Qualiport

[ May 22, 2000 ]

Margin Of Danger

By Maynard Paton (TMFMayn)

Carburton Street, London -- Bruce's Qualiport article from last Friday struck a chord with me. Unfortunately, the words "serial procrastinator" ring loud and true for the Qualiport's other writer too.

But unlike just about any other activity in life, procrastination can be a "good thing" when it comes to investment. Putting investment decisions off to another day can actually be more rewarding than carrying out your "buys" or "sells" as planned. Don't believe me? Well, put it another way. How often have you bought a handful of shares, only to see months later that you could have purchased the same set of shares at a much lower price? More often than not, I bet. It's the very rare investor who persistently never has the opportunity to reinvest at below his "buy price" ever again.

You only have to look at the Qualiport's record to see this investment phenomenon in action. Apart from the notable top-up of Emap (LSE: EMA), I think just about every other investment could have been picked up at a significant discount some time later.

Of course, trying to time the exact bottom of any company's share price is an impossible task. You may be lucky once or twice, but nobody consistently gets it right all the time. But you can buy near the bottom.

Valuation

What counts is getting a handle on a company's valuation. Although some have written about the perils of distant projections of a company's profitability, for a long-term buy and hold portfolio such as the Qualiport, it's a necessity. As I wrote last week: "With the right business in the right industry with the right prospects, conservative growth assumptions can be applied and a valuation benchmark set".

When we've set the "undervalued benchmark" to an appropriate company, involving a suitable margin of safety to limit the downside should the unexpected happen (Murphy's Law of Investment), we buy. It won't be the exact bottom, but patience, and a little bit of procrastination perhaps, should ensure we are there or thereabouts.

But, having written about the investment purchase decision and the margin of safety many times before, should there be an opposing overvaluation limit for selling within the Qualiport too? In other words, should the Qualiport consider a "margin of danger" in case the share price completely overshoots the bounds of realism?

Bruce remarked on the recent price history of Misys (LSE: MSY) on Friday. Having originally bought Misys over a year ago at 576p and topped up last October at 524.25p, the IT company then did the Qualiport proud and rode the "tech bubble" in magnificent style. The shares peaked at a whisker under 1300p in February. Nothing much changed at Misys in that time. If anything, there was actually a slight deterioration in its trading performance through some Y2K-inspired delays.

Elephants Don't Gallop?

In his book the Zulu Principle, Jim Slater coined the phrase "elephants don't gallop". Jim was remarking on the fact that because the profits at large corporate giants didn't grow as fast as their smaller brethren, he quite reasonably expected the share prices of blue-chips to follow a similar restrained pattern.

Unfortunately for Jim, that comment, just like the strategy within his book, quickly fell apart. Whereas in Jim's heyday, it was a major event to see a FTSE 100 constituent witness a 10% daily change, it's a common event in the volatile stock market of recent years.

The general long-term buy and hold strategy has previously reflected the sedate pace of corporate giants, slowly but surely plodding along, and their share prices largely reflecting this ramble. But, a definite dilemma occurs when the very long-term expectations of the stock market suddenly appear in a very short space of time.

The Qualiport aims to generate a 15% average annual investment return. Not an extravagant target, but ahead of the 12% historic annual gains that the stock market has averaged. So, take the aforementioned highs and lows of Misys. In under a year, we doubled our money. In other words, the share price that we could have reasonably expected perhaps five years down the track, with our 15% annual investment target in mind, had suddenly appeared in a few months.

Although the Misys business hadn't altered, the shares at nearly 1300p required a large dose of optimism to justify the price. In terms of investment, the game had changed. At 1300p, using the benefit of hindsight, the investment odds were stacked against us. The chances of a substantial Misys share price de-rating, should our original rough forecasts prove too rosy, were far greater than when Misys were under 600p. The margin of danger had significantly increased.

The same story can be told of Emap. After having bought Emap at 787p in October, the shares raced ahead to 1773p in late January. Again, another doubling of our money in a few months. And again, rose-tinted spectacles had to be worn to justify the stratospheric rating that Emap touched.

Short-term dilemma

The dilemma is this. As long-term investors, should we take advantage of such apparent overvaluations? Conventional wisdom suggests that investors shouldn't dive in and out of great stocks. That's true. But then, conventional wisdom wasn't written in a time when substantial companies went from clearly undervalued to clearly overvalued in a matter of months. If a very optimistic long-term share price suddenly arrives in a short space of time, then perhaps a sell decision should be considered.

(With that in mind, I shall be keenly awaiting any investment bubbles in sectors such as banking, insurance, food manufacturing and restaurants...)

Given the Qualiport's poor record so far, maybe the phrase "a bird in the hand..." ought to be fixed in our minds. I mean, had we sold Emap and Misys at around their peaks, then an adequate 15% annual return for five years could have been assured from these two investments. That would have left the Qualiport until 2004 to find a suitable reinvestment proposition. Repurchasing Emap and Misys at lower valuations, maybe...?

In hindsight

This is all written in the benefit of hindsight. Bruce did mention "Sell Misys?" to me at the peak of the recent tech boom. Of course, I was against that idea. Considering the stock market performance of Sage (LSE: SGE), I thought:

"The one thing that I've learnt after many times of believing that a company can't become any further overvalued, is to never believe that a company can't become any further overvalued."

Just like the adage from Jim Slater, and investment proverbs in general, no sooner had I accepted this investment belief, the stock market immediately goes and contradicts it.

Or then again, maybe I subconsciously put Bruce off from selling Misys through my own procrastination...