QUALIPORT
How Hope Can Lose You Money

By Maynard Paton (TMFMayn)
October 7, 2002

'Predictability' has been the stock market watchword over the last few years. As the global economy took a turn for the worse, plenty of untried, untested and unproven businesses have been found wanting. As such, investors have gradually flown back to 'quality'.

Of course, seeking financial and operational predictability is a key tenet of long-term investing. Indeed, "a company that has a predictable future" is one of the Qualiport's share selection principles. Simply put, if your chosen business hasn't performed well over the last, say, five years, why should its fortunes improve over the next five?

C&W

While it's simple to bang on about 'predictability theory', sticking with it in practice can be difficult. It's all too easy to fall for alluring visions of growth while dismissing seemingly dull, mundane -- but steady -- operators.

A good example of alluring -- but unproven -- growth comes from Cable & Wireless (LSE: CW.). The telecom firm was reviewed by the Qualiport last year. At the time, the investment story for C&W went something like this:

* C&W was busy building a global Internet Protocol (IP) telecom network;
* Growth in data transmission was set to rise dramatically over the forthcoming decade or two;
* After many disposals, C&W had a large cash pile which would act as a competitive advantage, because;
* C&W's competitors were all lumbered with heavy debts and/or facing bankruptcy.

So there was the prospect of C&W ultimately becoming a major global telecom player. Furthermore, the then share price (335p) was only valuing C&W's cash pile and its more traditional, but smaller, telecom businesses. The all singing, all dancing global IP business was in for free!

Lacking

But C&W was lacking that all important financial and operational predictability:

* Millions were being spent on the IP network, with profitability some years away. The inherent economics of C&W's IP business were far from clear. Remember...
* Great prospects don't always mean great profits. Air travel and steel production has grown over the decades, yet plenty of asset expenditure and intense competition have failed to reward long-term shareholders. In fact, 'asset-heavy' and 'commodity' sound good adjectives for a telecom firm...
* IP technology represents a step change within the telecom industry. At what point will it be superseded, and at what cost?
* Graham Wallace was appointed C&W chief executive in February 1999. With no previous telecom experience, the jury remained out on his talents.

The Qualiport concluded:

"For a worthwhile C&W investment, you need faith in two parts of the business. Firstly, that decent growth rates, margins and returns on capital can be achieved in C&W Global. And secondly, that the management have the talent to accomplish the necessary financial expectations. There's no degree of certainty with either."

What's happened at C&W since the Qualiport review? Well, the investment story remains the same. C&W is still pouring millions into the IP network, data transmission is still forecast to grow, there remains a big cash pile and rivals continue to go bust. But a handful of profit warnings (leading to a 64% share price decline) suggest all is not going too well. While C&W is confident of becoming cash flow positive in early 2004, there remains a severe lack of predictability in every department.

Will C&W come good in the years ahead? Well...who knows? So rather than try and make a complicated judgement full of reservations, take the easy option. Back to last year's C&W review:

"The Qualiport should remain faithful to its investment criteria. In other words, to stick to buying solid, dominant and proven companies, where the shareholder returns are generated up-front in the form of an attractive free cash flow yield. While C&W has unquestionable growth prospects, the company doesn't come up to scratch in the predictability of its future cash flows. And in terms of industry presence, I'm not entirely sure C&W can ever become the equivalent of a London Stock Exchange (LSE: LSE), Imperial Tobacco (LSE: IMT) or Johnston Press (LSE: JPR) in its IP market either."  

In other words, why hope your chosen company becomes a dominant, cash-generative gorilla, when there are proven gorillas already available?

Philip Morris

The subject of dominant, cash-generative gorillas prompts a short mention of Philip Morris (NYSE: MO). With a focus on the UK stock market, the company is out-of-bounds for the Qualiport. However, it's worth highlighting the increasing 'value' attractions of the tobacco firm.

Morris has been hit hard over the past two weeks. The company reduced its forecasts for profit growth in 2002 to 3-5% as increased marketing expenditure and low-cost rivals took their toll. However, 8-10% earnings growth is still expected next year. Then on Friday, a US jury awarded a smoker $28b in punitive damages against Morris -- a decision that now goes to appeal.

As has been stated before, tobacco is a great industry for locating predictable 'franchises'. And Morris, the world's largest commercial cigarette firm, is undoubtedly one of the best operators around. It has an illustrious history of rising dividends, great brands, a 50% share of the US cigarette market, many entrenched overseas positions and a habit of surviving and overturning adverse legal judgements. At $36.7, the stock is valued on a prospective price to earnings ratio of 8 and a forward dividend yield of 7%.

More: C&W: More Hope Than Certainty

The author owns shares in Johnston Press.