Qualiport

TThe Fool's ideal Qualiport business.

In the last two Qualiport updates, we've been looking at the criteria we consider a quality company should possess. We got as far as:

1. A well managed company
2. Strong, and ideally increasing, margins
3. Strong brand name and competitive advantage
4. A company that you understand, and that has predictable earnings
5. A company that has a proven past growth record
6. A company with minimal working capital requirements
7. A company that has a high return on equity

Today we will conclude this list, and very soon after the series will be consolidated and whisked away to the Qualiport archives for posterity. If you want to see more about the above points, check out last Friday's and this Wednesday's Qualiport reports. Once completed, it will provide a good measuring point for our current portfolio companies and for all potential future candidates. Remember, though, the criteria we are putting forward here depict what we consider to be the perfect company. A tiny few will come close to fulfilling some of them, let alone most. Many will fall down at the final hurdle. Read on, and as usual feel free to use the message boards for any feedback or suggestions.

8. A company that is a strong cash generator

Cash is king. Debt is evil.

Well, taken out of context, neither of these is entirely true. We encourage Fools to invest their hard earned in the stock market, as over the years it has proven to be the vehicle where you can earn the best returns on your money. When you invest in the stock market, you are taking your cash out of the building society and putting into a much more illiquid investment. So, when we say "cash is king," in this context it isn't. Most types of debt are evil, but not all. Credit card debt is the worst kind because of the punitive rates of interest you are forced to pay on that debt. On the other hand, a properly calculated interest-only mortgage is the most cost effective way to purchase your own home.

When evaluating individual companies, we're looking at their cash generating abilities. What you want to see is all the company's operating profits being translated into cash. There are many legitimate tricks accountants can get up to in order to mask the true earnings of a company. By concentrating on cash, which can't be fudged (your bank statement doesn't lie), you will get a better idea of the company's underlying progress.

This again links in with point number 6, "A company with minimal working capital requirements." A company that constantly has to invest in expensive fixed assets just to keep the business ticking over, or that has a large portion of their money tied up in depreciating stocks, is not a generator of free cash. Ultimately, free cash (the money available after interest, taxes, and capital expenditure has been deducted) allows a company to pay dividends to shareholders or, ideally, to re-invest in the business through such things as share buybacks and strategic earnings enhancing acquisitions.

Just because a company is in debt is not a reason on its own to simply ignore looking at the company. Just like it is not efficient for the individual to invest his cash at 6% in the building society when 12% is the long term return of the stock market, it is not efficient for a company to have a big cash balance. If the company can make a return on its equity of 15%, it is much more efficient for them to invest that money than leave it in the bank. If they can borrow money at 10% and invest it at a sustainable 20%, then the company is better off taking that route. However, much greater caution needs to be taken when evaluating companies in debt. Only by investing in the very well managed (point number 1) businesses will you feel comfortable, and even then it is possible for the best companies to stretch themselves too far.

9. A company that has identifiable future growth prospects

A company can generate all the cash in the world, but if it has nowhere to invest it because it has saturated the market or because it is in a regulated industry, then you don't want to be invested in that company. You could argue that there will always be expansion opportunities, because a company can just go out and make an acquisition. This, however, is a much more risky route to follow than organic growth, and the success of it is far from guaranteed. As Peter Lynch said in his excellent books (have you seen our new online bookshop?), a company's attempt to diversify through acquisition can often result in a di-worse-ification of its profitability.

You ideally want to invest in a company that is generating strong sales growth. Although we like companies with strong and increasing margins (point 2), there will ultimately come a time when a company is as lean and efficient as physically possible, and margin growth will stop. At that point, only by increasing its top line (sales) will the company be able to continue to grow.

10. A company that is attractively valued

Last but not least, this is the crunch point. A minuscule number of companies will successfully pass through points one to nine. Then, especially with the Footsie already up over 15% to date in the first 5 months of 1998, most of those great companies will fall down at the final valuation hurdle.

There are many ways to value shares, and we've already looked at some of them when evaluating the current companies in our portfolio. Each method is trying to establish what sort of annual return your investment in a company is likely to achieve. Because we follow a buy and hold strategy, you want to look at the valuation of a company at least 5 or 10 years into the future. If you find that, with a fair degree of certainty, you will achieve a compounding annual growth rate (CAGR) of 25% versus the current risk free rate of return of, say, 6%, you could be on to a good thing. If, however, you discover a great company that is selling at a forward price to earnings (P/E) ratio of 50, by most calculations there will be a minute margin of error in your investment. The best investment opportunities occur when there is a substantial margin of safety present.

That concludes the series on "What Is s Quality Company." This will be archived for future reference, so you can all look at Rentokil Initial and compare it to each of the criteria. I'm sure you'll find they will fail on some points, but as I keep saying, there is no perfect company.

The Next Step

Starting next week, we will attempt to put the theory into action. We will look at three of the biggest consumer branded goods companies in the country and see if any or even all of them match our Qualiport criteria. They are Cadbury Schweppes, Reckitt & Coleman, and the big daddy Unilever. I'm leaving out a fourth company, Diageo, and not because we don't like the new name for the merged Guinness and Grand Metropolitan. It's for a couple of reasons. Firstly, the newly combined entity will be difficult to evaluate, therefore making any sort of predictions about the company's future earnings almost impossible. The other reason is that Warren Buffett is an ex-shareholder of Guinness. He once had a big stake in the company, but sold it sometime in 1994. I'm not quite sure why he dumped them, but I assume he was suitably uninspired with their lack of tangible growth.

On Wednesday, we'll start with Unilever.

Have a great long weekend, Fools. As I said earlier, please feel free to give your feedback on the message boards.

Bruce Jackson (TMF Googly)

Qualiport Numbers

Today's Numbers                   Date            22/05/98


          Change     Bid
          pence       £

RTO        0.19      4.29
EMAP       0.13     12.58
MKS       -0.01      5.79         


Rec'd        #     Stock      Buy      Now    % Change   £ Change

19/12/97   1565  Rentokil     2.55     4.29     68.2%       1.74 
17/04/98    337  EMAP     11.85    12.58   6.2%       0.73 
11/05/98    722  M & S        5.535    5.79      4.6%       0.255


19/12/97   1565 Rentokil  4,040.63  6,713.85 66.2% 2,673.22 
17/04/98    337 EMAP   4,043.37  4,239.46    4.8%      196.09
11/05/98    722  M & S     4,052.24  4,180.38    3.2%      128.14

Cash                                    33.96

Total                               15,167.65 


                Day    Month    Year    History

Qualiport       2.3%    7.0%    55.9%    59.4%
FTSE 100        0.1%    0.2%    15.6%    18.3%
FTSE All Share  0.2%    1.4%    17.3%    19.7%