Qualiport

The Weekly Qualiport Report by Bruce Jackson (TMFGoogly)

Rentokil Update

The market has been on a bit of a roll since last week's report, with the FTSE 100 index rising an impressive 3.2% to 5272.3 and within reach of its all time closing high set back in October last year. Yet good old Rentokil again managed to more than keep pace with our benchmark index, just winning the week with a 3.5% increase. It closed today at 295p. Year to date, the Qualiport has a handy lead after just 3 weeks, being +11.7% vs. the Footsie's +2.7%. We're not counting our chickens yet, but we're happy to take this lead into battle over the next 49 weeks.

Rentokil Initial will be reporting their results for the year ended 31st December 1997 on Wednesday 11th March 1998. Naturally, we'll be reporting here on their progress. I don't expect any shocks, either up or down, on the earnings front. I'll be most interested to look at their margins for any sign of further improvement.

Marks & Spencer -- The Decision

As I have previously commented about Rentokil, and now Marks & Spencer, the beauty of both these companies is the relative predictability of their earnings. As we know, Rentokil actually go so far as to state their aim of 20% per annum growth in profits and earnings at the beginning of their annual report.

Whilst Marks & Spencer don't actually state their projected earnings growth, you don't need to be a rocket scientist (and believe me I'm not!) to work out a realistic growth rate. A company the size of M&S, with annual sales of close to £8 billion, physically can't grow by a rate much more than 15% per annum over the next 10 years. In the last 5 years, they have grown by a compounded rate of 10% per annum.

Before we decide whether M&S is a Qualiport buy, I want to re-iterate that we are looking to buy quality companies at attractive prices. You can't have one without the other.

Marks and Spencer is a quality company. It is the leading retailer in the country and has the leading brand name, its reputation is second to none, and its name is synonymous with quality. Headed by Sir Richard Greenbury, its board is steeped in experience -- M&S experience. Sir Richard is 60 years old and has been with the company for a massive 43 years. His deputy, Keith Oates, is 54 and a mere junior in terms of M&S experience at 13 years. Behind them, we find a whole bevy of directors bought up in the M&S culture. Most have well over 20 years' company experience.

So, we have decided that M&S is a quality company, with excellent management. We would therefore be willing to become part owners in this company if the price is right.

Valuation

In last week's Qualiport round up, I awarded M&S a 12% long term growth rate when calculating the sort of return we could expect if we bought and held shares in the company for the next 10 years. This may turn out to be a little optimistic so without boring you again with the full table, here's a possible range of growth rates with their 5 and 10 year target share prices.

Current Share Price : 600p
Current FY gross dividend : 13.0p
Current P/E : 22.4


10 Year 5 Yr Target 10 Yr Target 10 Yr  per annum Forward
Growth   Price       Price        Return           P/E 

7.5%     540p        775p          5.6%             13
10%      637p       1027p          8.2%             14
12%      734p       1294p         10.4%             15

As you can see, at long term growth rates of 7.5% and 10% there is little or no premium to be made above the risk free rate of return, which is hovering around the 6% mark. At those growth rates, you'd be better off leaving your money in the bank.

The main reason why the returns look relatively unattractive is the high trailing P/E the market has awarded M&S. At around 22, the current P/E is at a 120% premium to its last 5 year growth rate of 10%, giving the shares a trailing PEG of 2.2. Historically, the market has traded on a price earnings to growth factor of 1.5. Multiplying the historical growth rate by this factor gives a fair value P/E of 15.

In the past 5 years, during which M&S has grown its earnings by 10% per annum, the market has awarded this quality company an average P/E of around 20. Going forward, it is not inconceivable that M&S will continue to trade at this valuation for the next 10 years. As a proviso, they would have to continue growing at a minimum 10% per annum to maintain that premium rating. If that were to be the case, it would put a different complexion on the 10 year annualised returns. With 10% growth, the annualised return to 2008 would be 11.3% and with 12% growth it would be 13% with a future share price of 1725p. Suddenly the returns look a bit more attractive.

We have now come up with a 10 year target share price range from a low of 775p to a high of 1725p, with a most likely mid point of 1294p. The respective annual rates of return are 5.6%, 13.0% and 10.4%.

The Decision

Having weighed up the different potential returns, at this juncture I have decided NOT to buy Marks & Spencer for the Qualiport. This decision is based purely on valuation, as I am satisfied that this is a quality company worthy of Qualiport consideration.

In making this decision today, I am therefore not ruling out buying the company sometime in the future. If M&S were ever again to trade at an attractive price, I would be a fool (small "f") not to re-consider buying them. It's just at this level, there is relatively little upside potential. A company the size of M&S just hasn't the ability to surprise. Having said that, they are embarking on an unprecedented expansion programme, but even still I would say that their long term growth rate would struggle to exceed 12% per annum.

The shares are trading at an historically high level. Their average P/E over the last 5 years has been around 20, and they are now trading at a 10% premium to that level. It is quite conceivable that the share price could drop 10% too, bringing them back to 540p. Even at that level they would be no screaming bargain.

So there we have it. Rentokil are still all on their own in the Qualiport. As I've said in previous re-caps, we're not in a huge hurry to add shares to the Qualiport just for the sake of it. We are happy that Rentokil on its own will provide market beating returns over the long term. We do also realise the need to diversify, and are actively looking at various possibilities. With the market nearing its all time high, its just a little more difficult to come up with quality companies at attractive prices. The hunt continues.

Fool on,
Bruce Jackson (TMFGoogly)

Qualiport Numbers

Rec'd      #     Stock      Bought       Now     Change       Change
                             £            £        %           £

19/12/97  1565  Rentokil      2.55         2.95   +15.7%        +0.40
19/12/97  1565  Rentokil  4,040.63     4,616.75   +14.3%      +576.12


                   Week          Year         History

Qualiport          +3.5%        +11.7%         +14.3%
FTSE 100           +3.2%         +2.7%          +5.0%
FTSE All Share     +2.5%         +2.3%          +4.5%