Qualiport

Why Invest Using Qualiport Methods, Part II
Friday, 10th July 1998

Mehmet Varol's (TMF Coffee) guest appearance continues

On Wednesday we examined investment approaches that are heavily focused on the share price. One of them was based upon "turnaround" and value situations where the value of the company is higher than what the market thinks. In this method, there was no consideration given to the quality and the growth in earnings of the company. This we decided against due to the unpredictability of the time span that the share would take to be fully valued. This, we concluded, would reduce our profits significantly.

Secondly, we examined the use of charts in investing and concluded that charts may give an indication of the share price direction in the short term, but charts could change with the drop of a hat and alter their course dramatically. Therefore, if one was to use charts as an investment method, one's approach would be incredibly short-termist. If the chart altered course, one would have to alter the portfolio. This is why we don't like to invest using charts and we find this un-Foolish.

Thirdly, we covered the increase in the tendency to invest in companies with strong performing share prices based on strong fundamentals for companies that are at early stages in their growth. We highlighted that the share price may be hyped up based on sound fundamentals but all may end in tears when the short term investors move out. We urged you to take a long term view but also to be aware of not buying into the hype.

Finally, we explained that a very high growth rate is usually unsustainable and a share price may alter unexpectedly, locking us into a quality investment but for poor returns. We advised that an allowance be made to make sure we are paying fair value for next year's growth, and not over the odds for the following year's growth. The Fool Ratio takes two years' growth into account, so it may be useful to check this one out.

Warren Buffett's Investment Gems

Today, we examine some of Warren Buffett's investment gems -- first, buying and holding for the long term, and second, buying quality companies.

We also briefly mentioned on Wednesday's introduction that Buffett concentrates on particular issues relating to the company's economics as opposed to its share price. Then we mentioned he looks for consistently growing earnings and shareholder funds which also is conservatively financed. I would like to think we will have the opportunity to cover these issues in the future.

Buy and Hold Long Term

What are the advantages of holding a stock for the long term?

1) The Miracle of Compounding. We studied this at Step Two -- The Miracle of Compound Interest of our Ten Steps. Now may be a good time to refresh our memory banks and retune our attitude towards investment. Here we established that a long time with above average returns and regular contributions to our investment pool can add up to a lot of money. This table is so powerful that we re-produce it here:

   
         Fennella   Fyona    Frances     Freda      Faith     Florence
            5%        10%       12%        15%       20%          25%
Ground 0  50,000    50,000    50,000     50,000     50,000      50,000
    
5 years   63,600    79,900    87,300     99,400    122,500     149,800

10 years  81,100   128,700   153,800    199,900    305,000     457,000
   
15 years 103,500   207,200   271,100    402,100    758,700   1,395,000
    
20 years 132,100   333,700   477,800    808,900  1,890,000   4,250,000

30 years 215,200   865,600 1,480,000  3,272,000 11,700,000  40,000,000

40 years 350,000 2,250,000 4,600,000 13,250,000 72,500,000 370,000,000

  

Let's highlight a few things on this table that are significant. Let's look at Freda's portfolio of £13,250,000. If you notice, £10,000,000 of it is made in years 30-40. Doesn't this tempt you?

And compare this to Faith's portfolio, which in 30 years is worth 258% more than Freda's portfolio from only a 5% higher return every year.

In many books about Warren Buffett's methods you will see that he aims for a consistently performing company that grows its earnings by 15%. However, you will also read he has returned a rate of around 24% per year in his company Berkshire Hathaway since the mid-sixties.

This probably is no more than the market eventually catching up with the potential of his invested companies and re-rating them to ever higher multiples. So, he aims for 15% but gets 24%! This probably was one of the key points that convinced me towards Buffett's methods.

2) Mr.Brown's tax free loan from the UK government. We are all aware of the recent changes to the Capital Gains Tax (CGT) system, where longer term investment is rewarded with an increasing relief. This makes longer term investment a lot more attractive. Meanwhile, for another example and to eliminate this bias, I will use the old 40% CGT rate.

Let's say Freda was invested in ABC Technologies, where up to year 5 she made 15% profits. Then the company's technology was overtaken by DEF Technologies and her profits shrunk to 3%. She probably at that stage would have to consider an alternative investment giving better returns. After CGT her new portfolio size will be £82,240 after a £17,160 CGT bill. This, in effect, reduces her compounding profits to 10%. OUCH!

If Freda picked company XYZ Predictability and realised her profits after 40 years to buy that plot on the moon she dreamed about since her childhood, her portfolio would be worth £9,240,000 after a 30% CGT. This reduces the compounding growth to 13.9% pa. OUCH! Which is better, 10% or 13.9%?

Incidentally, the Inland Revenue managed to buy a plot with their share of £3,960,000 very close to Freda. There is no escape from the Tax Man!

Finally, you probably are grinning because, unlike Freda, you have locked your investment into a PEP or next year into an ISA, where you shelter your gains tax free. And one may think it would be possible to match Freda's performance by buying and selling with aggregate 15% returns. Read on Point 3.

This next point covers the reason we kept you waiting until today.

3) Buffett stays with a company for many years because if he has to invest in another company he may not find an investment which offers as good returns. We only need to look at our recent Unilever study. The reason the Fools are Dueling is because the valuation is well stretched. There is too much demand for the shares and the price is high because of the laws of supply and demand. If we are to invest in this company we would have to hope that the current confidence in the market continues and increases due to the quality of the company.

Subscribers to Jim Slater's Investing for Growth newsletter read the articles where he covers this subject with absolute clarity. Jim Slater points out that earnings multiples or price to earnings ratios (P/E) are getting ever higher despite lower rate of growth expectations. And he has avoided recommending shares for the sake of recommending. It is becoming more and more difficult to find value in growth.

This all makes me conclude that our valuation methods based on fundamentals are no longer supporting these share prices. This is what happens in "Momentum Investing." The laws of supply and demand could bring the whole thing to a tearful end. This could materialise if earnings are lower than expected or any other setback, for example a trend of rising interest rates or hints of a recession.

Hence, it would be prudent to conclude by reiterating Fool Law 1 about Compound Interest -- start early! I would also urge you to select quality companies with reliable track records in earnings and shareholder fund growth.

This is why I changed my approach to Buffett Methods. One off short-term profit possibilities may seem tempting, however I may be missing excellent companies that are quality investments and that would return larger profits over a long period of time.

Buying Quality Companies

In the first part of today's article we concluded that there are significant benefits to keeping a stock for the long term. We also gave an example where Freda chose to sell her shares and consequently paid a hefty CGT bill. This may have been a perfectly well run company, but if the technology got substituted it would lose its attractiveness as a long term investment. And we probably all decided that it is better to invest in companies that have products that could not be substituted so easily.

Our Qualiport companies demonstrate Buffett's criteria in selecting companies: simple products that have repeated demand, such as excellent brand names, service companies, or a business to do with communications. Our service company example is Rentokil Initial, an excellent brand name choice was Marks & Spencer, and in communications we selected EMAP. With Unilever, Cadbury-Schweppes, Reckitt & Colman we have been looking into businesses with repetitive consumable products with excellent brand names.

The advantages with brand-named consumables are that they have a high degree of repeat business and usually have higher profit margins. Buffett refers to these as being a "consumer monopoly." Buffett is keen on Coca-Cola and Gillette in this category.

He refers to communications businesses as "toll bridge" businesses. In order to advertise your product you have to pay the toll to get access to these markets. New York Times and Washington Post are examples.

These companies' main common feature is that they have predictable earnings year in year out and they are protected by high barriers of entry into the same market. Do you think Virgin can take on Coca-Cola? Probably the most they can achieve is gaining a small bit of the market.

These probably are the main issues that can make a quality company. There are several other features, which we covered in our The Ideal Qualiport Company.

Conclusions

Today, we covered the key facets of Warren Buffett's methods in investing -- buying and holding shares in quality companies for the long term.

We reviewed the miracle of compounding interest, where we demonstrated how patience and above average returns build a modest amount of money into a huge amount of money. We highlighted that the majority of the gains are made in latter years and a small difference in returns makes a lot of difference in the end. In this part we also mentioned that Buffett aims for 15% growth in earnings but has achieved 24% annualised returns. This is probably because the market eventually realised that these companies had consistently good earnings and started to attach a higher rating.

The next piece was on Mr.Brown's tax free loan, where we covered the effects of tax and the danger of having to realise profits earlier than expected. And we moved on to the next point, for the smarter people who shelter their investments in a PEP. Some also may think they could also outsmart the tax man and the market at the same time.

We reviewed the reality of today's markets, where valuations are getting stretched and it is becoming more and more difficult to find opportunities that are worthwhile investments. We decided that the short term buy-sell investor may outsmart the tax man but quite possibly fail at outsmarting the market. The point when we would expect the buy-sell operator to fail would be when the market sees that the earnings do not justify the high share prices that a conservative valuation would suggest.

I am very pleased at having had the opportunity to write for the Qualiport and thoroughly enjoyed it. It has helped me clear my thoughts, and I hope you have found the series enjoyable and useful.

Meanwhile, please feel free to ask questions and give your thoughts on whether you like Buffett's and the Qualiport's approach to investment on our message boards.

Mehmet Varol (TMF Coffee)

Qualiport Numbers

Today's Numbers            Date    10/07/98


         Change       Bid
          pence        £

RTO       -0.18      4.33
EMAP       0.00     12.76
MKS        0.09      5.34         


Rec'd       #    Stock       Buy       Now   Change   Change
                                                %        £ 
19/12/97  1565  Rentokil      2.55      4.33  69.8%      1.78 
17/04/98   337  EMAP         11.85     12.76   7.7%      0.91 
11/05/98   722  M & S         5.535     5.34  -3.5%     -0.195


19/12/97  1565  Rentokil  4,040.63  6,776.45  67.7%  2,735.82 
17/04/98   337  EMAP      4,043.37  4,300.12   6.3%    256.75
11/05/98   722  M & S     4,052.24  3,855.48  -4.9%   -196.76

Cash                                    33.96

Total                               14,966.01 


                Day    Month    Year    History

Qualiport      -1.4%    1.6%    53.8%    57.3%
FTSE 100       -0.6%    1.7%    15.5%    18.1%
FTSE All Share -0.5%    1.6%    15.6%    18.0%