Shares for the future: taking on the Decision Engine critics

Richard Beddard explains the intricacies of his rating system, and addresses why market darling Games Workshop only managed to score a six. 

Valuation, how much it is worth paying for a share, is the crux of investment analysis, however the Decision Engine deliberately goes about this in an oblique way. After a brush with critics on Twitter, I feel compelled to explain how.

Most weeks I score a share. The purpose of these scores is to determine which of the 40 or so shares I follow closely will be the best long-term investments. By long term, I mean at least 10 years.

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Knowing the individual scores tells us a little. The maximum score is 9, and in the event that a share scores 9 out of 9 it may well turn out to be a very good long-term investment. Generally, I am not interested in shares that score less than 5 out of 9.

Shares that score between 5 and 9 form the basis of the portfolios I run, both the model Share Sleuth portfolio I write about here on interactive investor and my own retirement portfolio.

Decision Engine

The system comes into its own when we list all the companies and the scores and rank them because then we can see the opportunity cost of owning a share.

Today is the Friday before the end of the month, when we routinely publish this list (occasionally it is the Friday just after the end of the month), and if you look at the table below you will see that no shares score 9, only two shares score 8, and nearly all of them score 5, 6, or 7 out of 9.

In this month's table, the bottom-ranked share scoring more than 5 is Hollywood Bowl (LSE:BOWL), which is ranked 38.

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)

Hollywood Bowl’s score is sufficiently high to merit a position in a long-term portfolio, but only if it is a big one because there are 37 higher ranked shares to choose from.

This is why I call the table a Decision Engine, because it helps me decide which shares to own. The higher the score, the more likely I am to include the share in one a portfolio, and the more money I will want to have invested in it.

The price criterion compares a company’s share price to its profit in a similar way to the famous price earnings ratio (PE). My calculation is a little more complicated, but for the purpose of this article you can think of it as a PE.

The price criterion is unique. The other four criteria, profitability, risks, strategy and fairness tell us something about the quality of the business and get scores of 0, 1, or 2, adding up to a maximum of 8.

Price gets a score of between -2 and 1, companies with a low PE get a positive score and companies with a high PE get a negative score. The maximum total score is therefore 9.

This reflects the common wisdom born out by statistical analysis that very generally, companies that have a high share price relative to their profits perform less well on the stock market than companies that have a low share price relative to their profits.

Very broadly then, shares on low PE’s are considered to be cheap, but it is more complicated than that.

The PE is a blunt instrument

It is important to recognise that the PE is a very blunt instrument. Many companies on high PEs become great investments, and many companies on low PERs perform poorly.

Last year’s profit, or next year’s does not tell us much about how much a company will earn in the future. There are countless factors, many of which we can never hope to know.

Allowing the PE to determine one’s view of an individual share would lead to many poor decisions, which is why I use a better version of the PE, and also why the resulting score for price is only one part of a company’s overall score.

It is the company’s overall score that determines whether a company meets my criteria for long-term investment, and is therefore, “good value”.

My scoring system is a formalisation of what many investors do in an ad-hoc fashion. We say, for example, that a PE of 25 (a price of 25 times profit per share) is a reasonable price to pay because that particular share has very good prospects, while we might only pay a PE of 10 or 15 for a company with a more mundane future.

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To be confident a business has good prospects over 10 years or more, I look for high levels of  profitability, a business that is addressing the challenges it faces with a coherent strategy, and managers that are distributing the spoils fairly for the benefit of customers, employees, shareholders, and society as well as themselves.

These are represented by the four other criteria I score: profitability, risks, strategy and fairness. Combined with price they give me an estimation of the company’s value, relative to all the other companies In the Decision Engine.

I mention this today because I got into hot water on Twitter when I updated my analysis of Games Workshop (LSE:GAW) and published the share’s score.

Games Workshop scored 8 out of 8 for profitability, risks, strategy and fairness. Much to my embarrassment, I could not find any significant faults in the business.

But it scored -2 for price because its PE was 45.

Other Games Workshop shareholders felt that it should not be penalised for its high price because it is such a good business. But my score of -2 is not the whole valuation, it is a bit of it.

Games Workshop scored 8 minus 2, which is 6, within my 5 to 9 window, and that does make it (probably) a good long-term investment and consequently good value.

The total score (unlike the price score) recognises Games Workshop is probably a great business.

Profit, what profit?

A second controversial aspect of my analysis is that my PE is not the result of dividing the price of the shares by a single year of profit. At the time this simpler PE was lower. It was 31.

I had taken the average of Games Workshop’s return on capital over the last five years and calculated how much it would have earned on the capital invested in the business in its most recent financial year.

I normalise returns because they can vary a lot from year to year, which can skew the PE. The period over which I normalise them depends on the company.

Five years ago, Games Workshop experienced a step change in profitability, which I believe it can sustain, so I do not include prior years of lower profitability in the calculation.

But within those five years there is considerable variation. It launched a new version of its biggest product in 2021, and its return on capital was even higher than it usually is.

Its next best performance in terms of return on capital was in its 2018 financial year, the last time it relaunched the same product.

I chose to average those five years. Other shareholders disagree. They say Games Workshop is getting better at converting revenue into profit and so the current level of profit is more representative of what the company might achieve in future.

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Fair enough. To be honest, the truth may well be somewhere in between. Profitability does fluctuate, and it has also improved.

I prefer to be prudent in my assumptions when it comes to calculating the PE, but Games Workshop’s total score does not ignore the fact that business might improve.

Its potential for improvement is captured in the other criteria, principally the scores for risks, strategy, and fairness. A strategy that addresses the risks a company faces should result in improvements for shareholders as long as the company is managed fairly.

None of this means I am right. The Decision Engine’s score might underestimate Games Workshop. The success of the portfolios I create with it does not depend on the performance of any one share.

Success depends on the Decision Engine being more right than wrong: that generally, shares with a high score do better than shares with a low score, and generally shares in the Decision Engine do better than those outside it.

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

Richard owns shares in many of the shares in the Decision Engine including Games Workshop. He is especially keen on those with high scores.

For more information about Richard’s scoring and ranking system (the Decision Engine) and the Share Sleuth portfolio powered by this research, please read the FAQ.

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