Qualiport

Ben Graham vs Warren Buffett

By Bruce Jackson (TMF Googly)

Kilburn, London -- The Qualiport aims to firstly identify great companies, then to value them. Inevitably, we're not the first to latch onto some of these companies, as the market has already placed a high market value on them. But we're firm believers in the adage that you pay peanuts, you get monkeys. We'd much prefer to pay Mars Bars in the hope that we will get elephants, the biggest and most formidable of animals out there in the jungle.

I don't need to remind many of you just how much the smaller capitalised companies have been smashed over the past 6 months. We covered that in our 1998 year end round up. Many people will be looking towards companies in that sector and possibly seeing a few bargains.

Take Headlam (HEAD), for example. Over the past 5 years, this smallish company is forecast to have grown its earnings at a compounded annual growth rate (CAGR) of 24.1%. Turnover will have more than trebled. Operating margins have consistently increased in each of the past 4 years. The dividend is forecast to have risen at a CAGR of 22.5%. In the last two years, cash flow per share has easily exceeded earnings per share. The share price, however, is down from a 1998 peak of 404p, hitting a low point of 193p in the same year. There has been no profit warning. The price has since recovered, closing yesterday at 272.5p, where the shares trade at a forecast price to earnings ratio (P/E) of 11.8. At their low point, the forward P/E was just 8.4. Click on the EPIC code above to find the latest quote.

On the surface, this company has many of the attributes of a Qualiport type company. But the Qualiport would never have got as far as looking closely at the numbers for Headlam, let alone attempted to place a valuation on the company. We would have taken one glance at its activities and moved swiftly on.

"Wholesale distribution of floorcoverings and the merchant converting of materials for supply to the clothing, soft furnishings and allied industries."

Is this the description of a quality company? One with a competitive advantage, high margins and operating in a growing industry? Not really. Operating margins stood at 7.51% in 1997, up from 4.21% in 1993. The word "distributor" in the company's activities gives the game away. Distributors are middlemen -- buying from various suppliers, consolidating those purchases, perhaps adding a little value to the raw materials, and then selling on to a third party. Retailers are effectively distributors, and that sector is also characterised by low margins. Pure distributors have relatively little competitive advantage and virtually no pricing power. Retailers, on the other hand, have their brand names -- just look at the brand name Marks & Spencer (MKS) have built up over the years. It is synonymous with quality, value and service.

Headlam appeared to offer a reasonable margin of error when its shares were languishing at 193p and may still offer value now at 272.5p. However, the Qualiport aims to hold shares in companies for the very long term, and Headlam doesn't appear to be a company with really long-term growth prospects. You can't argue with their performance over the past 5 years, and they could even replicate that over the next 5 years.

This emphasises the Qualiport's share picking approach. We don't first go hunting for value and then look at the characteristics of the company. You will note in the criteria for the ideal Qualiport company, valuation comes last out of the 10 points. Only if a company passes points one to nine will we look at its valuation. A company such as Headlam, even though it has performed outstandingly well over the past 5 years, would not get through to the valuation stage.

Benjamin Graham was the acknowledged value investor. He would look for companies that were trading at a significant discount to their book value, virtually regardless of the quality of the business. In those days (his classic book Security Analysis was written in 1934), quite a few companies met his exacting criteria. Today, precious few companies trade at a significant discount to their book value, and those that do normally do so for a very good reason.

Graham's most famous disciple, Warren Buffett, took his philosophy one step further. After buying a textile company called Berkshire Hathaway at what then appeared to be a knock down price, Buffett watched this business slowly deteriorate over the years. It was during that time that he realised that the textile industry was characterised by poor economics, high capital expenditure, and low competitive advantage. After many years, Buffett reluctantly shut down the textile business that was Berkshire Hathaway.

That experience taught him a very valuable lesson. From then on, Buffett only considered companies that he considered had superior economics -- that is, they were quality companies. If they passed that criteria, and they were selling at a discount to their intrinsic value, he would buy and buy big. That relatively simple but obviously effective policy has seen Berkshire Hathaway grow its book value by 24.1% compounded annually in the 33 years to 1997.

(Although Berkshire Hathaway the textile business has long been disbanded, the conglomerate Buffett chairs has retained the name of that original business. The textile business, although uneconomic, provided Buffett with much of the early cash he used to buy partly and wholly owned businesses that now make up part of one of the biggest companies on this planet.)

The Qualiport aims to follow this proven successful strategy.

Qualiwatch

The Qualiwatch series is attempting to identify six of the best companies in the world. We have almost £4,000 sitting in the bank, ready for investment in the stock market.

There have been some messages posted on the Qualiport message board questioning our venture outside the shores of the United Kingdom, and specifically looking at US quoted companies. I have responded by saying that since it is very simple for UK investors to buy US quoted shares, there's nothing wrong in considering them where they are industry leaders.

I do recognise that many UK investors will feel more comfortable investing in UK quoted companies, and generally that is a good policy to adopt. We can be familiar with the accounting methods used, and more importantly, the competitive environment. For example, I would never consider buying a US retailing company, because I've no idea of the competition and local economic environment.

The Qualiwatch series identified 6 growth sectors, from which it will look to identify great companies. They were: Technology, Internet, Financial Services, Pharmaceutical, Information Technology and Telecommunications. We have briefly looked at a few possible contenders from a few of those sectors.

In the last recap of 1998, I mentioned companies such as Colt Telecom (CTM) and Energis (EGS) as possible Qualiwatch candidates. These smallish telecommunications companies are growing rapidly, but not as rapidly as their share price, which -- especially for Colt -- is up in the stratosphere. However, as was rightly pointed out to me on the message boards, these companies are loss makers. They do not, therefore, pass the Qualiport criteria. They are out, out, out of contention. Sorry for any confusion caused.

Using the same policy, it is doubtful whether we will consider any pure Internet shares for the Qualiport. Many are making losses, although of our original shortlist, AOL and Yahoo! are profitable companies, and eBay are trading at about break-even. It will be interesting to follow the progress of a company in this mega-growth sector, but that's probably about as far as it will go for the time being.

We have granted official Qualiport status to one company -- US quoted PC manufacturer Dell Computer Corporation (Nasdaq: DELL). I'm now going to add two more companies to that list.

Vodafone (VOD) -- Telecommunications
Glaxo Wellcome (GLXO) -- Pharmaceutical

These two companies are global leaders in their sectors. Along with the rest of the market, their share prices have rocketed skywards in the past few weeks. However, at this first stage, we aren't looking at their valuation. It is very likely that neither of them will be great value. But, until we look, we'll never know.

I've been doing some valuation work on Dell and will share that with you next Wednesday. Because of its obscenely high return on equity, it is difficult to value Dell on that traditional measure. But because the PC industry is all about sales growth, some amazingly simple calculations will give us a good idea of their current valuation.

Have a great weekend, Fools.

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                    8/1/99 Close

              Company   Change   Bid
               EMA      +0.05   10.85
               IIG       0.00    2.54 
               MKS      +0.07    4.17
               PIZ      -0.01    7.69 
               RTO      +0.07    4.58
               ULVR     +0.01    6.88

Qualiport Stocks

Last Rec'd  Total #  Company   In At   Current   Change
 19/12/97    783       RTO      2.55     4.58     79.6%
 17/07/98    298       ULVR     6.72     6.88      2.4%
 27/10/98    755       IIG      2.58     2.54     (1.6%)
 04/11/98    245       PIZ      7.93     7.69     (3.0%)
 17/04/98    169       EMA     11.85    10.85     (8.4%)
 11/05/98    368       MKS      5.54     4.17    (24.7%)

Last Rec'd  Total #  Company   In At     Value      Change
 19/12/97    783       RTO    2046.53   3586.14   1539.61
 17/07/98    298       ULVR   2052.54   2050.24     (2.30)
 27/10/98    755       IIG    1972.64   1917.70    (54.94)
 04/11/98    245       PIZ    1966.34   1884.05    (82.28)
 17/04/98    169       EMA    2052.57   1833.65   (218.92)
 11/05/98    368       MKS    2054.11   1534.56   (519.55)


Cash:                                 £3,984.36
Current Total :                      £16,790.70

Total Invested:                      £16,184.62
Profit/(Loss) :                        £ 606.08  

Value Per Share

                    Day      Month      Year      
Qualiport          0.54%    -0.11%     -0.11%
FTSE 100           0.75%     4.50%      4.50%
FTSE All Share     0.73%     4.14%      4.14%

Click here for the latest Qualiport share price quotes.

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