Qualiport

The New Toy

By Bruce Jackson (TMF Googly)

Kilburn, London -- In another magnificent piece of market timing, on Thursday morning the Qualiport purchased 347 shares in Misys (LSE: MSY) at the premium price of 576p. That same day, the shares actually closed at a mid price of 567p. When you take into account the bid/offer spread, the broking commission and the 0.5% stamp duty, in less than 6 hours we'd lost 3.7%. Who'd be a day trader? Today the shares climbed 9.5p to 576.5p -- we're still losing money, but not too much. Of course it's only very early days yet, and over time the dealing costs will hopefully become relatively insignificant.

Misys is my new toy. Having learnt a fair bit about the company in the last few months, I feel I know it rather well. I'm also feeling on top of the numbers, because they are fresh in my mind. I feel confident that the investment in Misys, over time, will be a successful one.

I had similar feelings about Dell Computer Corporation (Nasdaq: DELL) when I bought it in January this year. Its first three months in the Qualiport, judged by its share price performance, have hardly set the world on fire, although Thursday night's 9% jump was much appreciated. Before Dell, PizzaExpress (LSE: PIZ) and Independent Insurance (LSE: IIG) were my favourites.

Children discard old toys without so much as a second glance. Investors clearly can't afford to do the same, unless they follow a FIFO (First In, First Out) investment philosophy, in which case it would be a novel but ultimately foolish portfolio management theory. Yet how often have we discussed Rentokil Initial (LSE: RTO) in this space in recent weeks? Since the 1998 results of March 2nd, it's all been rather quiet, both from the company and from the Qualiport. Since the beginning of this calendar year, the shares have fallen from 451p all the way back to 353.75p, a drop of 21.6%. As they were, and still are, our biggest holding, this goes a long way to explaining the Qualiport's underperformance to date in 1999.

No-one likes to talk too much about their losers. However, as can be seen from the numbers at the bottom of this page, Rentokil can hardly be considered a loser. It just could be that 1998 saw 3 years of share price appreciation in just one 12 month period. In the original buy report, and on page 254 of The Motley Fool UK Investment Guide, we forecast that the shares could stand at 427p on December 31st 2000. They hit that level 2 years ahead of time!

It just goes to show that no-one can predict the short-term movements of the market or of individual share prices. When we bought Rentokil, with the FTSE 100 at 5020 and the company trading at a 1999 price to earnings ratio (P/E) of 20 times, we thought they looked expensive. Little did we know that the stock market was about to take off and take Rentokil's shares higher with it.

I've recently received the Rentokil annual report and in the weeks ahead want to take a look at some of the important numbers. The same goes for Unilever (LSE: ULVR). But today I want to have a closer look at the Independent Insurance annual report.

The accounts of insurance companies are notoriously difficult to read and interpret. A set of accounts is basically someone's opinion as to the financial performance of the company. Although accountants have rules (standards) they must follow, the interpretation of them can vary significantly. The accounts for insurance companies, much more so than for "regular" companies, are open to wildly different interpretations. This is especially so when assessing the value of future insurance claims.

In 1998, IIG changed its accounting policy, preparing the numbers on an annual basis. Also, unrealised investment gains or losses were included in the profit and loss account, not hidden away in the balance sheet. I won't bore you any further by going into details of debits and credits, but suffice to say the change in accounting policy had a significant effect on the company's accounts. IIG restated 1997 profit from £45.7m to £58.6m, and fully diluted earnings per share (EPS) increased from 15.2p to 24.6p. Quite a difference.

The company is not (to my knowledge) deliberately trying to give the impression that they are doing much better than they really are. They are just giving a different opinion, and one which they believe will "give far greater clarity to the financial statements and enable an assessment of the current trading of the Group."

IIG's share price has been on a slide in recent weeks, despite the news flow being dry. Irrational short-term share market movements are part and parcel of investing. Some Fools on the message boards have been wondering whether we should look at the share price weakness as a buying opportunity. I won't go into the advantages and disadvantages of averaging down here, but instead look at one of my concerns about IIG -- cash flow.

In a "regular" company, I'd be looking for cash earnings to be equal to or higher than accounting earnings. Although accounting earnings can be legitimately fudged, the bank balance never lies. IIG's 1998 pre tax profits were £91.6m, yet net cash from operating activities was negative £15.3m. A large increase in debtors is doing the damage.

IIG writes policies with a period cover of three to five years. Distorting the accounts, and the cash reconciliation, is the fact that the whole insurance premium is included in the accounts in the year it is written. The payment to IIG for these policies is usually through a variety of instalment methods. The result is that debtors are unusually large and cash for premiums booked is not received until a later date. This is where the cash discrepancy falls out.

Is this cause for alarm? It's hard to say. What IIG is doing goes against all we've learnt at accountant's school. However, the company is very clear and open in the policy and admit that the long term policies "have a distortive impact on the financial statements." Looking briefly at the labyrinth that is Legal & General's (LSE: LGEN) 1997 accounts, L&G, too, has cash earnings well below accounting earnings. That may be some consolation. For further discussion, I direct you to some excellent and informative discussions about this matter on the IIG message board.

I'm happy to hang onto the Qualiport's IIG investment, although at this stage I won't consider adding to it. Fully diluted 1998 EPS are 28.0p, meaning that at 237p the shares trade on a trailing P/E of just 8.5. Insurance companies traditionally are not valued on a multiple of their earnings but instead on a multiple of net asset value, which for IIG is 2. For a company that consistently makes underwriting profits (most make losses), that could be considered low. However, as a comparison, Royal & Sun Alliance (LSE: RSA) has a multiple of net asset value of about to 1.1. Over time, if IIG keeps kicking goals, ultimately this should show up in its valuation. We're patient.

That's it for this week, and a heavy day. Next week we've got Unilever's first quarter results to look forward to. Have a great weekend, Fools. If you're after some light reading, check out the recently archived How To Value Shares series. See you Wednesday and on the Qualiport message board.

Company  Change    Bid
   DELL   +$3.40   $41.75 
EMA     -0.15    12.79
IIG     -0.01     2.33
MKS     +0.14     4.52
 MSY     +0.10     5.75 
PIZ      0.00     8.90
RTO     -0.04     3.52
ULVR    -0.06     5.68

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