Seven shares for the future

Our stock analyst is unhappy with just seven ‘magnificent’ picks. The solution is simple but not easy.

For a number of years now we have given this article, published every five weeks, the same title: “‘X’ shares for the future”, where X is a number, and the future alludes to the long-term. This version of the article, though, is the first where X has been less than 10. 

While it will not go down as a seminal event in stock market history, like Black Monday or The Great Crash of 1929, every time I think about it, I feel a bit uneasy. Right now, as I write about this number, my throat feels dry, betraying anxiety, perhaps even a tinge of panic.

Not so magnificent seven

What does this number mean, that it could have such an effect on me? It is the number of shares out of the 30-or-so that I rank using my Decision Engine that score 7.0 or more out of 10. The score is derived from five criteria, four relating to a firm’s quality, and the fifth relating to its valuation. 

Hitherto, I have used a score of seven to determine which shares to recommend for long-term investment. Shares that score seven or more have sufficient quality and value. This is nice and simple, it gives us our catchy headline, and I have used it to show readers which shares I would buy now if I were to start a portfolio from scratch.

Under current circumstances though, it is not very realistic. The share prices of the companies I have been following, some of them for more than a decade, have soared in 2019 and the tiny bit of 2020 we have already experienced, increasing their valuations. The scoring system penalises shares on very high valuations, by giving them a negative valuation score. Lots of companies are scoring less highly than they were, and the number scoring more than seven has fallen to 7. I don’t think I would ever be comfortable holding a portfolio that small and I feel a bit of a flop for not having dug up more opportunities that are both good and cheap.

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The answer to this problem is, as always, simple but not easy. I need to find companies of equal quality or better trading at lower valuations. It’s simple because I can express it in a sentence. It’s not easy because the quality hurdle is high. The Decision Engine is full of good businesses that I know quite a bit about. Learning enough about new businesses to unseat the existing ones takes time and often what I learn will lead me to believe they are not good enough.

This is where the arbitrary, all-or nothingness of using a score of 7 to determine which shares are good long-term investments becomes a pain. In constructing my portfolios, I never use it. I think that all of the shares are good enough to hold for the long-term and I aim to own more of the highest ranked shares and fewer or none of the lowest ranked, depending on the size of the portfolio. 

Shares scoring more than 7.0 are merely the ones I have most confidence in, the best of the best, those that I am confident are not overvalued, but I personally own shares that rank as low as 29 and score as low 5.3 (Tristel (LSE:TSTL)). I suppose you might call them fairly valued, and I think it is better to hold shares in fairly valued companies than none at all.

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Thinking in terms of absolutes can engender a kind of madness. A company doesn’t become a bad investment if it falls from 7.1 to 6.9 any more than it would if its price/earnings (PE) ratio rose from 19.9 to 20.1. Changes in valuation have a gradual impact on the attractiveness of an investment - otherwise we would be trading frenetically every time the share price triggered one of these absolutes. 

Triggers are for traders, long-term investors need to focus on their best ideas, which is why I rank mine. If I were to start a portfolio from scratch today, I would probably choose the 10 shares (those scoring more than 6.7), the top 15 (those scoring more than 6.3), or the top 20 (those scoring more than 5.9), although I would also consider staggering the investment to take advantage of any opportunities that arise over the year.

A man’s gotta do what a man’s gotta do...

I am pleased to report the cloying in my throat is clearing, partly because I have done away with an arbitrary complication, and partly because I know what I have to do. The average score of all 30 shares in the Decision Engine is 6.4, and, if I can nudge it up, that should improve our prospect of good returns over the long-term. 

In other words, I still have to find equally good companies at better valuations, but this is a marathon and not a sprint. The worst thing to do would be to panic and replace good companies just because they are a bit pricier than I would like with bad companies that are cheap, probably for good reason.

Last weeks write-up of Victrex (LSE:VCT) will be the last one where I judge a company by its absolute score. I will still report the score, but I will also report the rank so you can see how confident I am in the share in comparison to all the other shares I follow closely. Victrex scores 7.5, which ranks it third, as you can see from the Decision Engine table below:

As for future headlines. I think we’ll stick with the old formula. “30ish companies for the future, some more attractive than others” doesn’t have the same ring to it.

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