14 shares for the future

July's snapshot of the Decision Engine throws up some great long-term investments. Analyst Richard Beddard reveals those which are not only cheap, but of the highest quality.

Stockpickers make judgements about shares, comparing them to decide which to own. The Decision Engine is a somewhat rigorous method of making that comparison, while still incorporating the human element required to assess a business.

The Decision Engine rankings

Here's July’s edition of the Decision Engine's rankings, the output of 40 spreadsheets and many years of reading annual reports! 

It boils everything down to three columns, a company's name, its score, and its description. The companies at the top of the table should be the best long-term investments. The companies at the bottom should be the worst.

These are the survivors. I've discarded hundreds of companies because I did not feel they were worth evaluating fully (and there are dozens more I have yet to get around to evaluating).

Source: interactive investor                Past performance is not a guide to future performance

Each company is scored using five criteria. Each criterion contributes a maximum score of two to a total score out of 10. Four of the criteria are based on a subjective analysis of each business: Its profitability, resilience, adaptability and equitability. 

Assessing quality

I'm looking for businesses that have shown they can make good money even in difficult times, without having to rely on high levels of debt (they are profitable). I should be able to see how their strategies build on their competitive strengths or shore-up weakness (they are adaptable) and be confident that their strategies addresses the risks they face (they are resilient). I gather evidence to demonstrate their boards are building businesses to prosper for the long-term and not gouging customers, employees or shareholders for their own immediate benefit (the equitability criterion).

These evaluations happen annually, after a company has published its annual report. You can read them here on Interactive Investor. They also inform the trades I make for our sister magazine's Share Sleuth model portfolio.

Occasionally, I might re-evaluate a share at an intermediate point in the year, but being a long-term investor I prefer not to rush to judgement and tend to change my views only once I have all the facts.

Estimating cheapness

A share's score is also determined by the fifth criterion: Cheapness. Each share receives a score between minus two and two depending on its earnings yield, which is annual profit expressed as a percentage of the firm’s enterprise value. Enterprise value is market capitalisation (the number of shares in issue times the share price) added to the value of a firm’s financial obligations.

This is a way of putting companies with different levels of debt and other financial obligations on an even footing. Though it's a bit more complicated than the standard price earnings ratio, I think it is a better measure for long-term investors because debt can boost earnings and make a company look cheap, when also it might be very risky. I also normalise or adjust profit, ironing out temporary lulls or excesses, for the same reason: Divots like these can give a false impression of the long-term prospects of a business.

Roughly speaking, shares trading on earnings yield of 5% or less are deemed expensive and receive negative scores. Shares trading on earnings yields of between 5% and 10% score between zero and two. Shares that score more than 10% score the maximum two points for cheapness.

Since cheapness depends on the share price, and the prices of the most popular shares like Next are moving all the time while the market is open, the Decision Engine’s rankings are in constant motion. What you see in the table is a snapshot a day or two before publication. That said, because cheapness is only one of five criteria, it would take a huge movement in the share price to move a share a long way up or down the table.

Since the last update in June I've analysed Solid State, Trifast, Vp, Air Partner, and FireAngel Safety Technology (formerly Sprue Aegis).

Quality companies trading at a cheap price

Solid State, a manufacturer of technology used in harsh environments and distributor of electronic components, remains as one of the highest ranked shares though the fact that its name is not highlighted with a bold font in the table tells you the share’s high score has a lot to do with its low valuation.

An emboldened name means a share scores seven or more out of eight for the first four "business" criteria. You could consider it a mark of the highest quality, and Solid State came up just short. I characterise it as a company striving to be first rate. With a score of six out of eight, I believe it’s a good business, which, coupled with its low valuation (score: two out of two meaning a total of ten), could make it a very good investment.

Quality is rarely available at a cheap price yet there are eight shares scoring seven or more out of eight for the four business quality criteria that also score zero or more on valuation giving a total score of seven or more out of ten. These conviction shares are, in my opinion, also reasonably priced.

One such conviction share is fastener manufacturer Trifast. The company's profitability has dipped alarmingly in the past, but I’m slowly coming to the view that large numbers of long-serving staff who have worked through previous crises are adapting the company to better survive future crises.

Doubtful firms trading at doubtful prices

I was sceptical about plant hire firm Vp’s valuation and its reliance on increasing levels of external finance to juice returns. It’s score of five out of ten is just about good enough to keep it in the Decision Engine for another year.

By rights, with scores fractionally below five (the scores in the table are rounded), FireAngel and Air Partner ought to be jettisoned. I plan to evaluate them at least one more time though, because they are interesting businesses.

Smoke alarm designer FireAngel outsources many aspects of its business including manufacturing and much of distribution. It is a fashionable business model because, in theory, outsourcing allows firms to specialise in their best capabilities. I've always been a bit sceptical of this trend. I believe there is a price to be paid in terms of lost control. Businesses like FireAngel look extremely efficient until something goes wrong at their suppliers or distributors.

Many of the conviction shares you can see in the table, XP Power Ltd, Games Workshop Group and Thorpe (F W) for example, are vertically integrated, they do their own sourcing, designing, manufacturing and selling. While I believe these companies are better long-term investments, I want to keep tabs on a company that does things differently.

I find Air Partner a challenging share to evaluate, hence it’s the lowest ranked of all the shares I follow. There is no point banging your head against a brick wall, and at some point I will stop following a share if I just cannot work it out. But Air Partner, which is an air charter broker striving to become a broader air services business, scores highly on equitability, which is perhaps the foundation of a good business. Do the best for your customers, and profitability and the rest should follow.

Comparing shares, and compounding knowledge

The primary purpose of the Decision Engine is to compare apples to oranges, or component distributors to suppliers of air services to help me to decide when to buy shares (when they score more than seven) and when to to sell them (when they score less than five).

It has a secondary purpose too. Each year I learn a bit more about these companies and, I hope, that knowledge compounds like the returns from good investments.

Eagle-eyed readers will note I have added car supermarket Motorpoint Group to the Decision Engine, although I have yet to write it up.

Here are Richard's recent articles:

• Solid State: Striving to be a first-rate business

• Trifast: Continuous improvement adds up

• Vp: An acquisition too far

• Air Partner: Talks a good business

• Sprue Aegis: Do this and they'll be 'dirt cheap'

• 16 conviction shares to consider

• Walker Greenbank: Cheap but fearful

• Hollywood Bowl close to joining exclusive club

• Anpario: Gearing up for growth

• Are Next shares a buy for the long term?

• 16 shares for the future

• Is Portmeirion in the 'buy' zone?

• XP Power shares: They're electrifying!

Contact Richard Beddard by email: richard@beddard.net or on Twitter: @RichardBeddard

Richard owns shares in Solid State, Trifast, Vp.

Richard Beddard is a freelance contributor and not a direct employee of interactive investor.