16 conviction shares to consider

Richard Beddard's Decision Engine sieves the market for good long-term investments. Here, he reveals for the first time 16 conviction shares, and completely loses faith in one company.

The table below is the output of the Decision Engine, which helps me decide which are the most attractive companies traded in London. 

Although in years to come I may change my mind about some of these shares, I’m thinking about whether they have the qualities to prosper for decades when I analyse them.

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

I score the shares out of 10 and then rank them. Each of the following four business criteria receive a minimum score of zero and a maximum score of two, giving a total out of eight:

●    Profitability
●    Adaptability
●    Resilience
●    Equitability

Then I add the  business score to an "affordability" score of -2 to 2 to get the total score out of 10.

Every year, when a company publishes its annual report, I reassess it. Every minute the stockmarket is open, traders are giving their verdicts on the shares, which is why share prices move up and down so much. 

These two factors, my assessment and the assessments of other people (and their computers), determine the score for each share, and therefore the Decision Engine rank. The more conviction I have in the business and the more negative the views of traders on its immediate prospects, the higher the rank. 

Basically, I’m looking for good businesses at cheap prices and excellent businesses at reasonable prices: shares that score seven or more out of ten.

The table is published by interactive investor every five weeks, and in the four weeks between each update, we publish my verdicts on individual companies. I also use the Decision Engine to guide me in managing the Share Sleuth portfolio, a model portfolio, for interactive's sister publication, Money Observer (and my pension). 

The Decision Engine is powered by judgement. Behavioural scientists have shown how biased and counterproductive our judgements can be. If, generally speaking, investors make poor judgements, then there must be value in making better ones. Perhaps we can aspire to being more rational than average. 

The scoring system encourages me think about the investments I’m considering more carefully, to be more rational than average.

Scoring shares

This is my cue card. It reminds me what the basic criteria mean:

Profitable: Does the company make good money without borrowing excessively?

●    Has it made good money in hard times?
●    What does the company do especially well?

The business should be capable of sustaining the following ratios or better in future:

Post tax return on capital > 8%
Average cash conversion > 75%
Net financial obligations < 50% operating capital

Either it is stable and I can explain how it has achieved this level of performance consistently in the past, or it has changed, and I can articulate why this level of performance should persist.

Adaptable: How will it make more money?

●    Does the firm’s strategy build on its advantages?
●    Does the strategy exploit weaknesses in rivals?

Resilient: What could go wrong?

●    What are the risks?
●    Does the strategy address them?

Equitable: Will we all benefit?

●    Does the firm treat staff, suppliers, customers and shareholders well?
●    Is board pay restrained?

Reasonably priced: Is the share price modest?

The shareholders' return is the revenue a company earns less the cost of doing business: the firm’s post tax profit or earnings. 

Normalised post-tax earnings, profit adjusted to smooth out exceptionally good or bad trading conditions in the current year, should be no less than 5% of the market value of the enterprise - basically the price of its equity (the shares) and its financial obligations. That's like saying I don't want to pay more than 20 times annual profit for the business.

Earnings yield >5%

I will explain each of these criteria in more detail in subsequent articles, starting with the publication of the next Decision Engine update in July.

Conviction shares

I've emboldened some of the company names in the Decision Engine table. These are conviction shares, shares which score 7/8 or 8/8 for the four business criteria: Profitability, Adaptability, Resilience and Equitability. 

In my opinion, these business are most likely to make good long-term investments when we can buy them at a reasonable price. That time will come when the Decision Engine scores the share 7/10 or more. 

A conviction share like Renishaw can have a modest ranking even though I score the business 7/8. That's because its market valuation is so high (it scores -2/2 on affordability, so its total score is 5/10). Even though Renishaw shares look expensive, it cannot score less than five, which means I will not remove it from the Decision Engine unless I change my mind about the business.

The other shares, those not emboldened, are most likely to exit the Decision Engine, if I can find better businesses to replace them. These shares can still rank highly if, like Solid State, they score quite well in business terms (Solid State scores 6/8) and they trade on a very low valuation (it scores 2/2 on affordability, so its total score is 8/10). 

New developments

I’ve analysed Anpario, which remains a conviction share, and Next, which just misses out. And I've added two new companies to the Decision Engine: Walker Greenbank, and Hollywood Bowl Group.

• Anpario: Gearing up for growth
• Are Next shares a buy for the long term?
• Hollywood Bowl close to joining exclusive club
  

Three companies have very recently published annual reports, and I have yet to profile them. Sprue Aegis, Air Partner, and Animalcare Group are flirting with expulsion from the Decision Engine as they are low-scoring and I lack conviction.

Smoke and carbon monoxide detector supplier Sprue Aegis has experienced multiple calamities that have shaken my faith in the stability of the business.  Its principal supplier, a competitor, has finally ended the two company’s fractious relationship at some cost to Sprue. 

While things may settle down now Sprue has more straightforward relationships with new suppliers, another big source of unpredictability remains. The company benefits from surges in demand as governments pass legislation demanding householders and landlords install more detectors. 

Like waves, these surges release backwashes once the legislation has been introduced and demand subsides leaving distributors washed up with surplus stock. I don’t think Sprue has been adept at handling, or communicating these waves, resulting in highly volatile profits.

I had reduced Air Partner’s score because I didn’t sufficiently understand the accounts before the company delayed its preliminary results because of an accounting problem that probably precipitated the resignation of the finance director in April. 

The shares were suspended in early May and only returned to trading when Air Partner could publish its annual report earlier this week. While it appears to have dealt with the issue efficiently and the impact is relatively minor, the fact that it didn’t understand it’s own accounts doesn’t lessen my impression the accounts are difficult to analyse. 

Air Partner is an air charter broker diversifying into other air services, and its enthusiasm for diversification makes me wonder about the solidity of the core business.

I won't cast Sprue Aegis or Air Partner out until I have re-evaluated them fully, but I will no longer be including Animalcare in the Decision Engine. It has retained its name and its finance director, but the company has combined with Ecuphar, which was the bigger firm, so the result is more Ecuphar than Animalcare. Ecuphar was private and foreign, which means that not only has the business changed radically, but its historical performance probably eludes me.   

System1 Group, Vp, Trifast and MS International have published preliminary results, but I won’t be updating the Decision Engine until they publish annual reports. The Decision Engine currently ranks System1 highly, but that may change if I conclude industry wide developments have exposed fundamental weaknesses in the business. 

These developments include the widespread adoption of behavioural marketing techniques like those pioneered by System1, widespread reductions in marketing spending by consumer goods giants to shore up profitability, and the movement of huge chunks of advertising online. 

Heady days...

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

Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.