Qualiport

>Bruce rebuts Dave's "buy regardless of valuation" theory

Qualiport followers will know that, having spent the past few weeks looking closely at three of the best branded consumer goods companies in the country, I eventually decided to plump for Unilever. The early portion of the analysis was devoted to establishing whether Unilever was a quality company, and Unilever passed most of my ideal Qualiport company criteria. Once I decided that they could indeed grace the Qualiport, my investing style led me to then look closely at their valuation. Monday night's special report was the culmination of that work. At 680p and a trailing price to earnings ratio (P/E) of 33, I concluded that I would struggle to buy them now on valuation grounds.

In Wednesday's Qualiport update, Dave took over and argued that Unilever should be bought almost regardless of its current valuation. Make sure you check out his excellent arguments -- even in Duelling Fools we can be civil to each other, although I fear things will get a little messier as this report goes on.

The one thing we both agree on is that Unilever is a great company. I've worked this out in my usual slow and meticulous (OK, boring) way. Dave, on the other hand, has been a Unilever fan for a long time now. In between his doctor rounds you can just imagine him scarfing another Magnum ice-cream or whipping up some Birds Eye Fish Fingers for dinner. Me, I prefer to use their Lynx deodorant, especially influenced by their "lads" advertising campaign. Any lad seeing the Lynx ad shown straight after England's World Cup exit (the one where the hero saves the girls from the 2 headed monster, and in return gets a special show) will have been straight down to Boots to pick up a few tins of the stuff. Did you also know that Unilever are the second largest spender of advertising money in the world, behind arch US rival Procter & Gamble? In 1997, they spent £3.5 billion on advertising and promotions. On Wednesday, they announced a serious foray into the advertising world of the Internet -- click here to get the news release from our fab, newly redesigned, US web site.

Anyway, I digress. Dave and I both agree that Unilever is a great global company, with great products, brands (this weblink exports you to the external Unilever web site -- make sure you come back here quickl,y though) is well managed and is a growing company. In this duel, I won't therefore have to knock down the company and its business plan. This is all about valuation.

As you know, there are many different investing styles. Dave and I overlap in so much as we are long-term investors in quality companies. We also believe that the stock market is the best place to put your money over the long term, having returned about 12% per annum compounding over the past 50 years or more. Where we differ is in our buy points, and for me in particular this boils down to valuation. Again, there are many different ways to value a company, and it is far from a precise science. My attempts to put a valuation on Unilever on Monday were based on my favoured methods, but there are many more, including some that I've never probably heard of or tried.

Probably (or should I say "Certainly?") the greatest investor of all time is Warren Buffett. His company Berkshire Hathaway has achieved a compounding annual growth rate (CAGR) of 24.1% since he took control of the company 33 years ago. To put this amazing performance in some perspective, £10,000 invested in 1965 would be worth £12.4 million in 1998. No wonder he's worth around £18 billion. He made most of his money by investing in great consumer companies at a time when he perceived them to offer the greatest returns or, put another way, when they had the greatest margin of safety. Coca-Cola, when he first bought them in 1988, traded at $5.22 (split adjusted) and had 1998 earnings per share (EPS) of $0.36, for a P/E of 14.5. At the time, shares in the company were thought to be far from undervalued, but Buffett saw a great company and bought US$593 million worth. That's what I call backing your judgement.

As it turns out, if you look at Coca-Cola's current P/E of 52, you could have bought shares in the company at any time over the last 10 years and still achieved market beating returns. Whether you will see the same returns they've achieved in the last 10 years being replicated in the next 10 is very doubtful, but not impossible. They trade at an historically high rating, as does Unilever.

Buffett bides his time before investing in a company, waiting for the opportune moment when the market knocks them down to a level where he perceives that they present him long term returns way above those he could achieve from other forms of investments. He has the patience to wait years for the right moment and price before he stakes his claim. We could do that with Unilever.

Dave would argue that the right price may never come, and 10 years later with the share price at 2500p, I'll still be waiting. That is a good point, and hard to argue with. However, no one is making you invest in the company now, so although you regret missing a good one, you shrug your shoulders and move on. My favourite saying is "it is no use crying over spilt milk" -- no tears for me. If I was worried about missing out on great investments throughout the years, I'd never sleep. Why didn't I buy Pizza Express at 109p in 1994 (now 860p), or Sage at 100p in 1994 (now 1680p)? Sure, they would have been great, but investing is for looking forward, moving on when things aren't quite right, and looking for the next great company.

Dave's point about the valuation of Rentokil Initial is a valid one. Nothing whatsoever has changed about the underlying company in the 6 months since we purchased them, yet the share price has appreciated by almost 70%. With the company growing earnings by 20% per annum, by rights the share price should go up by 20% per annum. But the returns very much depend on the buy point. Would I buy Rentokil at 440p? Probably not, although I would do some valuation tests. On my usual conservative assumptions, using a 10 year compounding EPS model including dividends, I calculate that Rentokil could return a CAGR of 10% between now and the end of 2008. That's still better than the Unilever CAGR over the same period of 8.3%. So, either we should be pumping more money into Rentokil and really backing our own judgement and conviction, or we should be looking elsewhere for another great investment opportunity.

Looking back at Unilever, Dave says, "Unilever is always a buy, whatever the markets or its price are doing. Isn't it?" What if the Footsie was at 6000, and Unilever were at 900p? Still a buy? Or at 1100p? Surely then, even Dave would baulk at paying 44 or 54 times trailing earnings. My argument is there is always a time when valuation becomes important.

Because of Unilever's size, their ability to surprise the market by growing much more than an average of 12% per annum is just not there. I could maybe stretch it to 15% per annum for the next 10 years, but that would be the maximum. Over the very long term, a company's share price will have a direct correlation to the underlying earnings growth. The P/E will expand and contract, but always the share price will be dependent on earnings growth.

We could currently be in the midst of a global re-rating of share prices and the multiples they trade on. Technology has continually allowed many quality companies to become more efficient, and hence more profitable. Return on capital is at historically high levels and could even go higher. Interest rates are relatively low, and one could argue that high inflation is dead for good. There is no doubting that Unilever, or any company for that matter, could trade at a P/E of 30, 40 or 50 in ten years' time. That would make a mockery of my potential forward valuation of the company. History says otherwise, but records are made to be broken. Investors were probably thinking the same thing in the 1970's, when shares like Avon, Xerox and Polaroid were bid up to enormous multiples, in an era now known as the nifty fifty. Where are those companies now? OK, Unilever is not one of those, but it makes the point that in the past we have always seen share prices edge back to average P/E's. What makes now any different? Look at what has happened in Japan for the past 10 years.

I don't want to sound like a bear, because I'm not. The examples I'm giving are purely illustrative, and not indicative of my current thinking. I'm not going to count out completely the purchasing of Unilever at 680p. For me, it is a borderline decision anyway, and I'm all too aware of my conservatism when it comes to valuation. If I really pushed the boat out, I could imagine that Unilever could grow their earnings and dividends at 15% per annum for 10 years. They could trade on a P/E of 25 in 2008, giving them a CAGR of 15.0%. My personal target is to achieve sustainable growth of 15% per annum, so that is bang on target.

No one ever forces you to buy a part ownership in a company. I can choose to put in the bank for 6 months, earning a risk free 7% per annum, hoping to pick up shares in the company at a much cheaper price at a later date. Or, I can search for a company that I think will be able to achieve better returns than Unilever over the next 10 years. Or I can choose to invest in Unilever and hope that they live up to my most optimistic expectations. That, Fools, is the choice.

Tell us what you think. Are you a valuation Fool and think 680p is too high a price to pay? Or perhaps you are a valuation Fool and think 680p is a bargain. Or would you follow Dave's philosophy and buy them at 680p, knowing they are potentially overvalued at the moment? The message boards are waiting for your answer.

Stay tuned, for next week we've got some real treats in store for Qualiport Fools. Have a great weekend.

Bruce Jackson (TMFGoogly)

Qualiport Numbers

Today's Numbers            Date    03/07/98


          Change     Bid
          pence       £

RTO        0.08      4.44
EMAP       0.35     12.90
MKS       -0.03      5.42         


Rec'd       #    Stock      Buy      Now    % Change  £ Change

19/12/97  1565  Rentokil    2.55     4.44   74.1%      1.89
17/04/98   337  EMAP       11.85    12.90    8.9%      1.05
11/05/98   722  M & S       5.535    5.42   -2.1%     -0.115


19/12/97  1565  Rentokil  4,040.63  6,948.60  72.0%  2,907.97
17/04/98   337  EMAP      4,043.37  4,347.30   7.5%    303.93
11/05/98   722  M & S     4,052.24  3,913.24  -3.4%   -139.00

Cash                                    33.96

Total                               15,243.10 


                Day    Month    Year    History

Qualiport       1.5%    3.5%    56.7%    60.2%
FTSE 100        0.5%    2.7%    16.6%    19.3%
FTSE All Share  0.5%    2.3%    16.4%    18.9%