Qualiport

[ July 17, 2000 ]

Buying Distress

By Bruce Jackson (TMFGoogly)

Question: Why invest in shares?
Answer: Because over the long-term, studies have proven shares to be the best form of investment, bar none.
Action: Buy a cheap index-tracking fund, and contribute to it on a regular monthly fashion.

Question: Why buy shares in individual companies?
Answer: Because you want to beat the market average.
Action: Using your stock picking skills, buy shares in companies whose share price will rise.

That last action may sound just a little too obvious. But, it is worthwhile reflecting on why we choose individual companies rather than just sticking to a plain old index-tracking fund.

WE BUY SHARES IN INDIVIDUAL COMPANIES BECAUSE WE THINK THEY'LL RISE BY MORE THAN THE INDEX.

(The above statement assumes the index will continue to beat all other forms of investment, a not unrealistic assumption.)

That said, the Qualiport is failing in its mission to beat the market index. We're losing both in this year to date and since January 1st 1999. We'd have been far better off leaving our money in the bank. Oops.

Yet here we are, soldiering on, trying to turn the situation around. We're still looking for companies whose share price will rise by more than the index. As that is our objective, it's worthwhile asking this…

Question: Why do individual company share prices rise?
Answer: Because their earnings grow, and/or their price to earnings ratio (P/E) expands.
Action: Make sure you know which category your share purchase falls into.

My article of last Monday titled Quick Fix Valuation Guide received some excellent feedback on the Qualiport discussion board. That feedback reminded me of the two reasons shares rise - earnings growth and/or P/E expansion.

In the article, I posed the question;

Which of the following companies would you invest in?

              P/E    Future Growth Rate

Company A      10           8%
Company B      40          20%

Although there are plenty of unknown variables in this oversimplified example, I suggested Company B would be the better investment. Two discussion board posters begged to differ, and based on expanding earnings yields (1 divided by the P/E) they were right to choose Company A.

However, as was pointed out in a subsequent post, the correct answer -- whether Company A or B was the better investment -- depends on the year 10 P/E. That prompted me to whip up a simple spreadsheet. Below I've reproduced one of the tables, representing a possible scenario for Company A.

Year   P/E    Earnings   EPS    Share
                Yield           Price

0      10      10.00%    10.0    100
1              10.80%    10.8
2              11.66%    11.7
3              12.60%    12.6
4              13.60%    13.6
5              14.69%    14.7
6              15.87%    15.9
7              17.14%    17.1
8              18.51%    18.5
9              19.99%    20.0
10     10      21.59%    21.6    216

Notes:
1. Based on earnings growth of 8% per annum.
2. Variables are in bold
3. EPS * P/E = Share price

With no change in the P/E, the earnings yield, EPS and share price have all risen by 116% in a 10 year period. However, if you tweak the closing P/E, the effect to the final share price appreciation can be dramatic.

Let's assume the Year 10 P/E was 15 instead of 10. Suddenly, that puts the year 10 share price at 324 (P/E of 15 * EPS of 21.6 = 324), and total share price appreciation of 224%. Some difference to the 116% appreciation in the above table!

The Holy Grail

Buy companies with both growing earnings and expanding P/E's. The results in terms of share price appreciation can be explosive. The Qualiport has largely bought companies because of their earnings growth prospects, and not because of the possibility of an expansion in the P/E. That's indicative of paying too much for many of the Qualiport holdings, past and present.

The Problem

Most excellent companies already trade on premium P/E levels. Here's a quick selection, largely off the top of my head.

Company                    Prospective P/E

Vodafone (LSE: VOD)             56
Glaxo Wellcome (LSE: GLXO)      33
Pearson (LSE: PSON)             36
WPP Group (LSE: WPP)            35
Logica (LSE: LOG)               79

What's an investor to do? You have to be extremely patient, and hope that one day the share price of your target company comes back towards terra firma. Under what scenarios could that happen?

1. A general stock market correction or even crash, although they rarely occur, and even when they do, the correction / crash is never quite deep enough.

2. Your target company gets into serious trouble. The problem then however is that those troubles will usually be enough to put you off buying the company, because the predictability of earnings will be removed.

Having said that, Warren Buffett has made some of his most successful purchases by buying distressed companies. American Express (NYSE: AXP), banking group Wells Fargo (NYSE: WFC) and insurance company GEICO are excellent examples.

Moral of the Story

Look to buy temporarily distressed companies. The challenge is to ensure the distress is indeed only temporary. It's a tricky one to get right. But if you do, the double whammy of growing earnings and an expanding P/E will lead to explosive share price growth.

Your Turn

Know any of these companies? Does Computacenter (LSE: CCC) fit the mould? A recent profit warning saw the shares tumble from over 1500p to below 400p, where they trade on a forward P/E of about 14. Let us know on the Qualiport discussion board.

Where Next?

• Index Trackers -- Frequently Asked Questions