Qualiport

The series continues with points four to seven.

Portfolio Update

Before launching into part two of the definition of a quality company, I just want to remind Fools that one of our three Qualiport companies reported their annual results yesterday. This is an event in itself, because each UK quoted company reports its numbers only twice a year. Not for us is the quarterly reporting cycle that US quoted companies enjoy. We have to be patient. Although I'm a fan of knowing about our companies on a more regular basis than twice a year, quarterly reporting can often be detrimental to the long-term growth of the companies themselves. Because the market (and therefore the company's share price) places such importance on the quarterly earnings estimates, it can sometimes force the officers of a publicly quoted company to focus their minds on blocks of 3 months only, to the detriment of the longer term bigger picture.

Our company reporting this week was our newest Qualiport member, Marks & Spencer. The results had extended coverage in last night's Daily Fool and in this morning's press. Just briefly, M&S reported earnings per share (EPS) growth of just 4.1%, which was pretty much in line with the consensus estimates. Like most retailers, they are finding the current trading conditions tough going, and their exposure to the Far East doesn't help either. Nevertheless, their unprecedented expansion programme continues as planned. M&S' capital expenditure in the 1998 fiscal year was £740m, up an amazing 73% from the £426m spent in 1997. The company hopes to see the fruits of this expenditure in 1999/2000. And we thought this was a mature company?

I'll quote one Foolish line from yesterday's preliminary announcement, "The continued recession across much of the (European) Continent provided excellent opportunities for site acquisition although it has impacted on our performance in the short term." Like investing in the stock market, the time to set up new enterprises is not at the peak, but at the trough. Marks & Spencer are studiously, and Foolishly, avoiding the lemming like attitude of piling in at the top. If they can make a go of it in a recession, all the better for the future when the European economy eventually turns up, which it surely must.

When we bought our shares in M&S, we were hoping that they would go up by about 12% per annum over many years to come. We're still confident about that, as we are confident in the company's prospects and particularly its management. Much of our 1998 12% share price growth is already in the price, but hey, who's complaining? If the share price happens to go up 15% this year, we would not expect that appreciation to be matched next year. We're not trying to time the market, we're just investing in what we think are quality companies and holding them for the long term.

The Qualiport portfolio today hit an all time high in monetary terms, but not in percentage terms. Back on April 9th, when Rentokil Initial was still the only company in the portfolio, we hit a percentage gain high of 56.5% since inception. The gain to date now is 52.8%, but we are now a bit more diversified. In the same period of time, the Footsie 100 has gone up by 17.7%. In horse racing parlance, we're 10 lengths ahead, but there's still a circuit to go until the end of the year.

A Quality Company

On Friday, we started looking at the criteria we think a quality company should possess. In reality, no company will match all these criteria, because the perfect company does not exist. Some I'm sure come reasonably close, but none are perfect. To recap on the first 3 points:

1. A well managed company.
2. Strong, and ideally increasing, margins.
3. Strong brand name and competitive advantage.

And to add some more:

4. A company that you understand, and that has predictable earnings.

This should arguably have been the first point. It follows the Peter Lynch maxim of "buy what you know." It is no use investing in a company in which you don't understand the business. Always remember that you are buying a part-ownership in a business when you buy shares in a company. Try and imagine yourself as buying the whole company. You wouldn't dare buy a whole company without checking out their activities, interviewing the management, and understanding exactly what they do. The same goes for buying a part-ownership in a company. Who knows, one day you may even want to take over the whole thing.

A company which has predictable earnings is usually one which is involved in a business that is not constantly in a state of change. You don't want to be invested in a company that constantly needs to change its product range just to keep up with the competition. We encourage innovation, but you want to make sure you invest in the innovator and not the follower.

Warren Buffett said, "It is better to be certain of a good result than hopeful of a great one." This refers exactly to the predictability of earnings that quality companies possess.

5. A company that has a proven past growth record.

This links back to the good management and increasing margins points previously made. Looked at in isolation, a good past record means nothing. The worst managers in the world could often be in charge of a fast growing company with a fine record over the past 3 years. Conversely, the best managers in the world will not necessarily be running the best company. You would want to be invested in neither of these companies, but if you were forced to choose between the two, nine times out of ten you'd do better over the long term with the great managers.

A business with a proven growth record is a good starting point when you are trying to identify great companies. You cannot argue with the success of a company's past record, whereas forecasts into the future are much more subjective. Good companies will usually keep on growing. Poor ones will sometimes have their day in the sun, and probably tell you (again) how confident they are about their future prospects, only to disappoint like they have in the past.

By investing in companies with a proven past record of growth, you will avoid cyclical and turnaround entities. Turnarounds rarely succeed in the long term. For every Next or Blacks Leisure, there are hundreds which have failed.

6. A company with minimal working capital requirements.

This links in with the next quality --

7. A company that has a high return on equity.

You have £1000 to invest in your new enterprise, a local delivery business. You are hoping to make £100 per annum, which is a better return than putting your money in the building society. You have two choices.

a) You can buy a used van for £750, and spend the other £250 on incidental expenses. After year one you succeed in making £100 profit.

b) You can employ your kid brother for £200 a year and he does all the deliveries for you in his beaten up estate car. There are no other costs. After year one you succeed in making £100 profit.

Which is the better option? In a), your return on equity is 10%. In b), you've only invested a total of £200 to make your £100 profit, giving you a 100% return. The profits however are the same, so you may be thinking what's the big deal? If in scenario b) you were able to employ the other £800 and get a 10% return on it too, your total profit will be £180, or 80% higher than in scenario a). The reason you have been able to do this is because you have achieved a higher return on your equity.

Great companies require relatively little in the way of capital expenditure. For example, Rentokil Initial requires a relatively low level of operating assets because it is largely a service business where the scarce resource is not assets, but people and the customer base that the company has built up over the years. On the other hand, a company like British Steel requires a huge amount of capital expenditure just to keep the company ticking over. To make things worse, they are also a cyclical company, largely dependent on the overall state of the economy.

The Next Step

We've now got a total of 7 qualities that we think help identify a great company. Friday will see this series come to its conclusion, then next week we will attempt to put the theory into action by looking at the next Qualiport contender. As I've said previously, Fools must remember that although we are setting out the ideal criteria for a quality company, no company is perfect.

If you've ever got any comments, queries or suggestions, please share them on our message boards.

Bruce Jackson (TMF Googly)

Qualiport Numbers

Today's Numbers                   Date            20/05/98


          Change     Bid
          pence       £

RTO        0.06      3.93
EMAP      -0.01     12.36
MKS        0.07      5.80         


Rec'd        #     Stock      Buy      Now    % Change   £ Change

19/12/97   1565  Rentokil     2.55     3.93     54.1%       1.38 
17/04/98    337  EMAP     11.85    12.36   4.3%       0.51 
11/05/98    722  M & S        5.535    5.80      4.8%       0.265


19/12/97   1565 Rentokil  4,040.63  6,150.45 52.2% 2,109.82 
17/04/98    337 EMAP   4,043.37  4,165.32    3.0%      121.95
11/05/98    722  M & S     4,052.24  4,187.60    3.3%      135.36

Cash                                    33.96

Total                               14,537.33 


                Day    Month    Year    History

Qualiport       1.0%    2.5%    49.4%    52.8%
FTSE 100        0.5%   -0.4%    15.0%    17.7%
FTSE All Share  0.5%    0.7%    16.5%    19.0%