Qualiport

Guest piece by Mehmet Varol (TMF Coffee): A Fool's reasons for changing his investment approach

You probably often hear people saying, "You never know what is around the corner." I, for one, with my half open eyes, often mumble back, "Yeah, yeah." Now, this was proven right when Bruce caught up with me online. He asked me whether I would be prepared to do a writeup for the Qualiport. I was first delighted and then became a little worried. I finally came up with the idea to share the reasons why I recently changed my approach to investments.

Following my disillusionment with other methods I have tried, and then on reading various books on Warren Buffett, the legendary American investor, I became convinced that his approach made sense. What really impresses me is that his investment methods are strongly related to a company's economics, as opposed to simply how the market rates the company in terms of share price.

Buffett concentrates on the economics of businesses which have a strong brand name, which are consumer monopolies, or what he calls "toll bridge" businesses. He looks for a reliable track record and ensures the business is conservatively financed. Also, he buys when the price has a sufficient margin of safety compared to what the business is really worth. Buffett's most striking trait is that he buys and holds for the very long term. His reasoning is that he buys into sound businesses that consistently perform above average, so he almost never needs to sell his holdings.

Being new to Buffett style investing gives me a big advantage; the lessons from my previous investment decisions are still very fresh. Some have been profitable because I was quick to realise what was going on, but with others I incurred unnecessary losses.

This probably puts me in a similar position to some of you who are considering the Qualiport approach to investment and who may also have come across well known Buffett quotes such as, "It is better to be certain of a good result than hopeful of a great one." Everything Buffett says strikes one as common sense, so let's explore his style of investing a little further.

This article is in two parts: The first part concentrates on other alternatives to Buffett's methods. Today we demonstrate how it may be possible to make profits in the short term, but how this also exposes us to the possibility of losses as we change our portfolio due to short term share price movements. On Friday we will examine a number of Buffett's concepts that we believe offer better returns in the long term.

I do not intend to give a rundown on all aspects to Buffett style investing. If these features whet your appetite and you want to learn a lot more about his methods, I recommend that you stop by The Motley Fool UK Bookshop and pick up The Essays of Warren Buffet: Lessons for Corporate America by Lawrence A. Cunningham.

Bruce's approach in the Qualiport differs a little from Buffett, and it is a good idea to review The Ideal Qualiport Company, which explains the thinking underlying the selection of a Qualiport share. Our aim is to complement some of the thoughts mentioned in that article.

Trying to outsmart the Stock Market?

We have all read about ways to profit from Mr. Market and how if we aren't careful he'll take advantage of us. Here are a few methods I have examined in the past to do just that (profit that is, not get taken advantage of!):

Turnarounds and Value Investing

One of the companies I followed was British Steel. The majority of the investment statistics looked good on the Hemmington Scott Company REFS page and it may have seemed tempting. The value statistics were almost full moons (a good sign) and the growth rate looked attractive in relation to its price to earnings ratio (P/E).

However, looking at the shareholders funds, British Steel has grown 6% every year since '93. The shareholders have received a 6.6% return on their equity. Does this seem an attractive rate of return and thus an attractive investment? I wonder, has this anything to do with the high capital expenditures required to maintain the current plants and equipment?

It is true that British Steel may offer a one-off profit opportunity because by some valuation methods it arguably looks cheap compared to what it might be worth. If you are lucky, you may time your purchase successfully and realise a profit of 30% on this basis, which does not seem too far fetched.

But how long would this take? One, two, three years? The fallacy with this approach is this: if it takes 6 months you are making a 60% profit, 1 year 30%, 2 years 15%, 3 years 10% and so on. Meanwhile, British Steel, no matter how much they try with their efficient management, will not grow maybe more than 8% per year. One may also ask how can this below average growth of 8% help the share price climb back to where it should be?

This was one of the weaknesses of the approach of Benjamin Graham, one of the first people to look at the markets in a systematic, analytical fashion and the doyen of value investors, as identified by Buffett, who was one of his disciples. He identified and started to look closely at value in growth, i.e. businesses that are intrinsically growing but undervalued due to share price gyrations in the stock market.

This is why in point 2 Paragraph 4 of The Ideal Qualiport Company, Bruce refers to Buffett's point that we seek companies with "demonstrated consistent earning power -- future projections are of little interest to us, nor are 'turnaround' situations."

There is another reason to avoid one-off profit opportunities as opposed to consistently good long term profits. However, I have decided to cover this in Friday's Qualiport, just to keep you intrigued till the next edition.

Using Charts to Invest

A few months ago, the British Steel share price graph started giving out indications which a chartist always looks for and began to move with an upward momentum, looking like it may reach 190p. In fact it never did, as the news flow from the Far East and rising interest rates started to affect the British Steel share price adversely.

It may indeed be possible to make quick profits using share price charts. However, for every deal that succeeds, two may go wrong. It may also be possible to develop skills and hone your analysis to improve your performance. However, once a 20-30% profit is taken what do you do with the proceeds? Re-invest? And if so, where and at what price?

This brings us to the question of whether it is possible to make a greater return through several aggregate profits over the years than by buying and holding a single share. Personally, I prefer to hold a quality stock for several years as I have been taught by the market that by the time you are ready to move on to your next stock your choices may be more limited. This starts to affect judgment and invites poor performance.

Besides, I want to enjoy the rest of my life, rather than spending hours watching share prices, and the best way to do this is to establish good quality, long-term holdings.

Also, charts may significantly alter their course in the very short term, and it's hard to see what relevance this has to you if you are a long-termer.

Momentum Investing and Who Else is Jumping on the Bandwagon?

You often see stocks mentioned on Internet message boards which have sound fundamentals and which are perhaps close to being or which have already been awarded a price/earnings/growth factor (PEG). Briefly, the PEG is a key investment measure relating a company's P/E to its earnings growth. A growth rate in excess of its P/E may indicate good value. Hemmington Scott Company REFS' criterion for awarding a PEG is where there is a four year consecutive growth in earnings.

The story on the message board may often be quite detailed and convincing, with interim results or trading statements possibly ahead of expectations. When the majority of the statistics are reasonable it may tempt in more buyers based on the favourable picture. A surge in buyers alerts the market makers, who set the prices for share transactions, and they put their bid prices up. Once the price starts to move this invites more buying and this becomes self-feeding: more buying attracts more and more buyers.

This continues until somebody starts taking profits and the share price collapses. If the PEG was 0.5 in the first place this becomes 0.3 and cheaper. Then a new share gets the attention and the saga continues.

Probably if a lesson is to be learnt, it is this: we should ask ourselves if we have been influenced by the hype. Is this really a good opportunity or are we just jumping on the bandwagon?

Caution on PEG's!

I have seen a number of cases that have set me thinking that a low PEG does not necessarily protect the investor from market sentiment in the short term. The very recent example was JJB Sports, which reached 824p and with changing sentiment went down to as low as 467p. At 824p it was still reasonably priced against its growth rate.

The PEG valuation as suggested by Jim Slater works well for prospective P/E's of 10 to 20 and a forecast growth rate of 15-30% -- see Slater's book Beyond The Zulu Principle, page 130 (Point 2). This is also available in The Motley Fool UK Bookshop. He also mentions growth rates above these are unsustainable in the long term. At 824p the prospective P/E became 25, which clearly would have to regress to the norm at some point. And the Market decided that the time had arrived.

Incidentally, our Qualiport valuation method at a price of 824p indicated a compounding annual percentage return (CAPR) of 11.8% and at a price of 750p it indicated a CAPR of 13.8%, which would make one normally look elsewhere at those prices.

Should one deduce from this example that high growth rates are unsustainable in the long term? And could the price drop to a lower level quicker than expected? Consequently, would we end up getting locked into a good quality investment but for poor returns?

I find one way to avoid this problem is to make allowances when working out the PEG. Maybe calculate your PEG by using a more moderate growth rate, say 30% instead of 77%. Another alternative is of course is to use the CAPR model, which is used in our Qualiport valuations -- see the Rentokil Buy Report for an example of the conservative valuation.

Conclusions

Today we covered a number of investment methods in attempt to establish their strengths and weaknesses before we go on to look into various attributes of Buffett's methods.

We first reviewed the weaknesses in the "turnaround" situations. Due to being only a one-off opportunity and the difficulty in predicting the duration of the investment reaching full "fair" value, we decided against. We saw how the longer it takes to achieve full value the less our annual returns.

Also, we reviewed the use of charts in investing and concluded that, again, they may only work for short term one-off profit opportunities with a substantial possibility that they could also go wrong.

Then we looked into the current trend in momentum investing, where share prices are pushed up via a self feeding frenzy. Despite the company being profitable and having an apparently promising future, things can go wrong in terms of the share price. We also pointed out how despite their undervaluation, the shares can receive temporary support from short-termers and cause eventual huge losses for long-termers.

All the above investment methods required us to take profits or losses at an early stage and search for alternative investments that may multiply our gains. However, it is more likely that it will multiply our losses, since Market Sentiment over Company Economics is the main factor influencing our performance.

Finally, we took a cautious stance by highlighting one of Jim Slater's points, which is to be careful of prospective P/E's above 20. The danger may be that high growth rates are unsustainable and the share price may regress to the norm quicker than expected. This re-rating may cause one to be locked into a good quality investment but with a downside of poor returns. We concluded by saying it is quite possible to allow for this in the PEG valuation or using the Qualiport valuation tool, the compounding annual percentage return (CAPR) model.

Friday we will move onto a number of Buffett's investment gems to see what makes his approach so successful and what made him America's second richest man.

Meanwhile, please feel free to raise questions, your experiences and whether the Qualiport approach is something you would consider on our message boards.

Mehmet Varol (TMFCoffee)

Qualiport Numbers

Today's Numbers            Date    08/07/98


         Change    Bid
         pence      £

RTO      0.02     4.52
EMAP     0.18    12.70
MKS      0.00     5.35         


Rec'd       #    Stock     Buy     Now  % Change  £ Change

19/12/97  1565  Rentokil   2.55   4.52    77.3%     1.97
17/04/98   337  EMAP      11.85  12.70     7.2%     0.85
11/05/98   722  M & S      5.535  5.35    -3.3%    -0.185


19/12/97  1565  Rentokil  4,040.63  7,073.80  75.1%  3,033.17
17/04/98   337  EMAP      4,043.37  4,279.90   5.8%    236.53
11/05/98   722  M & S     4,052.24  3,862.70  -4.7%   -189.54

Cash                                    33.96

Total                               15,250.36


                 Day   Month   Year    History

Qualiport       0.6%   3.6%    56.7%    60.3%
FTSE 100        0.1%   3.0%    17.0%    19.7%
FTSE All Share  0.1%   2.7%    16.8%    19.3%