QUALIPORT
Quality Shares On Single-Digit P/Es

By Maynard Paton (TMFMayn)
December 16, 2002

The Qualiport aims to buy great companies at attractive valuations and hold for the long term. With a slot to fill on the portfolio's watch list, the occasional stock market trawl could throw up a share worthy of further inspection.

Sadly, no amount of statistical data will ever point you straight to a 'great company'. However, selecting those businesses that have certain financial characteristics can narrow the field down a little. Five consecutive years of earnings per share (EPS) growth could indicate a company having some sort of steady, predictable underlying business. Meanwhile, operating margins of 15% or more could highlight a company that does not suffer too much competition. On the attractive valuation front, a share that has a forward price to earnings (P/E) ratio in single digits does not, at first glance, look overvalued.

So, here are three firms that meet the above criteria. Are any Qualiport material?

1) Meggitt (LSE: MGGT)

Share price: 184p
Market value: £530m

Year to Dec 31st          1997    1998    1999    2000    2001

Turnover (£m)              265     294     346     386     435
Pre-tax profit (£m)         31      37      49      66      73

Earnings per share (p)     8.9    10.2    12.9     16.1   17.6
Dividend per share (p)     4.6     5.0     5.7      6.4    6.8

Meggitt designs and manufacturers systems and components for the aerospace, defence and electronics markets. Products include flight control displays for a wide range of aircraft and vibration monitoring sensors used in nuclear and energy processing plants. On the military side, Meggitt specialises in aerial targets, decoy systems and unmanned air vehicles.

On the face of it, supplying critical components to the aviation and defence industries must have high barriers to entry. Furthermore, a reputation for proven products ought to give Meggitt a decent competitive edge. However, Meggitt's products are neither the most understandable nor the most visible to the ordinary private investor.

The downturn in the global aerospace market is set to create a small profit shortfall this year. However, brokers predict a rebound in 2003, to leave the shares on a forward P/E of 9.7.

Qualiport verdict: Margins of 19% and a decent cash flow certainly give a quality feel to Meggitt. But pinpointing exactly the company's sustainable competitive advantage, especially given the inherently clandestine defence markets, will prove difficult.

2) Marshalls (LSE: MSLH)

Share price: 211p
Market value: £372m

Year to Dec 31st          1997*   1998    1999    2000    2001

Turnover (£m)              249     254     279     298     328
Pre-tax profit (£m)         25      34      41      41      46

Earnings per share (p)    10.6    14.0    17.6     19.1   20.1
Dividend per share (p)     5.3     7.0     8.0      9.0    9.5

(* nine months)

Marshalls manufacturers and supplies a wide range of specialist 'landscape' products to garden centres and builders merchants. Products include slabs, paving stones, cobbles, bricks, slates and even concrete millstones. The firm also provides 'street furniture' to local authorities, such as bollards, seats and litter bins.

Building materials is hardly a traditional home of great long-term investments, but Marshalls look to have a decent record. Although the firm's objective is to supply the highest quality products in the industry (presumably at a higher than average price), the average punter in B&Q probably can't tell one patio slab (and the manufacturer's reputation) from another. In short, there is plenty of scope for cheap product competition.

Profits are expected to remain flat in 2002 and rise 7% in 2003, putting the shares on a P/E of 9.6.

Qualiport verdict: The portfolio already has two 'home improvement' shares, Carpetright (LSE: CPR) and DFS Furniture (LSE: DFS), where keen pricing and top-notch management are the key investment ingredients. Marshalls appears weaker than both retailers on the competitive advantage front.

3) Torex (LSE: TOX)

Share price: 270p
Market value: £128m

Year to Dec 31st          1997    1998    1999    2000    2001

Turnover (£m)               21      22      47      88     132
Pre-tax profit (£m)         31      37      49      66      73

Earnings per share (p)     8.9    10.2    12.9     16.1   17.6
Dividend per share (p)     4.6     5.0     5.7      6.4    6.8

Torex is a leading IT solutions provider to various European healthcare and retail markets. The company's recent growth spurt has, in the main, been fuelled by a £100m acquisition spree. Unlike most other software businesses, Torex expects decent growth in the next year or two. EPS increases of 30% this year and 33% next put the shares on a P/E of just 7.

Worryingly, the board made this statement in the company's last preliminary statement: "Overall the absolute focus will remain on earnings per share growth.  Our proclaimed target of a minimum of 20% per annum has been surpassed yet again and your Board has no intention of relaxing this target." No need to identify the company's competitive advantage here; the acquisitive go-for-growth management style should put investors of red alert.

Qualiport verdict: Disaster looms.

Overall verdict

Of the three shares highlighted, Meggitt looks the best bet. But while the record looks good, it's not the easiest business to visualise and keep tabs on over a multi-year period. In short, long-term investors have more chance of success if their chosen company's products are understandable and competitive advantages obvious. Unfortunately, avionics is miles away from the clarity of tobacco, ports, share exchanges or radio. Supplying anything to multinational aerospace firms or governments also offers the 'highly prized customer' danger, too.

Generally speaking, when trawling for shares, if a ceiling on valuation is applied, there are always going to question marks over the business quality. Cheap crap is still crap, as somebody once said.

The author owns shares in Carpetright and DFS Furniture.