Qualiport

Bruce explains portfolio accounting

The question of portfolio accounting has been raised on the Qualiport web message board. It is not surprising, really, when you consider that we are showing a percentage gain for the year of about 30% yet the portfolio is actually losing money. Surely some mistake?

We covered portfolio accounting in an earlier Qualiport feature, just after we added EMAP, our second purchase, to the portfolio. I urge you now to read, or reread, that article. Here's the link.

I will now attempt to explain how a portfolio can be losing money yet showing a percentage gain.

On Jan 1 1998 you buy 1000 shares in BIG at 200p each. To keep things simple, we will ignore stamp duty, commission, bid to offer spreads and any other hidden costs. Your portfolio, consisting of just one company, look like this:

 
 Date  Shares Company Price Cost(£) Value(£) Change(£) Change
1/1/98  1000    BIG   200p  2000.00 2000.00    0.00      0%

BIG is such a larger than life company, and you think their prospects are excellent, that you decide that you will leave all your eggs in one basket, and that basket happens to be BIG. The shares continue to perform very well, and at the end of the first quarter, your portfolio (of just one share) looks like this:

  
 Date   Shares Company Price Cost(£) Value(£) Change(£) Change
31/3/98  1000    BIG   250p  2000.00 2500.00   500.00    25%

You've made a paper profit of 25% in just 3 months. By leaving all your eggs in one basket, you have prospered from your lack of diversification. To replicate that performance, a 25% gain, with a portfolio of 4 companies, you would have had to have four winners that averaged a 25% gain in just 3 months. That would have been harder to achieve than by letting your money ride on your certain BIG winner.

Come April Fool's morning, you decide to add another company to your portfolio. Having Foolishly done all your homework, you decide the lucky company is going to be. Before you buy your shares in your new company, though, you need to add some cash to your portfolio. Naturally, this should not affect the returns you've already achieved, otherwise we'd all forever be adding cash to our portfolio and racking up winning year after winning year.

This is where Value Per Share (VPS) comes into play. It is the same system that investment trusts use, and it is designed to track portfolio returns where money is flowing in and out at irregular time intervals. In our example, here's how it works.

On New Year's Day 1998, although suffering from a bit of a headache, you decided to split your £2000 initial portfolio investment into 400 imaginary (or portfolio) shares, each with a value of 500p. At that moment, your Value Per Share (VPS) is 500p. Another way of looking at it is your portfolio value of £2000 divided by your 400 portfolio shares gives you a VPS of 500p.

Moving forward to April Fool's Day, you still have 400 portfolio shares, but your portfolio value is now £2500, and that divided by 400 portfolio shares gives you a VPS of 625p. Compared to your starting VPS of 500p, your portfolio has appreciated by 25%, which is exactly the same as measured by the actual pound amount and the actual change in the share price of BIG. It all ties in nicely, because we are running a one share portfolio.

We've already worked out that adding cash to a portfolio should not change its returns. Just before we buy our shares in Small, we add another £2000. This new money buys £2000 worth of new imaginary portfolio shares at the current value of 625p, and those 320 (£2000/625p) new portfolio shares are added to the original 400 portfolio shares to give us a total of 720 portfolio shares. (Fool Quiz -- how many times can I mention the word "portfolio" in one article?) Your portfolio value is now £4500 (£2500 as at 31/3/98 plus the new £2000), you have 720 portfolio shares, so your VPS is still 625p (£4500/720). You have successfully added new money without affecting the returns on your portfolio.

A further 3 months down the track, at the half year mark, your portfolio looks like this:

   
  Date  Shares Company Price Cost(£) Value(£) Change(£) Change
30/6/98  1000    BIG   230p  2000.00 2300.00   300.00    15%
30/6/98  2000   Small   75p  2000.00 1500.00  (500.00)  (25%)

Yikes, not such a good quarter. The investment in Small has not done very well, whilst BIG has dropped back a bit, too. The portfolio is now showing a cash loss of £200. You ruefully think what might have been if you'd bought some more shares in BIG instead of diversifying into the obviously inferior Small.

Using the VPS method of portfolio accounting, you now calculate what you expect will be an overall loss. You still have 720 portfolio shares, and your portfolio value is now £3800. The VPS is £3800/720 = 528p. Compared to your starting VPS of 500p, you are still showing a profit of 5.6% even though your portfolio is actually losing money!

Accounting trickery? Nope, but I have to admit at first glances the concept looks weird. The reason your portfolio is up in percentage terms despite it losing money is because you had 100% of your portfolio invested in a 25% winner before you bought your second share.

This is exactly the same scenario that happened to the Qualiport. We had 100% of our portfolio invested in one big winner (our only winner at the moment) -- Rentokil Initial. By the time we got around to adding EMAP to the portfolio, Rentokil had gone from the 255p buy price to 382p, and the VPS had appreciated from 500p to 740p, a gain of 48%. Because we had 100% of our portfolio invested in just one big winning share, we were set for a wining year.

This happened much more by luck than design. If Rentokil had lost any ground at all in that initial (no pun intended) period, we would never have beaten the market this year. If we had our time again, and were starting the portfolio from scratch, we would have begun with something like £10,000 and invested £1,500 into our first share, leaving the rest of the money in cash. Then the portfolio's returns would not have hinged solely on the performance of just one company.

You live and learn, and we are the first to admit that a portfolio that is losing money is hardly a winning one. If we were making money and beating the market, you'd hear us shouting from the London and North Devon rooftops every night. But we're quietly continuing to learn ourselves, and to teach the Foolish message of long-term stock market investments. We are still confident that this portfolio will be a winner and are actively scouring the share price pages looking for more great companies to add to the Qualiport.

The Qualiport will beat the market in percentage terms in 1998, but 1999 will be the real challenge. We will have no help from our one-share portfolio advantage -- all four companies, and any other new entrants, will have to pull their weight if we are to win the race. Beating the market is not easy, but we intend to give it a good shot. You need a bit of luck, but you also make your own luck, as we did by making Rentokil our first share purchase and not one of the other three.

Have a great weekend, Fools. Feel free to shoot any comments or thoughts about VPS accounting onto the Qualiport message board.

Keep Foolish.

Bruce Jackson (TMF Googly)

Qualiport Numbers

Today's Numbers       Date    04/09/98


                   Day     Month    Year    History
Qualiport         2.12%   (1.58%)  28.47%    31.36% 
FTSE 100          0.94%   (1.57%)   0.61%     2.92% 
FTSE All Shares   0.79%   (1.80%)  (0.58%)    1.51% 


Qualiport Stocks

Last Rec'd  Total # Security  In At   Current   Change
 17/04/98    337      EMAP   £11.998   £9.250  (22.90%)
 11/05/98    736      MKS     £5.604   £5.250   (6.31%)
 19/12/97   1565      RTO     £2.582   £3.530   36.72% 
 17/07/98    595      ULVR    £6.804   £5.620  (17.40%)


Last Rec'd  Total # Security   In At    Value    Change
 17/04/98    337      EMAP   £4043.37  £3117.25 (£926.12)
 11/05/98    736      MKS    £4124.37  £3864.00 (£260.37)
 19/12/97   1565      RTO    £4040.63  £5524.45 £1483.82 
 17/07/98    595      ULVR   £4048.38  £3343.90 (£704.48)


Cash:               £67.82
Current Total:  £15,917.42