Qualiport

[ May 12, 2000 ]

Qualiport Under Fire

By Maynard Paton (TMFMayn)

Rochester, Kent -- The Qualiport discussion board has been humming recently. TMFs Nigel and Pyad have both stormed the board over the past week or two, casting doubt over the long-term predictability of corporate earnings and the ability to replicate the long-term buy and hold achievements of Warren Buffett.

These are all serious charges against the Qualiport, a portfolio that revolves around these aforementioned and now heavily criticised principles.

Firstly, I have to say that I can't blame them for the suspicion over the Qualiport philosophy. The mistakes are there for all to see in the Qualiport archives. Buying Marks and Spencer (LSE: MKS), overpaying for Unilever (LSE: ULVR) and not selling Rentokil Initial (LSE: RTO) after initially spotting the marked slowdown in sales have all cost the portfolio dear.

We're way behind the stock market over the two and a half years since the Qualiport's inception. I can't imagine the portfolio's record inspires any new Fools to use these criteria to locate their next stock pick.

Are earnings predictable?

So, are earnings over the long-term predictable? As usual, TMFPyad doesn't mince his words, as he comments in this post: "TMFNigel is right on long-term earnings per share forecasting. It is a dead end for investors. In most cases it will go wrong."

Uncle Pyad continues his argument by pointing out that the research performed by djwithers showed there was no correlation between earnings from one year to the next.

The argument against predictable long-term earnings considers stock market investment from a different angle than the Qualiport. The justification is purely a statistical approach and suggests that investors trying to pick the few "predictable" exceptions would be lucky to succeed. But this approach doesn't branch out into the real world. Here, companies are solely names to assign to an earnings history, rather than any living and breathing business operation.

Of course, what's missing from the statistical research are the "lucky few" predictable companies that prove to be the "exception". Would you be surprised if say, the names of Vodafone AirTouch (LSE: VOD), Glaxo Wellcome (LSE: GLXO), Lloyds TSB (LSE: LLOY), Sage (LSE: SGE), or Logica (LSE: LOG) were those lucky few? And would there be any "business" correlation between them? Perhaps a superior and proven financial operating history, with scope through industry growth or consolidation of significantly greater profits five or ten years down the line? Maybe they all have high barriers to entry, limited competition, or market dominance too. All business characteristics that lead to more "predictable" earnings, then...

The point is simply that if you were to identify the few long-term winners of the past, the statistical freaks so to speak, I'm quite sure a few common and very enticing business traits would be identified. Of course, as Pyad's numbers suggest, these winning companies are few and far between. And with that statement, I agree.

As I mentioned after querying the long-term buy and hold, the true 10-year growth company is the investing exception, rather than the rule. The fact that Buffett only has a handful of this type of common stock investments says it all. But that's not to say you can never find a long-term investment. You have to look in the real world of business, away from a snapshot of statistics, to where the long-term winners of tomorrow can be uncovered through their operating characteristics and industry potential.

But remember, no one said it was going to be easy to find "the next Microsoft (Nasdaq: MSFT)" on a reasonable valuation.

Buffett's nose

Pyad pushes the knife further into the Qualiport with this post.

He remarks: "My point is that many people, not a million miles from here [the Qualiport discussion board], and elsewhere, believe fervently that the Buffett approach is quantifiable and therefore replicable. You can see all the equations and spreadsheet figures being put up... I believe that the quantifiers are wrong and that the man simply has a nose. But people don't want to see this. They think they can read some stuff in a book and reproduce it."

The points made about Buffett's investing thoughts in the books are recommended to all investors. I'm sure regular Qualiport readers are familiar with the "investing is most intelligent when it is most businesslike" and "margin of safety" concepts. These and many other recent Buffett quotations are general points that will guide investors towards a more sensible investing approach and away from the Wise perception of a stock market casino.

Where Pyad is correct concerns the ability to simply turn Buffett's thoughts into a quantifiable set of stock selection criteria or formulae. Take my recent proposal of Games Workshop (LSE: GAW) for the Qualiport. The company seemed to fit most of the Qualiport's historic past performance criteria -- proven sales growth with scope for further international expansion alongside chunky margins through limited industry competition. Granted, there were one or two operational difficulties, but it appeared the demand for the company's core product was still intact. Or so I thought.

A subsequent profit warning blaming the Pokémon craze for a downturn in sales and all the Games Workshop "predictability" goes out of the window. My "smell" for the outlook of wargaming toys was, and still is, very poor. Of course, there were others who had a far better nose than me.

So, I guess investment all boils down to a subjective opinion of future. Basically, will this or that company, with its products or services, substantially succeed over the long term future? Take Lastminute.com (LSE: LMC). Some people say it's a great example of UK entrepreneurial spirit with an impressive brand, others say it's something similar to the South Sea Bubble Company. Some investors may have sniffed a long-term Internet winner, but who knows which opinion is correct? It's all down to how sweet you think the future smells.

Formulas for success

But let's go back to the Qualiport's investment criteria, guidelines that roughly correlate to Buffett's historic stock picks. Think about this. Has anybody ever published a sure-fire list of investing rules that subsequently created long-term stock market success? I can't think of any.

One of the very few certainties that exist in the stock market is that once a "formula for success" has been devised and proven, it then immediately ceases to work. Recent history is littered with examples -- Jim Slater's book "The Zulu Principle" and the dire performance of our own Foolish Beat the Footsie instantly come to mind.

Is it a coincidence that suddenly, after a deluge of Buffett books were published throughout the 1990s (the authors realising that Buffett liked the smell of "consumer monopolies" after the purchases of Disney (NYSE: DIS), Coca-Cola (NYSE: KO.) and Gillette (NYSE: G.)), Buffett starts to hit trouble? Back in the 1980s and early 1990s, Buffett could buy whatever he wanted because nobody had cottoned on to the characteristics he looked for in a business. Now, after several different stock purchases and an emerging pattern, the secret's out and everyone's playing the same game. Including the Qualiport.

Similarly to when Buffett gave up Ben Graham's deep value strategy (buying companies selling for less than their working capital) after the stock market quickly adapted to the strategy's success and he ended up picking real losers, so perhaps now the "consumer franchise" game has moved on too.

Buffett ain't Buffett anymore

Pyad makes this telling remark on the Qualiport board too: "Warren Buffett is not Warren Buffett". A comment made by Buffett, reported in this piece, raises my eyebrow.

"We look for how a company deals with adversity. A good example is America Online (NYSE: AOL) a few years ago. I had the impression that many customers were mad at AOL. But it was growing anyway. That's great -- it shows underlying strength. It helps when you're evaluating the depth and impenetrability of a moat."

With references to AOL, perhaps Buffett has put to one side the "long and proven profitability" factor to instead concentrate just on moats and sales growth? Anybody know for sure? But isn't buying a company without a great profit record "speculation"?

Anybody for a refinement?

Maybe the Qualiport should refine its stock selection criteria. Perhaps we should replace some of the specific guidelines with just general common sense and flexible investment principles. In essence, our aim should be to simply to try and buy Ł1 coins for 50p. Ideally, we should concentrate on great long-term businesses, but as everyone knows, these are few and far between. And even fewer sell on reasonable ratings.

Bruce suggests in this post that second-tier companies to be held for under five years could be a consideration. I'm not averse to that. Alongside more of a medium-term "value" approach, perhaps we should also try to develop our smell for the future rather than relying too much on the past. Incorporating companies that have less of a proven record but are offset by possible moats and significant potential may be in order. Like AOL, a few years ago.

Your thoughts and comments to the Qualiport discussion board, please.