A recurring dream

PORTFOLIO POINT: Strong recurring revenues, mixed with cheap valuations, will deliver above average returns, as our six stocks show.

Week after week I know that Eureka Report readers ask: 'How is the value-based portfolio travelling?’, and no doubt with the lift in the market over recent months anticipation has been heightened. Today I will outline the performance of the six stocks I chose at the start of October last year.

But first: do you remember what we wrote about back then? (See Value.able: Six new stocks). The market was down 20% and radio news programs led with stories of large losses overnight in foreign markets. Shortly afterwards the market officially entered a “bear” market.

And then it promptly bounced. I remember this period because it was when we started a new sub-portfolio with six stocks that had one thing in common: a high percentage of recurring revenue. We called it the Recurring Value.able Portfolio.

Now radio news programs are leading with stories of mayhem in Greece amid a vote to secure $171 billion in European funding without which Greece would fall into bankruptcy in mid-March. Putting aside the reality that if a country needs $US171 billion of funds, it is already bankrupt, and in the spirit of giving that appears to be upon us, let's review the Recurring Value.able Portfolio.

As I wrote back then: “All the companies selected enjoy high rates of return on equity; they all have manageable, little or no debt; and they all enjoy the benefits of low levels of capital intensity, helping to generate copious cash.

“But what really marks these companies: Hansen, Iress, REA, Reckon and M2 Communications as a little special is the significant levels of recurring revenue. Iress (ASX: IRE, MQR: A1), enjoys close to 80% recurring revenue through the supply of its information and trading platforms; Hansen (HSN, A1) close to 70% through the supply of billing platforms and software; Reckon (RKN, A1) close to 60% through its provision of online accounting, personal finance and practice management software; and M2 Telecommunications (MTU, A1) close to 67% through telecommunications and internet access plans.

“Think of the advantages of running a business that begins each year with a material amount of its revenue locked in for the next 12 months. It is these recurring revenue streams that help derisk a company through strengthening balance sheets. The solid financial position then enables a business to comfortably expand current operations and take maximum advantage of other opportunities as they arise.”

A year ago I wrote that a portfolio constructed from high recurring revenue businesses and purchased at prices representing a margin of safety, should outperform the index. It was on that basis that I created a second Value.able portfolio called the Recurring Value.able Portfolio. Sitting within the Value.able portfolio its purpose is simply to demonstrate to you the relative performance of these five holdings compared to the market.

You may recall I also overweighted the stocks that were trading at the largest discounts to my then estimate of intrinsic value and said: “I don’t believe the level of recurring revenue will change materially if Greece defaults and even if equity risk premiums increase because of more frequent recessions in the US” '¦adding “these holdings should perform as true defensives”.

Since I penned those thoughts, what has been the performance of each of the six companies’ shares? Hansen, Thorn group and M2 were all trading at discounts to our then estimate of intrinsic value, while Iress, Reckon, and REA Group were all at premiums to intrinsic value. The following table shows the share price increases and decreases for each of the six.

What I have done, is grouped those same companies by premium or discount to intrinsic value.

Those that were cheap are in the top half of the table, and produced a simple average return of 12.78%. Those that were expensive produced an average simple return of 4.72%. In other words, those with a high level of recurring income that were also cheap outperformed the All Ordinaries index; while those with a high level of recurring income but were expensive, on average, underperformed the All Ords.

Now, if you've been reading my column here long enough, you'll know that a short period is not long enough to measure relative or absolute performance and neither is a small sample, but nevertheless, we have to start somewhere and the reality is we have plenty of experience to support the notion that quality and value combined leads to outperformance over the long run.

As an update to our October piece on this subject, find following the Skaffold intrinsic value line charts for each of the six companies. They describe where the current price is compared to Skaffold’s estimate of intrinsic value and whether, based on current forecast earnings, intrinsic value is expected to rise materially in coming years.

Roger Montgomery is an analyst at Montgomery Investment Management and author of Value.able, available exclusively at rogermontgomery.com.