Qualiport

Rentokil fall below 300p

OK -- a joke's a joke. Whoever out there is ruining the returns on the Qualiport, you can now stop.

The portfolio for the next 100 years took another harsh battering today, dropping 3.7%. For the month of September, which is only 14 trading days old, we are down a whopping 14%. At the rate we're going, well be out of business by the end of the year!

So, what's going wrong? Obviously the market in general is on a down curve, but in comparison to the Footsie, the Qualiport shares look like they are descending Mount Everest without the use of any safety equipment. Geronimooooooooo! Even our only winner is coming back to the field, as Rentokil Initial today plunged 20p to 288p, falling below the 300p level for the first time since March this year.

At 288p, it is worth looking again at Rentokil's valuation. Remember when we bought the shares, they were priced at 255p and had a 1997 price to earnings ratio (P/E) of 25. In the period from 1994 to 1997, they traded at an average P/E of about 24, so our buy point looks reasonable. It was only in the earlier part of this year that the shares began to rocket, hitting a high point of 452p on July 8th. Then, they traded on a trailing P/E of 40, way above their usual average rating. In hindsight, at the time the shares were probably overvalued.

This brings me to another point. Many Fools may be thinking that if the shares were overvalued then, why didn't we sell them. Firstly, at the time, when the Footsie was close to its peak of 6179, everything and yet nothing seemed overvalued, if that makes sense. This is where the mind and emotion play tricks on you, not allowing you to rationally assess an investment decision. As the market went up and up, we were all probably guilty of forgetting about valuations. I thought that a P/E of 40 for Rentokil could be the new average for them going forward. Who knows, for without the Asian, Russian, Latin American and whoever is next crisis, that could well have been the case. We would have benefited from the expansion in the P/E from 25 to 40 in the space of just 6 months and then settled for 20% growth in line with their earnings forever more.

Selling an overvalued share is never easy, and to my mind depends a lot on market timing. We all know that it is impossible to time the market, and it would have been just a fluke if we sold Rentokil on July 8th at their absolute peak of 452p. In fact, if they were overvalued then, they were probably also overvalued at anything between 400p and 450p. If we had bailed out at 400p, we would have felt sick as we ruefully watched the shares march higher and higher.

There are only 3 events that will prompt the Qualiport to sell a share.

1. When we see a better investment opportunity.
2. If the company materially changes for the worse from the time we first bought it.
3. If we realise we made a mistake with the initial buying decision.

The company hasn't changed in the space of 9 months, and we know we didn't make a mistake. Therefore, the only way we could have sold our holding in Rentokil would have been if we'd discovered a better home for our money. That will always be a difficult decision, as how many companies in the world have increased their earnings by at least 20% for the past 16 years? In July, many individual companies were arguably overvalued. If we had switched our money out of Rentokil because we thought it was overvalued, the chances are that we would have bought shares in a similarly overpriced but quality company. The end result, a fall of 36% from their peak, could easily have been the same.

Our ideal holding period is 10 years. Over that time, individual companies will go through a huge amount of change. There will be periods when they struggle, and periods when the boom. This will be reflected in a much gyrating share price. Are Rentokil the company, going through a bad patch? We can't be exactly sure, but I'm guessing that they will be suffering, along with every other global company, because of the uncertain world economic conditions. But to what extent they are suffering is the big unknown. They are a very proud company, with proven exceptional management expertise. We can rest assured that they will be reacting with haste to the changing circumstances they are no doubt facing.

One thing has changed about Rentokil since we first bought our shares in the company. The 20% per annum earnings growth aim remains, but it is only a target for them to shoot at. The days of almost guaranteed 20% growth went when the company saw their first half earnings per share (EPS) rise by "only" 19%. That was a bit of a watershed moment for Rentokil and will probably see them embark on a new phase of their corporate development. No longer will they be looking for the ever bigger acquisition just so that they can hit their 20% growth target. That should be a big relief to the Rentokil management and actually free them up to concentrate on running the excellent set of businesses they've already got.

At 288p, Rentokil's trailing P/E is now 26, and for the year ending in 3 1/2 months, their forecast P/E is 23. Based on their historical trading record, this looks about right. We must remember that the days of guaranteed 20% earnings growth are gone, so the shares probably deserve to trade on a slightly lower rating.

It is worth reproducing the table and comments we used to value Rentokil at the time of our original buy report.

                                             Future
Year# Year  Mkt Cap Growth  EPS   Div   P/E   Price
0     1997   7,167    20%  10.3   3.04  24.0    
1     1998   8,600    20%  12.4   3.64  24.0   297
2     1999  10,320    20%  14.8   4.37  24.0   356
3     2000  12,385    20%  17.8   5.25  24.0   427
4     2001  14,242    15%  20.5   6.03  18.0   368
5     2002  16,379    15%  23.5   6.94  18.0   424
6     2003  18,835    15%  27.1   7.98  18.0   487
7     2004  21,661    15%  31.1   9.18  18.0   560
8     2005  24,910    15%  35.8  10.55  14.4   516
9     2006  27,899    12%  40.1  11.82  14.4   577
10    2007  31,247    12%  44.9  13.24  14.4   647
Total Dividend                    82.03

Adding the total dividends received of 82p to the 2007 share price of 647p gives a total return of 729p. For the share bought at 250p, that is a profit of 479p per share over the 10 years. The total annualised return is 11.3%, which is about the percentage the stock market as a whole has returned over the past 60 odd years. For comparison, the risk free rate of return for government bonds at the moment is around 6.5%.

Note that we expected Rentokil to trade at around 297p at the end of this year. Note also that we expected the P/E to contract to around 14 by 2007. When I saw today that Rentokil had declined to as low as 288p, my immediate reaction was to think that they were undervalued. But, because we did our homework in the first place, we can go back and look rationally at our original decision process. At 288p, I'd say the shares look about right, neither under- or overvalued. There are of course other ways to value a company, and it is probably worth looking at the different methods when assessing any company. Because Rentokil's earnings are so consistent, the above valuation method is still probably the best way to assess the shares. But now, especially since the 20% growth record looks to be broken, it is worth looking at other valuation tools, such as return on equity or a discounted cash flow technique. We will do that some time in the future.

Almost regardless of valuation, Rentokil the company are still one of the best managed in the world, and we are happy hanging onto our shares for many years to come.

The recent stock market correction has no doubt thrown up a few bargains for investors. Here at the Qualiport, we would like to try and take advantage of this, and we are actively searching for candidates to add to our portfolio. Whilst we are battered and bruised, we are still very confident in the stock market as the best wealth creation vehicle. We want to show our faith in the market by making purchases in great companies at attractive prices. Of course, if you've got any suggestions that pass our Qualiport criteria, please share them on the message boards.

Have a great weekend, Fools.

Bruce Jackson (TMF Googly)

Qualiport Numbers

Today's Numbers       Date    18/09/98


                    Day      Month     Year     History
Qualiport         (3.71%)  (14.04%)   12.21%    14.73% 
FTSE 100          (1.51%)   (3.69%)   (1.56%)    0.71% 
FTSE All Shares   (1.35%)   (3.53%)   (2.33%)   (0.28%)


Qualiport Stocks

Last Rec'd  Total # Security   In At    Current    Change
 17/04/98    337      EMAP    £11.998   £10.050  (16.24%)
 11/05/98    736      MKS      £5.604    £4.400  (21.48%)
 19/12/97   1565      RTO      £2.582    £2.850   10.39% 
 17/07/98    595      ULVR     £6.804    £4.620  (32.10%)


Last Rec'd  Total # Security   In At    Value     Change
 17/04/98    337      EMAP   £4043.37  £3386.85  (£656.52)
 11/05/98    736      MKS    £4124.37  £3238.40  (£885.97)
 19/12/97   1565      RTO    £4040.63  £4460.25   £419.62 
 17/07/98    595      ULVR   £4048.38  £2748.90 (£1299.48)


Cash:               £67.82
Current Total:  £13,902.22

Profit/(Loss): (£ 2,282.40)