Shares for the future: why the rule of three could be the answer
28th July 2023 15:20
by Richard Beddard from interactive investor
Columnist Richard Beddard has been irresistibly drawn to this rule, which may make his life as a one-man investment band much easier. The solution already has a name.
Before I wrote this article, I had an idea that a rule of three might exist, but I didn’t know or remember what it was. All I knew was that I had been irresistibly drawn to it.
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Rule of three
If you have read any of my articles before, you will be familiar with the factors I use to score, rank, and value shares because they are listed at the bottom of every company write-up.
If not, welcome, you can familiarise yourself with the categories by clicking on the names of the shares in the Decision Engine table at the end of this article, or you can read on because I intend to show why these categories conform to the rule of three.
The first four factors, the four that deal with the quality of a business, do anyway.
The fifth, price, is a special case and I only consider one factor, the normalised earnings yield, which is scored on a sliding scale. The higher the normalised earnings yield (the lower the price of the business compared to profit in a typical year), the higher the price score.
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The total of the five scores gives us a score out of 9, a proxy for the long-term value of an investment. I use it to compare potential investments and work out how much of each one to hold*
Back to the rule of three, and the first four factors. Beneath each of these factors I list three sub-factors. These are what I consider to be the three most significant sub-factors. The sub-factors that influenced my score.
They vary, depending on the share. When I sit sweaty-palmed staring at my blank share evaluation template, this is what I see:
Profitability: does the company make good money?
- Return on capital
- Profit margin
- Cash conversion
Risks: what could stop it growing profitably?
- Recession
- Competitive position
- Idiosyncratic
Strategy: how does its strategy address the risks?
- Strategy 1
- Strategy 2
- Strategy 3
Fairness: will we all benefit
- Management evaluation
- Employee satisfaction
- Society
These are prompts. They are not necessarily sacrosanct.
The sub-factors for profitability are pretty much set in stone. These are my three go-to ratios to evaluate the profitability of a business.
But strategies should be unique. They build on the existing capabilities of the business to differentiate them from rivals, so I cannot generalise them.
Each sub-factor could be the subject of at least one article on its own (and probably will be in the fullness of time), so I am not going to explain them today.
Today is about why I chose three for each factor.
I chose three because I am a one-man investment band, and a pretty average man at that. Rather than chasing down every rabbit hole, I must focus on the most important things.
By choosing a low number of sub-factors, I hoped to force myself to focus. By giving each factor one of three scores (0, 1, or 2), I hoped it would make me decisive. There are only three choices. Either I am confident the sub-factor makes the share a good long-term investment (2), I am on the fence (1) or I think the sub-factor reduces the appeal of the share (0).
Having recognised the hold that the rule of three has over me, I went looking for definitions on the internet.
Wikipedia says that groups of three are more humorous, satisfying, effective and memorable than other numbers because they combine brevity and rhythm in the smallest amount of information to contain a pattern.
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It may be why there were three bears, three billy goats gruff, three pigs, and three musketeers.
You have probably noticed, my devotion to the rule of three is not complete. There are four quality factors, and now I have re-acquainted myself with the rule, I am wondering whether that is necessary.
Maybe it would be better if there were three factors for quality, each with three sub-factors.
It is many years since the Decision Engine took its current form, and changing it would be a large undertaking, but it may be that the rule of three offers a solution to a conundrum that sometimes makes my life difficult.
Risks, and strategy, are two sides of the same coin. Risks are reduced if they are addressed coherently by a businesses' strategy. Perhaps they could be scored using the same factor.
It already has a name: does the strategy address the risks?
26 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 Advanced Medical Solutions Group (LSE:AMS), Bloomsbury Publishing (LSE:BMY) and Churchill China (LSE:CHH) have been through the process. To see how I scored them, or any share, please click on the share’s name in the table below.
Auto Trader Group (LSE:AUTO), Solid State (LSE:SOLI), Marks Electrical (LSE:MRK), D4t4 Solutions (LSE:D4T4), Oxford Instruments (LSE:OXIG), and Games Workshop Group (LSE:GAW) have published annual reports and are due to be updated. I also have a new candidate in the pipeline!
Generally, I consider shares that score 7 or more out of 9 to be good value. This month there are 26, the same as last month. Shares that score 5 or 6 out of nine are probably fairly priced.
0 | Company | Description | Score |
1 | Designs recording equipment, loudspeakers, and instruments for musicians | 9 | |
2 | Supplies kitchens to small builders | 9 | |
3 | Manufactures tableware for restaurants and eateries | 8 | |
4 | Manufactures filters and filtration systems for fluids and molten metals | 8 | |
5 | Manufactures pushbuttons and other components for lifts and ATMs | 8 | |
6 | Translates documents and localises software and content for businesses | 8 | |
7 | Distributor of protective packaging | 8 | |
8 | Imports and distributes timber and timber products | 8 | |
9 | Manufacturer of scientific equipment for industry and academia | 8 | |
10 | Distributes essential everyday items consumed by organisations | 8 | |
11 | Supplies vehicle tracking systems to small fleets and insurers | 7 | |
12 | Online marketplace for motor vehicles | 7 | |
13 | Makes light fittings for commercial and public buildings, roads, and tunnels | 7 | |
14 | Whiz bang manufacturer of automated machine tools and robots | 7 | |
15 | Casts and machines steel. Processes minerals for casting jewellery, tyres | 7 | |
16 | Manufactures natural animal feed additives | 7 | |
17 | Manufactures power adapters for industrial and healthcare equipment | 7 | |
18 | Sources, processes and develops flavours esp. for soft drinks | 7 | |
19 | Manufactures surgical adhesives, sutures, fixation devices and dressings | 7 | |
20 | Sells promotional materials like branded mugs and tee shirts direct | 7 | |
21 | Manufactures PEEK, a tough, light and easy to manipulate polymer | 7 | |
22 | Manufactures personal care and beauty brands | 7 | |
23 | Publishes books, and digital collections for academics and professionals | 7 | |
24 | Manufactures military technology, does research and consultancy | 7 | |
25 | Manufactures sports watches and instrumentation | 7 | |
26 | Manufactures/retails Warhammer models, licenses stories/characters | 7 | |
27 | Sells hardware and software to businesses and the public sector | 6 | |
28 | Manufactures power adapters for industrial and healthcare equipment | 6 | |
29 | Operates tenpin bowling and indoor crazy golf centres | 6 | |
30 | Manufactures specialist paper, packaging and high-tech materials | 6 | |
31 | Develops and integrates Customer Data Platforms | 6 | |
32 | Manuf's rugged computers, battery packs, radios. Distributes electronics | 6 | |
33 | Manufactures disinfectants for simple medical instruments and surfaces | 6 | |
34 | Manufactures vinyl flooring for commercial and public spaces | 6 | |
35 | Retails clothes and homewares | 6 | |
36 | Supplies software and services to the transport industry | 5 | |
37 | Online retailer of domestic appliances and TVs | 5 | |
38 | Acquires and operates small scientific instrument manufacturers | 5 | |
39 | Chocolate maker and retailer | 5 | |
40 | Flies holidaymakers to Europe, sells package holidays | 4 |
Scores and stats: Richard Beddard. Data: SharePad and annual reports
Richard Beddard is a freelance contributor and not a direct employee of interactive investor. Â
Richard owns shares in most of the shares in the Decision Engine.
More information about Richard’s investment philosophy and how he implements it.
Contact Richard Beddard by email: richard@beddard.net or on Twitter: @RichardBeddard
These articles are provided for information purposes only. Â Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties. Â The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.
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.
Disclosure
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