Qualiport

Where's that leprechaun?

"Jackson says Smaller Company Shares Are Undervalued."

By Bruce Jackson (TMF Googly)

Kilburn, London -- I wonder if my stunning pronouncement will have a positive effect on the beleaguered small cap index? Rupert Murdoch, media mogul and scourge of most Manchester United supporters, chose yesterday to turn his hand to stock market analysis. He claimed that many new Internet companies were heavily overvalued and unlikely to meet profit expectations. As of writing, there is a bloodbath in some of the Internet highflyers, although even after 10% and 20% falls many of them are still up 100%, 200%, 500% or more in the space of just a few short months.

It is very doubtful that Murdoch's comments had any significant effect on the market today. The Dow Jones fell overnight, as did the technology rich Nasdaq. The US market has traditionally set the scene for the Asian markets, and in turn the UK market, so it wasn't surprising that the Footsie headed south in early morning trading.

Have we seen this scenario somewhere before? If you can remember back to October 1997, world markets slumped as the Asian crisis first emerged. That market correction was however very short lived. Then, the summer of 1998 saw the next major correction, with the Footsie plunging 25% in just 10 weeks. Each down day started in similar fashion -- US markets falling, followed by Asian, followed by European, which fed back to the US…with the cycle repeating.

I am a long-term bull, but have been bearish about the short-term sustainability of the current market rally. Being a value investor, it has been getting harder and harder to find companies trading at a fair value, let alone a discount to intrinsic value. Momentum has been the name of the game for the past few weeks, with a reducing number of companies in the growth sectors of telecommunications, pharmaceuticals and information technology propelling the general market higher. Whilst some of this enthusiasm is justified, given that these sectors look to have very bright futures, the valuations awarded some companies are to my mind stratospheric.

Keeping control of your emotions is a crucial element of stock market investing. When the market is roaring ahead, as it was last week, it is relatively easy to get caught up in the hype. You buy shares in a company that just a few weeks (and many percentage points) ago you categorically said was overvalued. You are fearful of not being invested in the market, thinking that you'll miss the boat. After sitting on the sidelines for weeks, you finally take the plunge. That was last Friday.

Come today, you are again fearful. The market is falling, Brazil can't play football anymore, and you're losing money. It's not pleasant. Fear turns to panic. You sell, cut your losses, and go back to backing nags at the Chepstow races. Emotion, and short termism, has taken control of you. If this typifies you, although we don't suggest you gamble your kid's inheritance at the betting shop, the stock market is not the place to invest your hard earned cash.

It is on days like this that the Foolish long-term mantra is actually reinforced. We weren't selling shares during the last downturn, and we won't be doing so this time either. Instead of judging the suitability of the stock market as an investment vehicle in terms of days, we look at it in terms of years. The Qualiport came to life on December 19th 1997, when the FTSE 100 was a mere 5020. Even after today's fall, the index is currently over 16% ahead, in just over a year. But, although that smashes the returns from a no risk building society account, it is still too short a time period over which to judge the market's returns. Who knows, the Footsie could be headed as low as the 4649 it hit in October last year. It could go lower still. Or it could end up at 7000 in 6 months time.

You cannot time the market. Unfortunately for us, there's no little leprechaun ringing a bell for us when the market peaks, and likewise when it hits its trough. Those who wait for the crash are likely to miss the recovery as well, in the same way that some people have missed one of the greatest bull markets in the century waiting for a crash! The best way to enjoy the long-term benefits of the share market is to remain invested throughout.

Qualiwatch

Last Friday, we added Glaxo Wellcome (GLXO) and Vodafone (VOD) to our watch list. Together with Dell Computer Corp., that makes 3 great companies for us to run our slide rule over. Remember that we will only buy these companies if we think they can achieve our goal of 15% compounded annual growth over a 5 and 10 year time period. To that extent, we will place a maximum buy price on them. This will be adjusted as time goes by, reflecting the passing of time, results announcements and newsflow. It may be that we never buy shares in any of these companies, because we may consider them to be perennially overvalued, as many great companies often are. However, we want to be ready to pounce should the market throw up some attractive investment opportunities.

We're going to start the valuation process by looking at Dell Computer Corp. In 1998, the share price of this company appreciated by over 200%! To many investors, that automatically says, "It can't go any higher". But, we're not perturbed. Great companies see their share price regularly hit new highs. For value investors, it doesn't matter how much the share price went up or down last year - it's whether the shares represent value now that matters.

Dell are simply one of the most efficient companies on this planet. Return on equity (ROE) is about 80%. Free cash flow exceeds net profit by about 50%. Operating margins are 11% and rising, having been 7% in fiscal 1996. The balance sheet is extraordinarily lean. We won't go into the details here, but Dell generates oodles of cash because it keeps money sucking stocks and debtors to a minimum. Capital expenditure is relatively low, and creditors are on the increase. The upshot of all that activity is that Dell generates huge amounts of valuable cash, which it uses to fund research and development expenditure, future expansion, and an aggressive share buy-back scheme. All in all it adds up to potent combination.

When looking at various ways to value Dell, many calculations using their existing ratios such as ROE give a ridiculously high valuation. ROE in the range of 80% is clearly not sustainable in the long term.

Dell are in the business of selling commodity products, being personal computers, servers and workstations, and notebooks. Their efficient business model and superior customer service puts them ahead of their competitors. It also allows them to grow faster than the market average, as they take market share form bigger, less nimble, companies.

Any valuation comes down to sales growth. The price of computers is on the decline, but so are the components that go into a computer, such as the processor. Dell are able to maintain, and even slightly increase their margins, whilst growing sales rapidly. This is no mean feat. It is all very well increasing sales, but if it is at the expense of margins, eventually something has to give.

The PC market is estimated to be growing at 15% per annum. Dell are outstripping that rate, and more. Fiscal 1997 saw sales rise 47%, and fiscal 1998 they rose by 59%. In the 9 months to November 1998, sales were up 52%, and earnings per share (EPS) by a whopping 64%.

Much of the valuation of Dell comes down to sales growth projections. If you conservatively assume sales growth equals earnings growth, we can come up with a simplified earnings based valuation. Current estimates have Dell earning US$1.45 per share for the year ended January 2000. Assuming earnings growth of 30% for the next 3 years after that, followed by 25% for the next 2 years, then 20% for the next 4 years, we get 2009 earnings per share (EPS) of US$10.32. Slap a price to earnings ratio (P/E) of 30 onto those earnings are we have a potential share price of US$310. This gives a compounding annual growth rate (CAGR) of 14.5% per annum. Dell does not pay a dividend, instead preferring to re-invest the cash back into the business.

That's a quick first stab at a valuation for Dell. Even at a 1999 price to earnings ratio (P/E) of 75, using the above assumptions they get close to our 15% hurdle. Some people think the PC market is going to shrink, as the world moves to Web television and much simpler and cheaper terminals. This may be true, and causes a threat to a company like Dell. But do you think this superbly focussed and managed company will idly sit by and watch its sales bases disappear? Over US$250m of research and development expenditure per annum says otherwise.

More on Friday. Tell us what you think about Dell, the market, life and the universe on the Qualiport message board.

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                    13/1/99 Close

              Company   Change   Bid
               EMA     -0.17    10.85
               IIG     -0.01     2.51 
               MKS     -0.10     3.92
               PIZ     -0.05     7.50 
               RTO     -0.15     4.43
               ULVR    -0.34     6.26


Qualiport Stocks

Last Rec'd Total # Company    In At Current Change
 19/12/97     783     RTO     2.55   4.43  73.7%
 27/10/98     755     IIG     2.58   2.51   (2.7%)
 04/11/98     245     PIZ     7.93   7.50   (5.4%)
 17/07/98     298     ULVR    6.72   6.26   (6.8%)
 17/04/98     169     EMA     11.85  10.70   (9.7%)
 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 3468.69 1422.16
 17/07/98     298     ULVR    2052.54 1865.48  (187.06)
 27/10/98     755     IIG     1972.64 1895.05   (77.59)
 04/11/98     245     PIZ     1966.34 1837.50  (128.84)
 17/04/98     169     EMA     2052.57 1808.30  (244.27)
 11/05/98     368     MKS     2054.11 1442.56  (611.55)


Cash:                                 £3,993.99
Current Total :                      £16,311.57

Total Invested:                      £16,184.62
Profit/(Loss) :                        £ 126.95  


Value Per Share

                    Day      Month      Year      
Qualiport         -1.83%    -2.96%     -2.96%
FTSE 100          -3.04%    -0.55%     -0.55%
FTSE All Share    -2.83%    -0.30%     -0.30%