QUALIPORT
Successful Investing Is All About Valuation

By Bruce Jackson (TMFGoogly)
November 25, 2002

The Qualiport's strategy, in a nutshell, is to buy companies with long-term sustainable competitive advantages, when they are trading at attractive valuations, and hold them for the long-term.

Of the three components of the strategy, long-term sustainable competitive advantage is by far the most difficult of the criteria to measure, and to get right. Today's article will concentrate on that particular aspect, and offer an alternative to that part of the strategy. As you'll see, it's all about valuation.

Difficult To Measure

There is no statistical measure of a company's competitive advantage. You could try using a couple of measures, but invariably they will fall short of the mark in determining a company's long-term and sustainable competitive advantage.

The recently disposed Qualiport holding of PizzaExpress (LSE: PIZ) is a classic example of the difficulties of measuring a company's long-term competitive advantage. Operating margins of over 20% put them very much in the upper echelons of quoted companies. At that level, they indicated some sort of competitive advantage. The Qualiport (literally) bought that argument.

As we've seen with recent announcements, competition is now hurting PizzaExpress. Like-for-like sales are falling. Expensive refurbishments are now required in order to stimulate sales growth in older restaurants and to generally refresh the brand. This sort of thing doesn't often happen to companies with a long-term sustainable competitive advantage.

If operating margins are not necessarily a measure of a company's long-term competitive advantage, what are? I'm afraid there's no easy answer. In fact, the only way to measure it is to immerse yourself into a company, knowing it back to front, knowing its profitability drivers, knowing its strengths and weaknesses, knowing its management, knowing its key employees, and knowing its competitors and its competitive environment, amongst other things. Phew! Most private investors, myself included, just haven't got the time, the access to the company, or even the skill to be able to do this.

Having said that, the Qualiport has put together a list of 16 companies that it believes are 'superior companies' [note that PizzaExpress will be removed from this list when it is updated next month]. The manager of the Qualiport, Maynard Paton, has done a lot of reading and research when putting together that list of companies. When you look at companies like London Stock Exchange (LSE: LSE) and Clydeport (LSE: CLY), to name just two, to me their long-term sustainable competitive advantage is readily apparent. It's not impossible to identify these types of company, but it's bloody difficult!

Circle of Competence

The Motley Fool encourages people to take control of their money and make better financial decisions. If you are going to follow the Qualiport strategy, we urge you to put in the time and effort needed to establish whether a company has a long-term sustainable competitive advantage. In order to do that, you must remain within a relatively narrow circle of competence. For example, try as hard as he might, fellow Fool writer James Carlisle has still not managed to explain to me how Autonomy's (LSE: AU.) – one of his favourite companies – software actually works. It's well and truly outside my circle of competence. I happily pass on it, and its competitors, if I knew who they are.

If you do follow the Qualiport strategy, let me assure you that by far the hardest part about it is determining a company's competitive advantage. Don't get under any illusions that you will get it right every time. In fact, be prepared to get it very wrong on occasions, as the Qualiport did with PizzaExpress. But, if you read voraciously, learn from your mistakes, and most importantly put in the time and effort, you may well be able to come up with a relatively narrow selection of companies who enjoy strong competitive advantages.

An Alternative Strategy

As you can ascertain from the above, I believe it is very difficult to determine whether a company has a long-term sustainable competitive advantage. Many time-challenged private investors will simply not be able to achieve any long-term success in identifying these companies. Warren Buffett does it. He's a genius, but even he makes his share of mistakes. What hope therefore have the rest of us got?

I believe that most stock picking private investors are better off concentrating firstly on buying companies cheaply – buying them at a valuation that offers a significant margin of safety – rather than first trying to ascertain their long-term sustainable competitive advantage. My thinking is that valuation is much more measurable, and therefore much less open to interpretation and mistakes.

Measurable criteria such as a price-to-earnings (P/E) ratio of less than 10, dividend yield of more than 4%, dividend cover of more than 2, no debt, operating margins of greater than 10%, market capitalisation of greater than £75m, and cash earnings greater than accounting earnings should help point you in the right direction. Not every company passing those criteria will be of investment quality - in fact far from it - but it should help point you in the right direction when looking for investment opportunities.

Interestingly enough, one company that passes all the above criteria is PizzaExpress. Hmmm...Happy hunting!

The author holds shares in PizzaExpress. However, he is rather bearish on the future prospects for the company, as he has major doubts about their long-term sustainable competitive advantage. Read his thoughts and vote in this poll on the PizzaExpress discussion board.