QUALIPORT
How Low Can Shares Go?

By Maynard Paton (TMFMayn)
April 28, 2003

How low can shares go? That's the question every investor has asked during the last few years. Just when you thought a share couldn't get any cheaper, the bear market marks it down yet again. Still, investors have to jump in at some point. So how much 'value' should you seek?

Free cash

For some time now, the Qualiport has used the free cash flow yield as its valuation anchor. In essence, the portfolio hunts for companies that are quasi gilts, whose annual profits can be deemed almost as reliable as coupon payments by the Government. Of course, quoted firms don't hand all their free cash over to shareholders; therefore, only those firms likely to reinvest retained cash at superior rates of return make the cut. Read more.

The Qualiport demands a free cash flow yield of 7.5%. There was no rocket science coming up with that figure; gilts a few years ago were yielding 5%, so a 50% premium (i.e. another 2.5%) appeared a reasonable margin of safety. Though the return from gilts has subsequently fallen to 4.0-4.5%, the 7.5% benchmark has been maintained.

But is 7.5% a realistic level? Just like everybody else, the Qualiport too has watched surely-they-can't-go-any lower shares go umm... lower. In fact, pretty much every share bought by this portfolio with an 'attractive' 7.5% free cash flow yield became even more 'attractive' soon after! With that in mind, it's worth assessing just how low Qualiport shares can go.

Watch list

The table below lists the twelve watch list companies that are assessed using the free cash flow measure. For each firm, the table highlights the share price low point seen during the past six months and the resultant free cash flow yield calculation.

(Needless to say, this is not an exact study. Some of the shares could have offered greater free cash yields prior to the last six months, though with the market as a whole hitting a fresh multi-year low in March, discrepancies shouldn't be too significant.

Also, depending on when exactly the six-month share price low occurred, the free cash flow yield could be historic or prospective. Given most watch list companies have not made that much profit progress of late, this issue should also have a negligible effect.)

Share                      Share price   Free cash
                              low        flow yield 
                              (p)           (%)

Associated British Ports      359           8.0
Capital Radio                 357.5         6.6
Carpetright                   571.5         7.7
DFS Furniture                 319.5         9.6
Emap                          644           7.7
Games Workshop                413.5         6.8
Halma                          96.5         8.9
Johnston Press                320.5         8.1
London Stock Exchange         275           9.0
Metal Bulletin                110           7.1
Scottish Radio                542.5         5.4
Ulster Television             226           7.9

Average                                     7.7

The average 'low point' free cash flow yield comes to 7.7%, slightly higher than the portfolio's 7.5% requirement. So to get a better bargain, should the Qualiport consider requiring a higher yield? Well, no.

Firstly, many of the share price lows were just one-day affairs. Unfortunately, such fleeting bargains are almost impossible for the Qualiport to take advantage of. The portfolio has to announce its trades in advance, and can only do so on a Monday or Thursday.

Secondly, there's no guarantee any of the watch list shares will ever return to the low levels of the recent past. When the FTSE 100 hit 3,287 in March, it revisited a level first seen in late 1993 and created some real, panic-priced bargains. The market could go lower still, but why should it? By hoping for 'highly attractive' opportunities to occur, there's a danger of being excessively pessimistic and missing out on what prove to be just 'attractive' situations. Read more.

Overall then, the portfolio will stick to its 7.5% free cash flow yield requirement. With ten-year benchmark gilts yielding 4.3%, a decent market of safety is still in evidence. Nobody knows how low any particular share will go, but the Qualiport has long accepted it will never be able to pick a bottom.

The author owns shares in Carpetright, DFS Furniture, Games Workshop, Halma, Johnston Press and London Stock Exchange.