Qualiport

Why Valuation Matters
Friday, 4 December 1998

Qualiwatch adds a 6th growth industry

Over the past few weeks, we've been reiterating the investment strategy of the Qualiport. In brief, we aim to buy quality companies at attractive prices and achieve a compounded growth rate of 15% per annum over the long term.

There are lots of other investment strategies. Many people follow many different strategies. In fact, one of the busiest message boards is called Investment Strategies -- check out what other Fools are talking about. Why not weigh in with your view?

Here in Fooldom, we have at least two distinct portfolio strategies. Beating the Footsie is a mechanical portfolio, which takes about 10 minutes per year. The Qualiport is a share selection portfolio, and valuation is an important part of its strategy.

In the new year, we will be starting a third portfolio. This one will throw valuation out the window. Some people argue that if you buy and hold truly great companies, the buy point is completely irrelevant. They say that over the very long term, the share prices in these companies will inevitably rise and rise. We are currently putting together the principles of the new portfolio. It will be more aggressive than the Qualiport, and therefore a bit more volatile and probably with a higher degree of risk. But we definitely won't be undermining or compromising the Motley Fool's message of buying and holding great companies. Stay tuned for more details over the next few weeks.

Qualiport veterans may remember the debate Dave Berger and myself had before we purchased Unilever (ULVR). Dave is firmly from the "sod valuation, buy quality at any price" camp. On the other hand, I prefer to look closely at a company's valuation before buying shares. This is the final step in our ideal Qualiport company criteria. As to who is going to be right in the great debate, we'll have to take a rain check on that one for the time being. We'll look again in 2007.

The Qualiport says valuation matters. Let's take a relatively simple example. A successful IT company, named Macrohard PLC, has grown earnings at a compound rate of 30% for the past 10 years. In anyone's books, that's fantastic going. In the flight to quality, the share price is marked up higher and higher. The company still operates in a growth industry, but competitors are circling, and as the company gets bigger and bigger, it simply won't be possible for it to replicate the growth rates it has seen in the past.

Let's assume that Macrohard PLC trades on a 1998 price to earnings ratio (P/E) of 60. Its long-term growth rate is 18% per annum. That's still a pretty tall order, but not unrealistic for this well respected company. Also, let's assume the P/E heads back towards what may be considered a more normal level as time goes on and ultimately will trade at a P/E of 22.

1998:  Share price 240p  EPS 4.00p  P/E 60
2008:  Share price 442p  EPS 20.1p  P/E 22

Under the above scenario, the 10 year compounded annual growth rate (CAGR) is a relatively sedate 6.3%. You would almost have been better leaving your money in the risk free building society account.

Looking a further 10 years out, let's assume the growth rate from 2008 slows to 15% per annum and the P/E reduces further to 18.

2018:  Share price 1525p  EPS 84.7p  P/E  18

The CAGR from 1998 to 2018, a period of 20 years, increases to 9.7%. This is still below the 15% aim of the Qualiport, and below the 12.2% average gain in equities since 1919.

A twenty year holding period is an absolute eternity. To hold a company through the good and bad times for that length of times requires an extraordinary show of faith and a great deal of discipline. Both of these factors are lacking in most investors.

Now, of course the above is only an example of what can happen if you disregard valuation. There are no rules to say that Macrohard's P/E will fall back down, and the company could even trade at a P/E of 80 in 2008. History says otherwise, but rules are made to be broken. Investors ought to remember that over the very long term, only two factors affect a company's share price -- its cash profits and the multiple of those profits.

I feel one of the mistakes we've made in our early purchases concerns valuation, but the Qualiport is an educational portfolio, and we're a big part of that learning process, too. In life, and especially when it comes to stock market investments, you learn the most from your mistakes. Going forward we'll no doubt make many more mistakes, but hopefully we'll have learnt from the ones we've made in the past, and we'll minimise those errors in the future.

Some people think they can achieve returns of 40% per annum on their portfolio. This is just baloney. Sure, some years will see you make 60%, when everything goes right for you. But other years will see you lose 25%. Because of the nature of the companies the Qualiport chooses, and the attention to their valuation, it is highly unlikely that we'll see one year returns at those sort of extreme levels. That's why we aim at a realistic 15% compounded return.

Qualiwatch

As a result of reading AceInvest's excellent message board post on the web, I will be adding Financial Services to the Qualiwatch growth industry sector. This was an area I had overlooked, but as AceInvest rightly points out, individuals are increasingly going to have to save for their own retirement. The state pension is unfortunately woefully inadequate.

The list of growth sectors now stands at:

Technology
Communications
Pharmaceutical
Internet
Information Technology
Financial Services

We've briefly covered the first four on that list, and next week we will start our coverage of the last two. Our aim is to identify the best companies in each sector before looking at their valuation.

Have a great weekend, Fools. Keep the interesting ideas and discussions coming to the Qualiport message board.

Bruce Jackson (TMF Googly)

Qualiport Numbers

                    4/12/98 Close

               Company  Change    Bid
                 EMA    +0.05    11.10
                 IIG     0.00    2.25 
                 MKS    -0.04    3.92
                 PIZ    -0.05    8.40 
                 RTO    +0.18    3.98
                 ULVR   -0.04    5.95

Qualiport Stocks

Last Rec'd  Total #  Company   In At   Current  Change
 19/12/97    783       RTO      2.55     3.98    56.1%
 04/11/98    245       PIZ      7.93     8.40     6.0%
 17/04/98    169       EMA     11.85    11.10    (6.3%)
 17/07/98    298       ULVR     6.72     5.95   (11.5%)
 27/10/98    755       IIG      2.58     2.25   (12.8%)
 11/05/98    368       MKS      5.54     3.92   (29.2%)

Last Rec'd  Total #  Company   In At    Value    Change
 19/12/97    783       RTO    2046.53  3116.34  1069.81
 04/11/98    245       PIZ    1966.34  2058.00    91.67
 17/04/98    169       EMA    2052.57  1875.90  (176.67)
 17/07/98    298       ULVR   2052.54  1773.10  (279.44)
 11/05/98    368       MKS    2054.11  1442.56  (611.55)
 27/10/98    755       IIG    1972.64  1698.75  (273.89)

Cash:                                £3,975.57
Current Total :                     £15,940.22

Total Invested:                     £16,184.62
Profit/(Loss) :                      (£ 244.40)

Value Per Share

                   Day      Month    Year     History
Qualiport         0.93%    -0.52%   31.82%    34.79%
FTSE 100          0.28%    -2.82%    8.69%    11.19%
FTSE All Share    0.20%    -2.83%    5.87%     8.09%

Click here for the latest Qualiport share price quotes.

For an explanation of Value Per Share accounting, please click here.