Qualiport

[ September 1, 2000 ]

Are We Too Long-Term?

By Maynard Paton (TMFMayn)

Carburton Street, London -- We'll start with a question. What is investment?

Everyone will have their own individual answer, but my reply would be "to purchase a £1 coin for 50p".

Essentially, that is what all investors (as opposed to speculators) are thinking when making any purchase on the stock market. When the rational investor makes a share purchase on the market, it's for one reason -- because the company is fundamentally undervalued given its future prospects.

The difficulty for the investor is determining whether a company is undervalued, overvalued or fairly valued. Every company has its price. In theory, the true "intrinsic" value of any business is the net present value of its future cash flows. But obviously some businesses are more difficult to value than others.

Loss-making dotcoms, mining companies in Darkest Peru and biotech outfits busy developing the next wonder drug all have some "intrinsic value". But because of the unpredictable prospects of their business (will the mining company strike gold?), which in turn affect the profit assumptions of the future, determining a realistic intrinsic value is nigh on impossible. Given the difficulty in applying any valuations in these sorts of businesses, the typical investor looks elsewhere.

So let's move to the other end of the investing spectrum. Enter Buffett and the Qualiport. Step 4 of the Qualiport's Ideal Company -- "a company you understand, and which has predictable earnings".

Too predictable?

Predictable profits, usually derived from a company's durable competitive advantage, lead to an easier time when it comes to determining the company's value. These sorts of businesses may be easier to value, but it's still a difficult task. The chances of performing an accurate 10-year discounted cash flow model on any company are very small.

Nevertheless, it goes without saying that the more "visible" a company's prospective profits and its competitive advantage are, the more unlikely the investor will ever find a clear bargain. And given the difficulties in performing valuations, what the investor should seek is an obvious undervaluation that leaves a suitable margin of safety.

However, more often than not, when the company's future appears predictable and rosy, the market will be asking for 110p for that £1 coin. Not a great investment opportunity.

To find the £1 coin on offer for 50p, investors have to believe that their vision of a company's future is far brighter than the market's. That can be done in two ways.

Avoid the crowd

With the stock market a mixture of human emotions, investing opportunities can be had as unfounded pessimism takes over from rational thinking. When the perceived outlook for the stock market is poor, when sectors fall out of fashion and when companies hit short-term trouble, so undervaluations can be found.

Warren Buffett has used Mr Market's manic-depressive traits to great effect over the years. He bought Washington Post (NYSE: WPO) during a deep recession (who wanted stocks then?), he bought GEICO when it was on the brink of bankruptcy and he bought Wells Fargo (NYSE: WFC) when it was suffering heavily from bad debts. As the "problems" eventually cleared, so Buffett made a handsome profit on all three.

Or do more research

Alternatively, when the stock market is in a reasonably optimistic mood (which it usually is these days...), investors have to possess an "edge". Investing is a competitive pursuit. Plenty of analysts pore over every major UK company each day, every day. If you want to outperform without the help of market pessimism, then you'll require more understanding of a business's products and prospects than the stock market. For the average private investor, that's a tough proposition. And in fact it's an impossible task for those studying the FTSE 100 top tier.

But the battle of knowledge against the market fails to prevent most individual investors from attempting to outperform.

Scuttlebutt

In this Fool's Eye View, Bruce (TMFGoogly) wrote:

"Investors should learn as much as possible about a company before parting with their hard-earned cash. It was Warren Buffett who said if you're not prepared to hold a company for 10 years, you shouldn't hold it for 10 minutes. If you really are going to follow the great investor's advice, you ought to know a hell of a lot about a company before buying it.

For example, an investor needs to know these things about a company:

• what's its overall strategy?
• what are its weaknesses?
• who are its competitors?
• what's its competitive advantage?
• has it got outstanding management at all levels?
• what do the employees, and ex-employees, think of the company?
• do people actually enjoy working for the company?
• how big is the overall market for the company's products?
• what do the company's competitors think about it?
• what is its marketing strategy?"

Hmmm... I suspect most private investors don't have the time or resources to try to find answers to most, if not all, of those questions. Yet to take Buffett's "business perspective" angle on investing, and to get one up on the market in the information stakes, most of that research needs to be done.

As a short cut, most investors (including the Qualiport) prefer the safety of the company's historic record. If it's shown consistent growth in the past, then surely the company must possess some management talent, superior products and a competitive advantage? But these sorts of "predictable" companies lead back to the valuation dilemma. They'll never normally show an obvious undervaluation.

Options

Every Buffett-inspired investor has three options to beat the market.

• Buy great companies when the market becomes excessively pessimistic;
• Buy great companies when they suffer one off problems, and;
• Buy great companies when your research and knowledge gives you a distinct "edge" over the market's perception.

Option 1 is open to everyone, although some patience is required for the necessary panic to take hold.

Option 2 is again is open to everyone. But the trouble with this method is determining whether the problems are one-off or not. Marks and Spencer (LSE: MKS) was once deemed a great company. Will it return to its former glory?

Option 3 is open to those who have the time and resources to perform the necessary company "due diligence" to "beat the market".

In terms of the Qualiport, I suspect only option 1 is truly viable. Option 2 could be tricky (witness this near-disastrous attempt earlier this year). And option 3? Well we're in a better position than most private investors, but not to any exceptional degree.

Is Pyad right?

So given that:

• the Qualiport's performance has been mediocre so far;
• the Qualiport's managers could be waiting a while (like Buffett?) for option 1 above;
• the Qualiport's managers bring little to the table in terms of having an "edge" in specific companies, industries or products, but;
• the Qualiport's managers do have a liking for buying obvious £1 coins for 50p...

...it leads me to ask... "is Pyad right?"

Think value

TMFPyad has long been an outspoken critic of anyone trying to emulate Buffett's business investing perspective and long-term strategy. Instead, he applies his own rigid "deep value" investment strategy.

This underlying strategy requires little in-depth understanding of a business. Instead, any purchase would have to exhibit an obvious undervaluation with the distinct possibility that the market will re-rate the company in the near-term future. Effectively, a bargain entry price will offset the lack of understanding about the business.

Overall, it appears a rather simple, but sound, approach. And just because of the lack of specialist knowledge and time needed, I do think that most investors would be better off considering this "value" investing style rather than Buffett's business perspective method.

These factors haven't passed the Qualiport by. In the recent past, I have used this "forget the business, focus on value" methodology with Lloyds TSB (LSE: LLOY). Would the Qualiport be better off adopting a similar "value" approach? Next week, I'll explore some possibilities.

Your say

Would the Qualiport be better off adopting a short-term "value" approach, rather than, or as well as, the current long-term philosophy?

1) No -- You're doing a great job with the current criteria. So why change?
2) No -- Stick with the current philosophy. You'll come good in the end.
3) No -- Your record suggests a tracker is in order, not another strategy.
4) Yes -- But only because of the poor performance with the current philosophy.
5) Yes -- Short-term value investing is the only way to consistently beat the market

Click here to vote.

Where Next?

Read Pyad's latest Value Investing feature
Bruce ponders Special Situations.