By Rodney Forrest
Ray Dalio, arguably the most successful hedge fund manager in the world, manages $160b. 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 LinkedIn, “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, as Warren Buffet says “price is what you pay, and value is what you get.” So, it’s important to re-assess when we are wrong, to ask if the original valuation fundamentally changed.
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 Friday’s close, based on a five-year earnings forecast.
So, 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, some are good friends, however, the statistics paint a bleak picture.
In “Contrarian Investment Strategies” by David Dreman, he does a detailed diagnostic on the success rates of analysts. He assessed a sample size of over 500,000 individual analyst estimates over 23 years, and came to these 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, the odds are ten times greater of being the winner of the New York State Lottery than pinpointing earnings five years ahead.
What is an alternative then? The Acquirer’s Multiple (AM), developed by Tobias Carlisle, is a valuable way to assess companies driven by deep value techniques. In his new book “The Acquirer’s Multiple,” Carlisle says:
“The Acquirer’s 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 cash flows.”
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 Carlisle found through back testing, is that companies with high AM scores 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 capitalisation - cash + debt, you reach the Acquirer's Multiple. Taking his method and doing another scan of the ASX300, after calculating all the Acquirer Multiples, FMG is has the #1 AQ score in the ASX300. I will share the score later, but first, what makes Andrew Forrest's company so good?
- 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 it’s a “price taker,” the EBITDA margins are over 56% and historical EBITDA is over $4b. A price taker does not have high EBITDA margins, it rather operates at marginal cost.
To then look at the performance of FY18 YTD and where it will finish, knowing that analyst consensus forecasts are more often wrong than right. The table below sets out a range of valuation scenarios (detail at end):
- Scenario 1 (Yellow) – Base case, using current spot & futures pricing: Full Year weighted average USD$66.85 62fe
- Scenario 2 (Green): Same as Scenario 1, but in H2, the discount gap improves
- Scenario 3 (Red) - Bullish: Full Year weighted averageUSD$70.35 62fe, with Q3/Q4 +10% in futures
- Scenario 4 (Blue): Same as Scenario 3, but in H2, the discount gap improves
- Scenario 5 (Brown) - Bear: Full Year weighted averageY 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 (NPAT), the Earnings per Share (EPS), the 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 the Acquirer’s Multiple, including depreciation and amortisation, the range comes out at +25.5% (bear) to +44.7% (bull). The base case is +31.0% based on current spot YTD results and futures pricing.
By comparison, last year the Acquirer’s Multiple for FMG was +24%. Looking at the 108 ASX 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 companies with an unusually high Acquirer Multiple, as Carlisle flagged, are potential buyouts.
FMG also has $130b of EBITDA ‘in the ground’, yet to buy the company would only be c$16.8b. By comparison, Wesfarmers bought Coles for ~$20b in 2007, yet Coles has half the free cash flow of FMG.
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). The base case is 9.6% 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). The base case is $9.62 based on current spot YTD pricing and futures pricing; a significant premium to last Friday’s closing price of $4.65.
Commentators continue to say the “boom is over” but they are referencing the human labour and start-up capital requirements. With automation now the main game (FMG has over 100 driverless trucks), and CAPEX requirements now limited, the incremental return on funds deployed is high, enabling high EBITDA margins.
Iron ore is the foundation of economic growth and expansion. It is highly improbable a world exists without demand for steel, as multiple economies are now in synchronised global growth: China, India, Europe and America.
What we also do know as fact is that the Chinese still have over 600m people to move into the middle class and they aim to invest over $5 trillion yuan in the One Belt One Road Initiative. If you were going to invest $5 trillion yuan, and a key commodity you need to source is iron ore, (which Australia has in abundance), 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” (when there is only one buyer in the market) return. The forward curve has recently exploded 15% since the rhetoric of pollution crackdowns by Xi Jinping in Northern provinces, but 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.”
“Learn to understand your weaknesses. The quality of your life depends on what decisions you make. Learn to evolve as soon as possible. Happiness is usually attained when the particular event exceeds your expectations.”
“Being open-minded is far more important than being bright or smart.”
“Reality + Dreams + Determination = A Successful Life.”
“Pain + Reflection = Progress.”
(Latin-All the best)
Note: The author is of no relation to Andrew Forrest
Ray Dalio’s book “Principles: Life and Work” can be found at - Principles-Life-Work
Tobias Carlisle book “Acquirer Multiple” at – Acquirers-Multiple-Billionaire-Contrarians
David Dreman book “Contrarian Investment Strategies” at - Contrarian-Investment-Strategies-Next-Generation
(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)