Friday, November 11, 2005

Recommending Redflex Holdings

I would like to recommend a new stock for your research and perhaps purchase. If you follow my occasional investment newsletters (and upcoming Financial Planning website), you know I don’t recommend new ideas lightly. They have to be original to me, not some pass along idea. The company I am recommending is Redflex Holdings. This is a company we discovered the hard way: by getting a traffic ticket.

Redflex Holdings is a technology company with Australian originations. It has moved its USA HQ to Scottsdale, AZ (who can blame them!). Redflex has its roots in military communications. It continues a Communications Division that has contracts with Lockheed and the US Navy. In Australia, Redflex developed a “traffic enforcement” technology, using cameras mounted at intersections and high speed digital photo analysis to determine drivers who violate red lights (hence the name of the company). The technology is very precise and accurate and the results are great for the municipalities that contract with Redflex: they get better traffic control enforcement, leaving police to higher duties like fighting crime, and cities do not have any capital expense, but share the fines with Redflex. Redflex also offers a “speed limit enforcement” system that is gradually being deployed around the world.

My interest in this company is based on several factors: a contractual monopoly, or as Warren Buffet calls it, a “toll business with a wide moat”, recurring revenues due to its business model of sharing fines with the municipalities contracted to it, a small business base with a very large potential market, significant penetration and demonstrated success, an established business (defense contractor) that feeds capital into the new growth business (this provides dependable cash flow to finance growth reducing risk of growing faster than liquidity permits), provides a service that is very beneficial to society and not a fashion or fad.

Here are some of the metrics which are attractive: low awareness by the investing community (I had never heard of this company until we received a ticket), reasonable price compared to growth rate (40% revenue growth and 50% earnings growth year over year vs. a P/E of around 30), Positive Operating Cash Flow ($15M in 2005 vs. $5M in 2004, price ratio of less than 6 times cash flow), Reasonable price to sales ratio (about 1.8, very good for a fast growing tech company), solid return on equity (15% as calculated by $9M earnings per share divided by $60M net equity per share). Here is the Annual Report: http://www.redflex.com.au/ASX_announcements/PDF/274690.pdf

Many times, the financial metrics for a small growth company are not nearly as attractive as this. Often a lot of faith is required to purchase a small cap growth stock. They frequently are expected to lose money for several years (Amazon STILL is losing money!) That makes this story even better.

What can go wrong? There could be a backlash against automated traffic enforcement. In the Annual Report is a warning that the Ohio state legislature has a bill that would require manual (police officer) enforcement. I think that while this is the emotional response (BIG BROTHER), that eventually people will get used to the idea and accept it. The accuracy is undeniable as the ticket received in the mail has photos of your car with a closeup of the intersection traffic signals and your license plate. You cannot deny the light is Red as you are in the intersection. You can see its color in the photo. The timing of the infraction is to the 1/10th of a second along with indication of speed traveled (which is the basis for the future implementation of speed control).

There may be patent or other intellectual property challenges. Redflex won such a suit earlier this year (actually, it was dismissed). So, like all investments, this has some risk. But I think the upside is worth the risk in this case. Redflex trades as RDF on the OTC BB as RFLXY (20.50 USD on Nov. 11). It trades as 1 share to 8 on the ASX (Australian) exchange. Today (Nov. 11), the RDF.ASX closed at 3.54 AUD on 293K shares (about 3 times normal daily volume). The exchange rate is 1.34 AUD to the USD. So there is no difference between the two markets on converted price. The stock has been going up all year on increasing contracts for the Traffic systems (several signed this week). This could be a very large winner over the next 5 years based on the available market and the minimal penetration to date.

Monday, July 11, 2005

The Power of 11

In this week’s Barrons (July 11, 2005) is a great article on the merits of investing at the market’s current valuation. Jeff Murphy and I joke about the Power of 11. This is our own spin on the common advice of saving / investing 10% of income for a comfortable retirement. Just to be different, we have updated this “saw” to 11% invested in the market for an 11% return (compounding will cause the amount invested to double every 6.5 years, growing in an exponential fashion).

Well, what should I find this week but some academic research that not only reinforces the number ‘11’, but also makes a very compelling case for the fact that the market is currently overvalued, and that the 11% market return is “baked into the cake” over the very long term. What was eye-opening for me was the way this number was derived: from backing out of “Return on Equity”. Of Course! The ROE is a ratio of the profits (Return) as a percent of equity (Book Value as calculated by Assets minus Liabilities). The results are inherently “normalized” because book value should be inflated or deflated by the value of the currency, maybe not in one year, but over a period of years, say twenty.

Not only does the market provide a consistent 11% ROE over long periods of time, but it also grows very dependably at a 5% rate: Very encouraging for the long run. However, in the short run, using the same metrics, it can be shown that the DOW is more than double its historical value based on this analysis. It should be 4500, not 10,500. How does it get back to its long run average? Does it collapse by 50% or more? Probably not. But this builds the case for sideways trading for another decade while the Return catches up with the Equity.

Why is this 11% number so constant? People (the market) determine the price of the assets that comprise the aggregated “Stock Market” through the bidding process. People have the same sense of valuation over long periods of time, all other things being equal, like currency. To make this point from a different perspective, human beings have essentially the same fundamental needs requiring satisfaction: air, water, food, shelter, etc. These survival needs are programmed into us by our basic genetic code. Most of us, statistically, must make decisions on what to buy, how much to pay, for those basic necessities of life: Adam Smith’s “Invisible Hand”. It can be reasoned that since we all have the same genetically wired perspective on how the essentials should be valued, in the aggregate we end up valuing all market assets in a similar way.

Competition amongst us dictates that we will bid the price of a basket of financial assets to a return of no more than 11.6% and no less than 10.5%, in the long run. If short term exuberance or discourage gets the best of us for a period of time, we will inherently wait until the return adjusts to our required comfort zone or norm.


Read On:



The 11% Solution

Forecasting broad market earnings creates new problems for investors

By ADAM BARTH


EVERY BUSINESS DAY, INVESTORS ARE BOMBARDED with new economic data, macro and micro, all of which supposedly affect the value of U.S. stocks. While some investors may dismiss macroeconomic information such as quarterly gross domestic product, initial jobless claims and factory orders as irrelevant in the making of portfolio decisions, few probably would file this year's and next year's earnings estimates for the Dow Industrials or Standard & Poor's 500 under a "More Useless Information" heading.

But that's what they ought to do: Insights about individual firms are valuable; fixation on broad measures of current or future earnings isn't. Not because predicting corporate earnings is an impossible task, but because future long-term macro-earnings can be predicted with almost complete precision.

Examine the Dow's annual return on equity for each 20-year period since 1920 (that is, 1920 through 1939, 1921 through 1940, and so on): Average earnings as a function of book value barely varies in the slightest, and has remained basically immune to inflation, wars, massive changes in the tax code or any other external factor.

For the 34 consecutive 20-year stretches between 1934-1953 and 1967-1986, the return fell in an incredibly narrow range of 10.5% to 11.6% -- or an average of around 11%. Furthermore, the Dow's book-value growth rate has remained near its 4.8% historical average from 1920 to 2003 for every 20-year period on record.

A Simple Calculation

Finding the Dow's normalized earnings in any given year is as simple as multiplying 11% by the Dow's book value at the time. These earnings will grow at a little under 5% per year -- the Dow's steady and predictable 20-year book-value expansion rate.

Although almost all analysts focus on the current or following year's earnings forecast in valuing stock indexes such as the Dow, the approach is primitive and misleading. While earnings gyrate from year to year, the Dow's earnings over the coming 20 years or any 20 years is virtually preordained.

The popular notion that the long-term earnings growth rate is highly variable and affected by the daily news that speculators, economists and the media slavishly focus on is a great red herring.

The portfolio strategy of "relative value" is based on this red herring. The many purveyors of this strategy tout their "bargain" investments in companies trading at price-earnings ratios in excess of 20 and well above any asset conversion or private-market value.

Where is the margin of safety for these investments? According to these investment managers, it exists in how underpriced their investments are, relative to the market. While these managers claim to be "bottom-up" value investors, they actually have tied their fates to that of the broader market.

A major reason for these managers' decision to shadow an index is the belief that stocks' superior performance in the past proves that they have been mistakenly undervalued, and should now command a richer valuation. As a result, most money managers have rejected traditional equity-valuation standards as overly demanding, and have replaced them with newer measures.

A Peculiar Notion


The most popular and influential of these new approaches is the "Fed model," which holds that U.S. stocks' earnings yield should equal that of the federal government's 10-year bond.

This Fed model rests on the absurd proposition that corporations' equity -- their most junior and risky obligation -- should be equated with U.S. government debt. This approach is nonsensical, as it completely ignores companies' priority of obligations and posits that U.S. public corporations' equity cost of capital should be the same as the risk-free rate. The Fed model pretends that the cardinal risk-and-return principles of finance do not exist.

In the rush to create valuation models that justify current stock prices, investors and economists have missed the clear evidence that historical valuations are not only logical, but virtually necessary.

The 11% solution demonstrates why this is so. Of the Dow's 11% ROE, 5% has consistently been retained -- thus allowing the Dow's 5% earnings-growth rate. The remaining 6% has been free cash flow available for distribution to shareholders in the form of dividends and stock buybacks. As such, the Dow is a perpetuity that can be easily valued by dividing its current free cash flow (6% of current book value) by its expected rate of return minus its long-term growth rate (9% minus 5%).

With the Dow's current book value a little under 3000, its normalized free cash flow is roughly 180. Dividing 180 by an expected return of 9% minus free cash flow growth of 5% (.09 - .05) yields a valuation for the Dow of 4500, less than half of its current market valuation. To justify a Dow value of 10,500, one has to lower the future expected investment return for the Dow to 6.7%.

From 1920 to 2003, Moody's Aaa corporate-bond yield averaged 5.9%. Recently, Barron's Best Grade Index has shown a current yield of 5.24% for top-grade corporate bonds. Assuming a forward rate of return of 6.7% for the Dow would imply an equity-risk premium of just 0.8% to 1.5%.

The preceding analysis will probably shock most investors. Conventional wisdom is that the Dow's earnings are much higher, and that its P/E ratio is much lower. Conventional wisdom, however, is based on some bizarre assumptions and beliefs.

A normalized 20 P/E ratio for the Dow would imply a normalized 18% return on equity (5% earnings yield x 3.6 book value multiple = 18%). While the Dow averaged an 18% return on equity over the prior decade, assuming a lasting return on equity anywhere near this figure is absurd, given the historical record.

Although there have been many short periods in the past during which the Dow Industrials' return on equity significantly exceeded 11% (such as the 1920s, when it also averaged 18%), an elevated return on equity has always come at the expense of future profits, and ROE has always reverted near its 11% average over each 20-year period. While the causes (excess credit creation, faulty accounting) may be contested, the results are incontestable.

Putting history aside, basic logic alone dictates that a sustained 18% ROE is impossible. A return of this magnitude would mean that American business as a whole is capable of lasting, monopoly-type profits. The truth is the exact opposite: Big Business' profit growth has consistently trailed broad economic expansion, with nominal GDP growth increasing at a 7% rate and Dow profit growth lagging behind, at near 5%, for nearly every 20-year period on record.

Small Margin of Safety

Current stock-market valuation levels have made the search for equities that possess a margin of safety a generally difficult task, and the job of professionally managing money even more difficult, given the myriad pressures and incentives to remain fully invested.

In response to this challenge, many investors have turned to a relative, rather than absolute, value approach.

The problem is that these investment approaches are radically different, despite some seeming similarities. In choosing relative value, investors subject themselves to the value of the broad market.

This is not a prudent choice, given the current valuation of large-cap U.S. stocks and the limits to these companies' profitability and growth, as demonstrated by the 11% solution.

Monday, May 23, 2005

Bill Gross and the Coming of Stagflation

It is time to make a slight change in my past prognostication of “stagflation” in the USA economy and the resulting investment implications. I think the “stag” is here to stay for a while, but am changing my position on the “flation”. I derive quite a bit of my economic and interest rate insights from reading Bill Gross’s monthly commentaries. This month, Bill is making a change in his call on the future of inflation and interest rates, so I will too.

What does this call mean for a USA investor? Bill argues for a practical limit on real interest rates of 0% (real interest rate = inflation minus nominal short term interest rates). We are currently at 1% (as shown by TIPS), so he makes the case that there is very little room left for further real interest rate reduction by the Fed. The real interest rate in early 2003 was 4% (at the end of the last recession when real interest rates were typically high as the Fed stimulates the economy. This stimulation can also be seen in a steep Treasury yield curve). A declining real interest rate is reflationary or inflationary and signals monetary stimulation. Since there is little more room to stimulate, as given by the low real interest rate, there is little chance for a significant increase in inflation, so the argument goes.

From this line of reasoning comes Bill Gross’s and Pimco’s interest rate forecast for the next 5 years on the 10 year Treasury of 3% to 4.5%, nominal, with inflation at around 3%, as it is right now. This bodes well for Treasury bonds and other high quality debt instruments (municipals, high grade corporates). It is also modestly positive for stocks since low real interest rates make corporate cash flow yield (CF/price) relatively more attractive.

There is still a case for hard asset inflation for those assets that are supply-limited with high demand in the developing world. Oil may be one such asset, grains another (with an improving diet among the billions in Asia who are seeing a rising standard of living). There is also a longer term case for precious metals. When the world comes off “Bretton Woods 2” (as Gross tags it, the use of the US dollar as the world’s reserve currency) and switches back to some type of gold standard, as is predicted, it will greatly increase demand for gold and related precious metals. China is likely to make a gradual move away from the dollar as a benchmark over the next five years. Since there is no other reasonable paper benchmark (the Euro, unlikely; the yen…No Way!), either gold, or an index of commodities is likely the future reserve for the Chinese currency.

But the outlook for financial assets, and real estate is more of a financial asset than hard asset in today’s highly mortgaged / leveraged world, is not so good. Financial assets rely on a contraction of real interest rates to increase their value, and as Gross points out, the Fed-orchestrated contraction has run its course.

Neither can a case be made for any type of manufacturing product, either the capital goods to conduct manufacturing or the consumer and industrial products made by manufacturing. This is a world marked by excess supply of manufactured goods, with low cost labor in developing economies, a flood of capital into those economies to build manufacturing plant and the remains of the manufacturing expansion of the late 90s. It is this excess supply of manufactured goods that keeps a cap on inflation, limits employment growth in the developed economies, an also limits the upside for the stock market, especially the capital equipment and technology sectors.

Friday, April 15, 2005

"Fool's Gold in Oil Patch" Makes Dorsey the Fool

TO: Patrick Dorsey, Morningstar Editor:

Patrick, I found your analysis of the oil sector in “Fool’s Gold in the Oil Patch” posted on the Morningstar.com website to be highly flawed in its assumptions. Although you try to support your arguments with data from Morningstar, the data does not at all confirm the points you are making. I found your chart on the price of gasoline versus demand in California to be particularly unimpressive. It makes the assumption that gas prices in the US respond to demand in California. I don’t think so. Gas prices respond to the cost of oil first, and the availability of refining capacity second. A maintenance shut-down at a large refinery has much more to do with short term price variations in gasoline than does demand. Demand for gasoline changes in the short term due to seasonal factors, not due to driving patterns.

To dissect your weak arguments, first examine your statement about the acceptable price of a barrel of oil to the makers of the market, namely OPEC and the Saudia Arabia princes. It is flawed from the outset. You make the point that they are implicitly targeting a mid-30s price for oil, yet on CNBC this morning, Prince Alaweed stated that Saudia Arabia has abandoned that target and are instead targeting $40-50 / barrel. He stated OPEC’s comfort with $50 per barrel oil based on the observation it was not causing significant global economic damage. So your argument about where the price of oil will settle is already in danger.

Next, you make the case for the long run price of oil per barrel to be around $20. This is incorrect. Please cite your sources when you make statements such as this. The long run price is closer to $40 per barrel. Someone “Infinitely” (your choice of words to describe where oil would have to go to make a good investment) more credentialed than you to make statements about the long price of oil is Ben Bernanke, one of the Federal Reserve Board members and the leading candidate to replace Allen Greenspan as chairman. In a speech / article he authored in October 2004 (http://www.federalreserve.gov/boarddocs/speeches/2004/20041021/default.htm) he makes the compelling case, backed up by serious research, that $39 is a minimum price based on industry data. He references that as of October last year, the futures market was implicitly pricing the long run value of oil between $38 and $60 per barrel (2/3 probability). Of course, the futures market has priced oil even higher recently (as of April 2005), but we will let that point go for now.

Your financial analysis of the market, using Morningstar “return on invested capital” data appears compelling and may “Fool” some of your readers. However, it does not take into account the backward looking nature of the data. 2004 industry returns were based on oil prices from 2003 and 2002, since most industry players hedge in the futures market to smooth their earnings. The industry profits do not respond instantly to changes in the sales price of oil. 2005 and 2006 oil prices will be much more informative about the effect on industry profits of price per barrel in 2004.

Also, your position is in opposition to (besides the Saudis), T. Boone Pickens and Tom Petrie (of Petrie-Parkman) all of whom know much more about the industry than do you. Check out their websites and do a little research.

What your thesis completely ignores is the significant changes in global demand and supply over the past 10 years. In the 80s and 90s, the Pacific Rim nations developed as suppliers of electronic and heavy industry goods to the USA. Their development did not require significant increases in oil-based energy. It did not drive demand higher at a time when global oil reserves were still sufficient for global demand. Now, however, nations with much larger land mass per capita are undergoing development (China, India, Brazil, and Eastern Europe and Russia to a lesser extent). These nations will be voracious consumers of oil-based energy to meet their public’s transportation needs. Alternatives to oil-based transportation are well off in the future. Fuel cell technology is more than a decade from commercial reality (check out the price of Ballard Energy stock). Even when it becomes a reality, the first versions of fuel cell vehicles are expected to run on natural gas. So your demand story based on replacement technologies is just plain wrong.

The supply story is equally wrong. In the past, there was always plenty of cheap oil to exploit when demand increased, allowing for supply to meet (or exceed) demand. This was the case in the 1970s when the Middle East oil infrastructure was not completely developed. Now, however, the easy oil is gone. There are no new discoveries where, like Jed Clampett, you can shoot your shotgun at the ground and have oil spurt out. All the world’s oil, even in Saudi Arabia, will require more expensive techniques for extraction, at the very least pumping and in many cases stimulation techniques involving insertion of chemicals and /or steam into the wells. This will raise the bar on the minimum economic cost of a barrel of oil. Producers do not produce for long below their break-even point which puts a floor under the price of oil. That floor is going from $20, where it was in the 80s, to $40, where it will be by 2010. This is the information you can glean from industry experts if you will take the time to research the industry, before spouting your wisdom.

The bottom line: I am glad there are people like you to scare investors out of the oil market. It leaves better investing opportunities for people like me.