Qualiport

[ March 10, 2000 ]

Decision Time

By Bruce Jackson (TMF Googly)

Maynard and I have been in deep Qualiport discussion this morning. We're sitting on almost £2000 cash, with another £2000 to be added on April Fool's Day. By then, we'll be positively rolling in the stuff. We're not desperate to throw it into the market. But we want to make sure we make the right decision.

In a nutshell, we're looking for great companies that are attractively priced. Easy, hey? Well, not quite. In this market, most great companies are fairly priced at best, with many of them positively overvalued. Looking for an example? How about Guardian iT (LSE: GRD)? They offer disaster recovery services, and from what I've seen have an attractive business model. Are they a buy at 1400p, where they trade on a forward price to earnings ratio (P/E) of over 90? Give me a break.

On a couple of occasions in the past, the Qualiport has been guilty of paying high prices for what have turned out to be average companies. Unilever (LSE: ULVR) is a classic example. Believe it or not, consumer goods companies like this were all the rage back in the early part of 1998. They were in the midst of a re-rating, because investors were happy to pay up for their solid and predictable earnings. How things have changed!

The ideal time to buy great companies is when they are going through a temporary glitch. The glitch is something that affects virtually all companies of all sizes over the years. Smooth and predictable earnings growth, whilst ideal, just doesn't happen to most companies. In reality, they thrive in good economic conditions and struggle when the economy turns. That's just life.

Many of Warren Buffett's big purchases have been made when companies are going through a massive glitch. He bought insurance company GEICO at a time when they'd virtually gone bust. But he knew the industry, knew they wouldn't go bust, and piled in, buying big. He had minimised the downside by buying them at a ridiculously low price. The same goes for his investment in the bank Wells Fargo. I think he bought them when they traded on a P/E of about 3. Buffett has also said he's not a big fan of the banking industry, saying he doesn't like the economics.

Lloyds TSB

And you know -- he's right. That may be a bit rich coming from a shareholder in Lloyds TSB (LSE: LLOY). But having followed this sector quite closely for the past few years, and written about it in our new Industry Focus 2000 (14 Foolish investment ideas for the future for £17.50), eventually you realise that this is a highly competitive industry. As my colleague Stephen Bland (TMF Pyad) has continually said, the way to make money out of banks is to buy them low and sell them high. And by (or is that buy?) low, he's talking about P/Es of 7 or less.

Lloyds shares are currently about 545p, where they trade on a 2000 forecast P/E of 10 and dividend yield of 5.7%. To me, that looks cheap. But, that doesn't mean the shares can't fall lower. A P/E of 7 implies a share price of below 400p. One would like to think the dividend alone would put a floor beneath the share price, but nothing's guaranteed. Shareholders in Royal & SunAlliance (LSE: RSA) will know that, as the shares in the faded insurance giant now yield over 8%.

The thing that originally attracted the Qualiport to Lloyds was the acquisition of Scottish Widows. That instantly moved them into a growth market. With individuals having to take control of their own financial destiny, especially as regards their own pension arrangements, fund management companies like Scottish Widows are set to benefit. But will the acquisition work? Based on Lloyds' track record of successfully assimilating acquired companies, one would have to say yes. However, there's no guarantee.

Choices, choices...

As Qualiport managers, we've got about 2000 companies to choose from when making an investment decision. We want to have a portfolio of about 6 companies. We like to call our best investment idea number 1, second best number 2 and so on... (I think you get the drift). Why then dilute your best investment ideas by spreading your money across choices number 7 to 10? Which brings me back to Lloyds TSB. It currently resides in a Qualiport consisting of 7 companies. I wouldn't rank them number 1 on that list -- I'd put Dell Computer Corporation (Nasdaq: DELL) in that position -- nor would I rank them number 7 -- that's reserved for Unilever. But are we sufficiently confident in their future to risk further capital, especially given that there may be lots of other investment opportunities out there? At the moment, neither Maynard nor I are convinced. We're not missing out on any upside, because we already own a decent chunk of Lloyds. For the time being, we're happy to keep it at that.

Independent Insurance

Last Friday I previewed Independent Insurance's (LSE: IIG) results, saying I expected fully diluted earnings per share (EPS) of 19.2p. In the end, earnings came out at 19.5p per share. Who needs analysts? My back of a fag packet estimate was close enough!

Since then, the shares have been unmercifully hammered, closing below 200p for the last couple of days. The market was spooked by an unexpected £20m charge for claims prior to 1997, yet another change in accounting policy which produced a £13.4m benefit, and the continued lack of cash generation. On the latter point, in his presentation to analysts, Chief Executive Michael Bright said they expect to report significantly improved first quarter cash flow at the time of their Annual General Meeting. That should happen by April.

Whilst the company is haemorrhaging cash, Independent's investment returns continue to suffer. It's all well and good to be an excellent insurer, which it is, but the real money is made on the investment side of the business. Until they manage their cash better, it's hard to get super-excited about the shares, even if they are trading on a trailing P/E of just over 10.

We've already topped up once on our IIG holding, and are happy to leave things at that for the time being. The company is currently seeing excellent new business growth in the first two months of this year, and really hopes this is the start of a sustained period of excellent organic growth. The Qualiport won't miss out on the upside, if and when it comes.

Buffett

Tomorrow (Saturday) sees Warren Buffett's annual letter to his Berkshire Hathaway (NYSE: BRK.A) shareholders posted on the company's website. I would thoroughly recommend that all investors read it. Buffett has seen all this market hype before, so it will be interesting to read his perspective on the valuations of some technology companies. I've read all the published reports, going back to 1977. They helped me understand the insurance industry, and the art of investing. There's been quite a few good books written on Buffett, but none are better than reading the man's own work.

Have a great weekend. Comments and thoughts as ever encouraged to the Qualiport discussion board.

Related links
• Googly on Guardian iT
• Stephen Bland and value investing
• Berkshire Hathaway's website

Note
The Qualiport was launched on December 19th 1997 with an initial investment of £4040.63, all in Rentokil Initial. Further cash was added as holdings in Emap, Marks & Spencer and Unilever were bought during 1998. The vagaries of the value per share accounting method caused percentage return calculations for calendar 1998 to be somewhat distorted. To avoid confusion and somewhat misleading figures, the Qualiport's returns are being measured from 1/1/99, at which point the total portfolio value, including cash, stood at £16,809.60. An additional £2000 cash is added to the portfolio on April 1st and October 1st each year. The total cash investment in the portfolio to date has been £20,184.62. To access the Qualiport's total trade history, click here.