Qualiport

[ September 8, 2000 ]

Notional Value

By Maynard Paton (TMFMayn)

Rochester, Kent -- Last week, I asked this rather controversial question:

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

The answer given appeared evenly split between "stick with the current philosophy" and "short-term value is the only way to consistently beat the market". Hmm...

Okay. Today, I'm going to explore a short-term "value" methodology. But first, a few clarifications:

•  The Qualiport is not going to suddenly change its overall investment direction overnight, and;
•  The Qualiport is not going to immediately liquidate some of its existing holdings to introduce short-term value "side bets".

Instead, the hunt for "value" will be done, initially at least, in theory. I'll run my own notional portfolio.

Over time, this exercise will determine whether our (my) short-term value stock picks can outperform those holdings we (I) select/retain using the current Qualiport philosophy. Whatever happens, it should be (please excuse the awful cliché) a "win-win" situation.

We'll discover either:

•  the new style of investment is far more suitable and successful;
•  that we're better off with the existing strategy, or;
•  a suitable middle ground that encompasses both methodologies.

Whatever happens, we can't really lose, given that the experimental side is confined to paper. My ideal outcome would be to develop both styles, the Qualiport having core long-term holds alongside shorter term value side bets. As we know, the long-term buy and hold is the investing exception, not the rule.

And let's face it -- everybody's investment style evolves. Most investors start by picking up somebody else's philosophy, but then gradually develop their own technique. "Find your own line" as jarvisrad writes. I agree.

And whether an investor's success is solely based on intuition, statistics, a company's business fundamentals, charting or whatever, there is no "correct" way to consistently beat the market. Just as long as you do beat the market, and are confident you're using a sustainable technique, then that is the investment style that is correct for you. And in that desirable market-beating situation, nothing else matters.

Value Filters

I'm a big fan of the simple dividend yield. I think it's perhaps the most reliable of all valuation measures. It can easily be compared to other non-equity sources of investment, notably risk-free Government bonds (gilts).

Here's my theory, largely based on a simple valuation philosophy contained in this feature on Lloyds TSB (LSE: LLOY).

If a company:

•  has a prospective dividend yield significantly greater than the risk-free return from government bonds;
•  has anticipated future profits that allow subsequent dividend payments to be increased, and;
•  has substantial dividend coverage to allow the dividend to be maintained should profits not meet expectations;

...then it's an investment "bargain". Theoretically, investors should gradually twig that this company can sustain a "risk-free" yield greater than that of gilts and thus a "yield de-rating" should occur.

For example, Company A has a share price of 100p and a prospective dividend of 8p (a dividend yield of 8%). We'll say the risk-free rate of return from gilts is 6%. If investors gradually realise this 8p annual payment is sustainable or could actually increase over time, then Company A's dividend yield should decrease to the more "normal" 6% level.

So, for the yield to decrease to 6%, Company A's share price would have to rise to 133p. Add in the 8p dividend payment as well and you have a 41% return, excluding spreads and dealing costs. Of course, time is an issue. How long will other investors take to help you "out the value", assuming they actually do help you? With this "help of the market" factor a major issue, it makes sense to focus on those companies where the value will have more chance of being realised. In other words, to concentrate on those companies with the largest yields and the greatest increase in earnings forecasts.

A stock picker's nose

That's the statistical part done with. If we left it at that, then the stock picking would just be a mechanical exercise. In my opinion, pure mechanical strategies never work over time. I mean, if they did work, then surely the world's richest investor would be a computer. So here's the factor that allows me to introduce a subjective human opinion into the equation.

•  The company operates in a "steady" industry or produces a "day to day" product.

I'm effectively after no great profit surprises, either caused by a seismic shift within an industry or a sudden drop in demand for the company's products. Basically it's a "get out" to ignore certain companies I deem "unsuitable".

Is milk toast?

Here's my first notional selection -- Dairy Crest Group (LSE: DCG), the dairy products processor. Low margins, low growth, heavy capital expenditure and commodity products. To say the least, not a traditional Qualiport company. But the shares exhibit "value".

Briefly, here are the main facts:

•  At 185p a share, Dairy Crest is valued at £221m;
•  Government bonds currently yield a risk-free 5.7%;
•  Dividends per share are forecast to grow by 7.7% to 14p in the current year, equating to a prospective dividend yield of 7.6%;
•  Earnings per share are forecast to grow by 12.1% to 31.6p in the current year, equating to a prospective price to earnings (P/E) ratio of 5.6;
•  The prospective dividend is covered 2.3 times;
•  Demand for milk and butter isn't going to suddenly fall;
•  Benefits from the recent merger with Unigate's (LSE: UNIG) dairy operation should underpin the increase in earnings.

The shares look cheap. Maybe for a good reason that my very limited research has missed. We'll see.

In a few months time, I'll return to this feature, revisit Dairy Crest's progress and count my paper profits or losses. And until then, that's it for the topic of short-term value plays.

Twice a week

Due to some proposed publishing alterations that are in the pipeline and from listening to popular demand, we've decided to re-schedule the Qualiport to Mondays and Thursdays with immediate effect. In fact, Bruce gets the opportunity to do both Qualiport features next week, as I'm away on holiday.

Where Next?

• Visit the very quiet Dairy Crest discussion board
• TMFSorted asks "Is milk toast?"
• Should you yield to Lloyds TSB?