.34 billion by just under $200 milllion, at $26.16 billion. Since this the first time in probably forever that Big Blue has not beat the top line, the stock is certainly not too happy after hours. That this is happening despite the company's boost to its EPS forecast is quite troubling.

Earnings summary:

• Q3 Revenue USD 26.16bln vs. Exp. USD 26.34bln
• Q3 Operating margin 46.8% vs. Exp. 46.24%
• Q3 Services backlog of USD 137bln, up USD 2.4bln
• Q3 Software revenue USD 5.8bln, up 13%
• Q3 Americas revenue USD 10.9bln
• Sees year adjusted EPS at least USD 13.35, saw USD 13.25 vs. exp. USD 13.33

Also notable is that total ST and LT debt increased by $1.5 billion from $28.5 billion at December 31, to $30 billion at the end of Q3: at least someone is benefitting from relevarging at all time low yields.

From the release:

"In the third quarter, we drove revenue growth, margin expansion and increased earnings as a result of our innovation-based strategy and continued investment in growth initiatives," said Samuel J. Palmisano, IBM chairman, president and chief executive officer. “Growth markets delivered outstanding revenue performance across software, hardware, and services and contributed to the company's expanded margins. We also achieved strong results in Smarter Planet, business analytics and cloud.

"Based on this performance, we are raising our 2011 full-year operating earnings per share expectations to at least $13.35."

Full-Year 2011 Expectations

IBM raised its expectations for full-year 2011 GAAP diluted earnings per share to at least $12.95 from at least $12.87; and operating (non-GAAP) diluted earnings per share to at least $13.35 from at least $13.25. The 2011 operating (non-GAAP) earnings exclude $0.40 per share of charges for amortization of purchased intangible assets, other acquisition-related charges, and retirement-related items driven by changes to plan assets and liabilities primarily related to market performance.

IBM Value Analysis

IBM actually looks pretty good at the moment. Return on equity is forecast to decline, so this will be the area to watch. If IBM cann't stabalise ROE then they could suffer ongoing decline in the underlying value of the business.

Even so, it is very profitable right now and this has been reflected in the share price in recent years. Issues to watch out for is the debt level - however this is offset by very strong cash liquidity

 

Comparing to Google:

Google also looks good, which has the benefit of having very little debt on the books - unlike IBM. However, the market also tends to pay a premium for Google, which means that it is currently a bit pricey. Value seems to be stabalising around the $500 per share mark.

And Apple:

Whilst the loss of Steve Jobs is unlikely to have any dramatic implications for Apple in the near term, it is also a wonder how they can continue to increase their profitability as they have done in recent years.

What is most likely is that profitability, as measured by Return on Equity, should decline over the next few years. If profits are able to stabalise at current levels, the current share price at and around $400 is reasonable.

Meanwhile at Microsoft:

Even though we could see futher deterioration in the profitability at Microsoft, it may be just looking like the pick of the bunch now. It has a large margin of safety at current prices and, unlike apple, does not require the expectation of profitability growth to sustain or increase the current share price.


The quality of Microsoft is high with good cash flow and capital management.

Whilst some areas of the US market may be weak at the moment, the technology sector looks strong right now. With good profitability, cash flows and cash levels, this is an area that I think could significantly outperform the broader US market over the next year or two.

ASX20 XJO VALUE ANALYSIS UPDATE

Xjo (Asx20 Proxy) Aggregate Value Composite Index


I haven't posted any updates for some time.

I've beefed up my analysis system and now have integrated it with a new ASX20 XJO composite.

The update shows that the market appears to be well supported by value at current prices.

Sentiment indicators suggest that there has been too much bearishness lately, for obvious reasons with the Euro debt crisis in the spotlight, however unless company earnings deteriorate dramatically from here, there is some value to be had in the market.

Clearly anything can happen in the short term, but I still don't see a potential for a market crash based on the information at hand. This analysis suggests to me that the likelihood is for the market to maintain current levels, with volatile swings in the short-term.

BHP acquisition of Petrohawk Energy (NYSE: HK)

Good deal or bad deal?

Given a take-over price of $38.75 per share, I hope that BHP can see considerable potential in Petrohawk because based on current metrics, the deal doesn't look very good to me.

On the face of it, sounds like a great deal for Petrohawk shareholders, with existing value at around $15.36 and current price of $23.49. The BHP offer at $38.75 represents a huge premium over current price.

Is BHP running out of attractive acquisition targets that can pass under the political radar? If this is the case, it is not a great situation for BHP shareholder value.

Global gold stocks review & valuation: US & Canada

Value Short-List

Since this is an earnings based valuation model, I've excluded companies which are expected to be unprofitable over the next two years and those which are not currently producers.

Earnings Based Models for Valuing Gold and other Resource Stocks

I use an earnings based valuation model to obtain estimates of underlying business value to assist in finding companies for investment at prices significantly less than their value . As a shareholder of a business, you generally want good return on your capital, low dilution of your shares, and growing profitability with strong incremental return on reinvested profits. Some people like dividends, but I think that it is a personal preference. Generally high levels of profits being paid out in the form of dividends means that there are few profitable opportunities to reinvest profits back in to the business.

I believe that to be successful over long periods of time the trick is to be able to see where earnings are headed and to find the big trends. I think that it is also appropriate to use an earnings based method for valuing producing resource companies, which goes against what others believe. Many consider EV/Resources or EV/Reserves a good way to compare companies and determine relative value. However for me this doesn't make a lot of sense. I'm not saying it doesn't work, but it doesn't fit within my view of how the world works. I'll explain.

As an investor, I can choose to put my capital at risk if I expect that I can derive a rate of return greater than the risk involved. This return can be in the form of profits that are reinvested back in to the business or as a return of capital via dividend or other form. This is the key point. I need to have a certain rate of business revenue, less cost of operating the business, to derive a profit. You can put this down as a stock versus flow argument.

"A bird in the hand is worth two in the bush"

If I invest in a producing mining company my intent is profits. I want the proverbial bird in my hand and not left out in the bush. I'd also like it sooner rather than later, you know, the whole time value of money concept. In a cyclical commodity cycle and long term gold bull market, I definitely want the stuff in the hand.

Why is this? A bar of gold in the  hand is worth more than nuggets in the ground.  The reason for this is two-fold. Firstly, the gold in the hand is de-risked, whilst the gold in the ground may have difficulties with extraction and price of extraction may increase due to rising fuel costs, labour costs and so on. Secondly, the gold in the hand has optionality. It can be stored and utilised at any time. It can be sold and used to transact and acquire another business, it can be used to acquire new tenements which have known reserves or for greenfield exploration. It can be used to pay dividends, buy back shares, pay down debt.

This leads us to the flow argument. A producing mining company has flow as well as stock, while an explorer has only stock. Things change: commodity prices change, regulations change, governments change... you get the point. If you can get the flow out of the ground as quickly as possible at the lowest possible cost, you have something of real value. If you cannot get the flow out of the ground as quickly as possible and the cost is unknown, or at worst uneconomical, you have a potential liability on your hands. The former is desirable whilst the latter leads to capital raising in the form of more shares or more debt. When investing in mining companies, I'm actually investing in the flow and not the stock. 

But what about the mine life, you may ask. Surely if the mine life is expected to be short this is a bad thing, right? Well, given the value of flow over stock, this isn't as great a concern for me. If I'm investing in a company which is focusing on getting the metals out of the ground quickly, with low cost, profitable, strong cash flows and a demonstrated ability to do what they say they will do, what would stop them from purchasing another company that has less effective management or further tenements with known reserves that they are able to economically extract? This is the business side of the operations that I think is under-appreciated compared to the reserves. As with all businesses, effective management can lead to great things whilst valuable resources can be ruined with poor management. This is the key and this is why I value the flow of production over stock in the ground. From this point of view, you don't need to worry about the fact that individual resources are not infinite.

Companies included:
Barrick Agnico-Eagle Alamos Allied Nevada Argonaut Aurizon AngloGold Aurico B2Gold Centamin Centerra CGA Couer Claude Crocodile Colossus Drdgold Eldorado Franco-Nevada Freeport Goldcorp Great Basin Gold Fields Rangold Harmony Hecia Iamgold Jaguar Kinross Kirkland Minefinders Newmont New Gold Northgate Nevsun Oceana Osisko Perseus Royal Rubicon San Gold Semato Yamana