Qualiport

[ January 17, 2000 ]

An alternative selection strategy?

By Maynard Paton (TMFMayn)

Carburton Street, London -- Ever since the Qualiport commenced over two years ago, Bruce has kept a keen eye on suitable companies that fit the overall criteria for the portfolio. In past articles, Bruce has covered the merits of both Vodafone (LSE: VOD) and Glaxo Wellcome (LSE: GLXO). Both companies operate in what can be considered "growth" markets and possess rather enticing financial characteristics. Neither Vodafone nor Glaxo would look out place in anyone's long-term blue-chip portfolio.

So why aren't these two giants of British industry in the Qualiport? It's all to do with the valuations of these fine companies. The Qualiport tries to buy long-term growth businesses at reasonable, or preferably, attractive prices. In previous features, Bruce has placed fair value share prices on both Vodafone and Glaxo. But so far, neither Vodafone nor Glaxo has come into range since the buy price targets were set.

The problem for investors who adopt a similarly conservative approach to valuations as the Qualiport, is that such companies could always appear just out of reach. It may be months or years before Vodafone or Glaxo come into our sights. In fact we may be on the sidelines in ten years time, still waiting.

So could we end up never purchasing a part of these companies? Perhaps. In today's stock market, everybody knows about the success of Vodafone and Glaxo. Everybody knows about the growth in the telecom markets, fuelled by Internet data transmission. Everybody knows about the financial and predictable rewards a successful drug can achieve.

Unless there is any bad news to contend with, investors in such businesses and industries will always be optimistic. It is that optimism of future growth that puts the shares beyond our interpretation of fair value. "You pay a high price for a cheery consensus", as Warren Buffet once wrote. With such anticipation built into the share prices, there just isn't room for any downside should either company disappoint in the short term.

So what is the conservative Qualiport investor to do, when looking for new investment ideas? Concentrate on the "recognised" quality companies and wait for a share price blip? Indeed, isn't that the philosophy of Buffett and his stock picks? Identify suitable companies then wait to buy at a fair price.

Given that a prime requisite of a Qualiport company is sales growth, and the stock market assuming a "growth at any price" philosophy at present, we may be waiting a long time for any suitable "growth" proposition to come our way.

Following this method, we would be constantly revisiting our sums on Vodafone every six months. We'd be learning a lot about Vodafone, a company that we didn't own. But that's not necessarily a bad thing. However, I've found from my own experience that it is difficult to consistently follow a company unless your money is actually riding on the shares (Nothing concentrates the mind as much as watching your own share price slide...).

So, is there an alternative to this "check out the business, then check out the price" strategy? How about "Check out the price, then check out the business"?

LarryDuff makes the suggestion in another of his excellent, thought provoking messages to the Qualiport board. In fact, I've used this "reverse" method that Larry describes to discover, and then purchase, companies for my own personal portfolio.

Being someone who is rather cautious towards high flying P/E super stars, having been stung by one or two in a past investment life, I always look for companies on a generally undemanding profit multiple. And if the business has a record of sales and profit growth behind it, all I need to consider are the overall business merits.

I ask the standard questions. Can the historic financial performance continue into the long-term future? Does the business have a "durable" competitive advantage? Can we be assured of predictable growth in profits? But, just as important as the business investigation, I have to consider why the shares are selling on an unspectacular rating.

Has the company just been ignored by the stock market as a whole? This sometimes occurs. However, more often than not, if the company has an exceptional history of growth, I have to contend with a certain amount of "bad news". It is the ability to determine what the bad news is, then decide whether it has a long lasting fundamental effect on the business, that is key to this strategy.

If the company is undergoing temporary "problems", but still has long-term business prospects that appeal, an investment opportunity could be at hand. Why? Because just as the stock market sometimes becomes wildly optimistic with good news, at other times it can become overly pessimistic with the bad news. Deciding whether the "problems" outweigh the "cheap" valuation is the difficult bit when using this approach.

Searching high and low.

I've always considered CD REFS from Hemmington Scott my favourite investing tool. It doesn't give out "tips" or "advice", but just snapshot investment statistics on every listed company. The beauty of this particular product is that it allows the user to apply various criteria to reduce the whole universe of possible stocks to just, in theory, a handful of possible investment picks. (And that's the end of the plug for a product supplied by rival website operator!)

Slight caution is needed as the latest edition of CD REFS has data as at 30th December 1999. But it should suffice for our purposes for an initial trawl of the market. The criteria I've used for this initial hunt for any Qualiport replacement is as follows:

• In accordance with Foolish investment principles, the company must have a market capitalisation of £30m or greater and the company shares must be 50p or greater.
• Sales to have compounded 10% or more over the last five years.
• Earnings to have compounded 10% or more over the last three and five years.
• Operating margins 15% or greater. This is a subjective figure. I've used this filter to look for a competitive advantage. Any business with 15% margins would appear to have some sort of pricing power over it's customers.
• A current P/E ratio of 20 or less. Another subjective criteria, this time on immediate valuation.

Feeding in the above criteria into the January edition of CD REFS gives 65 qualifying companies.

The beauty of this method is that I'm presented with a relatively short list of companies. It's far easier to decide the merits on just these prospects, rather than to think of a suitable company or sector from scratch.

I won't list all 65 companies, but a few caught my eye. In order of market capitalisation, a dozen potentials:

SSL International (LSE: SSL)
Johnston Press (LSE: JPR)
Ashtead (LSE: AHT)
Photobition (LSE: PHB)
Business Post (LSE: BPG)
PSD Group (LSE: PSD)
Southnews (LSE: SNW)
Triad (LSE: TRD)
Lavendon (LSE: LVD)
KBC Advanced Technologies (LSE: KBC)
City Technology Holdings (LSE: CIE)
Whitehead Mann (LSE: WHT)

A few of them have had a hard time of late. I remember Business Post and Triad issuing profit warnings in the last year or two. Were those problems temporary? Can they come back? In future Qualiports, I'll be taking a look at a few of these contenders. Are any viable for a long term investment?

One outcome of the search is that it presents a host of smaller companies. Only 15 of the 65 selected are greater in market capitalisation than the £565m Pizza Express (LSE: PIZ), the Qualiport member with the lowest capitalisation.

Given that small companies, by their nature, should have more potential to double their profits than a large company, is this now the area the Qualiport should be looking? Imagine if you had discovered Sage (LSE: SGE) when it was valued at under £565m! Or am I getting too carried away?

If you have any thoughts on mechanical sieves to help select long-term investments, or opinions on the twelve companies listed, or indeed ideas for other suitable long term investments, then let us know on the Qualiport message board.

Related Links

• Bruce decides on Glaxo
• Bruce looks at Vodafone

Qualiport Numbers
17/1/2000 Close

Company  Change    Bid
DELL(US)+1.90    44.00
EMA     +0.33    15.75
IIG     +0.05     2.75
MSY     +0.30     8.93
PIZ     -0.09     8.18
RTO     +0.09     2.70
ULVR    -0.19     4.63
LLOY     0.00     6.70


Qualiport Stocks

Last Rec'd Total # Company    Buy  Current Change

 22/04/99  542     Misys      5.57  8.93    60.2%
 17/04/98  301     Emap      10.20 15.75    54.4%
 27/10/98 1133     Indep Ins  2.60  2.75     5.8%
 19/12/97  783     Rentokil   2.55  2.70     5.7%
 04/11/98  245     Pizza Exp  7.93  8.18     3.2%
 27/01/99   74     Dell (US) 44.63 44.00    (1.4%)
 29/09/99  356     Lloyds TSB 7.56  6.70   (11.4%)
 17/07/98  266     Unilever   7.53  4.63   (38.5%)

Last Rec'd Total # Company     In At  Value   Change

 22/04/99  542     Misys      3065.85 4840.06 1774.22
 17/04/98  301     Emap       3139.85 4740.75 1600.91
 27/10/98 1133     Indep Ins  2990.63 3115.75  125.20
 19/12/97  783     Rentokil   2046.53 2110.19   63.66
 04/11/98  245     Pizza Exp  1966.34 2002.88   36.54
 27/01/99   74     Dell (US)  2007.42 1973.33  (34.08)
 29/09/99  356     Lloyds TSB 2723.20 2383.42 (339.78)
 17/07/98  266     Unilever   2052.00 1230.92 (821.09)

Cash:                                          £ 57.27
Current Total :                             £22,454.56

Total Invested:                             £20,184.62
Profit/(Loss) :                              £2,269.94

Value Per Share

                  Day  Month   Year  History      
Qualiport       +1.79% +2.84% +2.84% + 6.32%
FTSE 100        +0.17% -3.76% -3.76% +13.38%
FTSE All Share  +0.36% -2.38% -2.38% +18.36%