Shares for the future: a record month and a new scoring system

In last month’s Shares For the Future article, I solicited feedback on a new and improved way of scoring shares for their long-term investment potential.

I was pretty pleased with it, because it promised to fix four aspects of my current system. It would:

• Evaluate how the business makes money
• Focus on challenges and the prospect of overcoming them
• Demand fairness as an integral aspect of the business
• Score a share out of ten, instead of nine!

Your response was cathartic, a plunge in an ice pool for a part-time system designer. It was uncomfortable to begin with, but became more invigorating the more I dwelled on the criticisms and suggestions.

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I should explain why change was necessary, with reference to the current scoring system, before unveiling the improved system, tweaked after the interventions of readers.

This is how I have been scoring companies:

Does the business make good money? [0, 1 or 2]
+    Return on capital
+    Profit margin
+    Cash conversion
What could stop it growing profitably? [0, 1 or 2]
+    Recession
+    Competition
+    Idiosyncratic
How does its strategy address the risks? [0, 1 or 2]
+    Strategy 1
+    Strategy 2
+    Strategy 3
Will we all benefit? [0, 1 or 2]
+    Management 
+    Employees
+    Society
Is the share price low relative to profit? [Sliding scale from -2 to +1]
+    Yes/No. A share price of XXX values the enterprise at about YYY million/billion, about XX times normalised profit.

Rule number one in investing is to understand the business, but there is no evaluation of the business in this scheme in terms of what capabilities it brings to bear, who the customers are, how it profits from them, and why this combination makes it special.

The second and third categories list challenges and ways a company is addressing them, but separating the two categories makes them difficult to score. For example, it leads me to score risks the company has already addressed, in which case they may no longer be risks that need trouble us.

The fourth category, fairness (“Will we all benefit”), is important, but any company worth investing in for the long term should not be pilfering from shareholders, ripping off customers, gouging suppliers, or taking out more than it gives back to society. Eventually, disaffected stakeholders will revolt, and even if that takes a long time, profiting from it would be uncomfortable.

To my mind fairness is integral to how a good firm makes money and how it plans to make more, not a bolt on category.

The fifth category, price, is calculated according to a formula and does not fall within the scope of this revamp.

Each category except price has a maximum score of 2 (price has a maximum score of 1), giving a total out of 9.

This was the prototype for an improved system I put to readers last month:

The Past (dependability) [0 or 1 for each]
●    Profitable
●    Growth
●    Through thick and thin

The Present (distinctiveness) [0 or 1 for each]
●    Distinctive business
●    With strong finances
●    And experienced management

The Future (coherence) [0 or 1 for each]
●    Fixable challenges
●    By coherent actions
●    And long-term incentives

Nobody disagreed that three categories each with a maximum score of 3 would result in a score out of ten when combined with the price score, but there were many other  concerns...

Ruffled brows

TE, PM and MB worried that I was not considering the company’s culture. MB pulled me up by invoking my own principles:

“You have previously articulated a focus on people (e.g. you like to quote Treatt’s CEO on this)... Are you being true to your own beliefs and approach?”

LR declared that the scoring system is “nebulous and difficult to measure”, and pushed me hard on distinctiveness, “what is it?” he asked.

TM would like me to include another “d”, dividends. They wrote: “...bread today as opposed to jam tomorrow would finish it [the scoring system] off nicely.”

AP would like me to add short interest.

SW advocated an ‘X’ factor, a bonus point for that something special: the visionary chief executive, the company’s heritage, the amazing product.

Ruminating on the feedback made me realise that I had been vague in my language, and assumed away my people-focus, so I have shuffled things about a bit and tweaked the language:

The Past (dependable) [0 or 1 for each]
●    Profitable growth
●    And strong finances
●    Through thick and thin

The Present (distinctive) [0 or 1 for each]
●    Discernable businesses
●    With experienced people
●    That create value for customers

The Future (directed) [0 or 1 for each]
●    Addressing challenges
●    With coherent actions
●    That reward all stakeholders fairly

LR’s criticism that the scoring system is vague and nebulous troubled me, because I am trying to pin down a vague and nebulous thing, a verdict on how a business makes money and how it should make more.

All companies are different, and it is not possible to prescribe, check-list style, desirable and undesirable characteristics. It is in the process of understanding businesses and their strategies that we find out what makes them special.

The scoring system is a guide. It tells me what questions to ask of the annual report, or the directors, other investors, and so on. The answers I collect and work out will provide the detail LR desires.

For example, LR would reward companies that are improving their profit margins, but I might reward a company with dipping profit margins, if for example, it was a result of higher investment. Context matters.

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Words matter too, though. If the guide is more precise, then I will extract better answers from my sources.

Where I have changed the wording, it has largely been at the instigation of MB, who set off a chain of thought that also led me to an alliterative sequence of labels describing the kind of businesses the system is meant to uncover: dependable, distinctive and directed.

I prefer this, the second prototype, because it tests my comprehension of a business and how it creates value, and it broadens the emphasis from management to all the people that interact with it.

This addresses, at least vaguely, LR’s question about the nature of distinctiveness. Companies have to be distinctive in a good way, they have to add value, preferably for everyone.

And it brings fairness back to the fore, as I originally intended, not as a separate category but as an integral part of how the business makes money, and how it will make more.

Some of your suggestions, while gratefully received, were not incorporated.

Dividends are not an ingredient in my definition of a good long-term investment. Income investors sacrifice returns, but not because shares that pay a good dividend are necessarily poor long-term investments, there are plenty of good dividend payers in the Decision Engine.

By stipulating a high dividend yield, income investors rule out the dependable, distinctive and directed firms that choose not to pay large dividends. That may well be because they can reinvest money at a higher rate of return, and shareholders will benefit from the rising value of the firm and higher dividends in future.

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Sacrificing returns may well be rational, it is convenient if you are living off income from shares to receive regular dividend payments, but I choose not to restrict the returns from the Decision Engine this way.

Good investment strategies, like good business strategies, must be distinctive. We need to focus our attention selectively.

By focusing on businesses and their direction, we can tune out confounding price signals such as short interest, effectively traders speculating that the share price will fall in the near future.

As for the ‘X’ factor, SW is not the first person to suggest it, but I think it would at best be superfluous and at worst an opportunity to rig the system. In trying to work out what is special about how a business makes money, and how it will make more, we are by definition searching for the ‘X’ factor.

31 Shares for the future

I re-score each share in the Decision Engine once a year, after the publication of the annual report.

Since the last update a month ago, Cohort (LSE:CHRT), Goodwin (LSE:GDWN), Cropper (James) (LSE:CRPR) and Jet2 (LSE:JET2) have been through the process.

James Halstead (LSE:JHD), PZ Cussons (LSE:PZC), Renishaw (LSE:RSW) and Hotel Chocolat Group (LSE:HOTC) have published annual reports and are due to be updated. I may take bottom-ranked Hotel Chocolat off the hot plate, though, and substitute it for an idea that has been simmering in the background.

Generally, I consider shares that score 7 or more out of 9 to be good value. This month there are 31, which is a record. Shares that score 5 or 6 out of nine are probably fairly priced.

Sometimes things happen between reviews that may be sufficient to change my score next time I evaluate the share. However, I do not make the change until I have received and reflected on the next annual report. The purpose of this policy is to prevent me from knee-jerk decisions and make sure I have as much information as possible.

XP Power Ltd (LSE:XPP) and Quartix Technologies (LSE:QTX) fall into this category.

Power converter manufacturer XP Power has run into financial difficulty due to a large fine, heavy investment, and weak trading. This raises questions about management, and its investment-led strategy which, for the time being at least, it cannot afford.

Andy Walters, the majority shareholder, has returned to the board at vehicle tracking company Quartix, replacing the chief executive he hired and immediately warning that profits will be lower than expected.

It is a confusing situation. Mr Walters has been a good steward for the business, but he is 67 and has already retired once. We need clarification of the company’s strategy, and a better succession plan than the last one.

Scores and stats: Richard Beddard. Data: SharePad and annual reports
Shares marked with an asterisk* score less than 5 out of 6 for Profitability, Risks and Strategy. They are more speculative
Click on a share's name to see a breakdown of the score (scores may have changed due to movements in share price)

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

Richard owns shares in most of the shares in the Decision Engine and XP Power and Quartix mentioned explicitly in this article. He weights his portfolio so it owns bigger holdings in the higher scoring shares.

More information about Richard’s investment philosophy and how he implements it.

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