19 shares for the future

The Decision Engine has never looked better, identifying 19 good companies at attractive prices.

You know the drill. Most weeks I profile and score a business and its stock market valuation and every fifth week I publish a snapshot from the Decision Engine. The Decision Engine ranks all the shares profiled in the last year by their scores so we can see which of these companies will be the best long-term investments. 

Each share is scored against five criteria. Four relate to the business (a company can receive a score of 0, 1, or 2 for each), and the fifth scores the company's stock market valuation. 

Companies trading on a low valuation score a maximum of two, but companies on high valuations can receive a negative score, up to minus two. The maximum theoretical score is, therefore 10 and the minimum is -2. In time, any share scoring less than five is likely to be dropped and replaced by a more promising share to maintain our focus on decent investments.

The valuations are calculated on the fly because one of the basic inputs is the share price of each company which changes every day. The business scores are judgements made once a year, preferably soon after a company has published its annual report. We are looking for companies that are profitable, adaptable, resilient and run for the benefit of customers, employees and shareholders as well as the directors because these are most likely businesses to prosper for a long time.

Evolution not revolution

Unlike share prices, businesses do not usually change overnight, so the business scores rarely change mid-year. But sometimes stuff happens, which prompts a re-evaluation. One way a company can change almost overnight is by acquiring another company. 

The significance of an acquisition depends on how much the company spends on it, and what it is getting in return. In 2017, Animalcare (LSE:ANCR) acquired Ecupharm. Animalcare was a profitable distributor of veterinary products developing its own pet medicines. It appeared to be a good business getting better. Ecuphar was a bigger company, distributing across Europe. 

The combination might increase Animalcare's geographical reach over time, but it also saddled the company with much higher levels of debt and a history that would likely remain unfamiliar. Ecuphar was a Belgian business that had grown rapidly by acquisition under its chief executive, who became chief executive of the enlarged group displacing Animalcare's executives. I did not drop Animalcare because it had become a bad company overnight, but overnight it had changed drastically and the new Animalcare was incomprehensible to me.

Change is often a good thing, but it is easier to make sense of evolution than revolution.

Two portfolio companies have announced significant acquisitions in the last few months. Acquisition is a core element of both company's strategies, so the news itself is no surprise, but the size and cost of the acquisitions require further examination.

Cohort plays Chess

Cohort (LSE:CHRT), which is a group of defence technology businesses, acquired Chess last December. Strategically, it is a very good match. 

Cohort has had a hard time selling its expertise to the cash-strapped Ministry of Defence (MoD), which runs more of its own training these days and is increasingly procuring off-the-shelf products instead of commissioning new designs. Consequently, Cohort has become more product focused, which not only gives it more to sell the MoD - it reduces Cohort's dependence on the MoD because products are easier to sell abroad. 

Chess makes products, and it exports them. It manufactures fire control and surveillance systems, cameras mounted on stabilised platforms that acquire and track targets for weapons systems, for example. It also makes counter-drone systems. The acquisition will give Cohort a foothold in the US, and increase its European presence. 

But the acquisition is sizable, and not as cheap as Cohort's previous acquisitions. So far Cohort has paid just over £20 million, about twice Cohort's operating profit in 2018, for an 82% stake in Chess, which made a profit before interest and tax of £2.4 million in its last full year as an independent company. But, depending on how Chess performs, Cohort could be on the hook for another £20 million in a few years time when it pays a performance-related earnout and buys the rest of the Chess shares.  

To my mind Chess is a medium-sized acquisition at an uncertain but quite hefty valuation. To earn a decent return on its investment, Chess must enhance Cohort, and Cohort must enhance it. I believe there is a good chance this will happen because of the strategic fit, and because Cohort has demonstrated new subsidiaries win more business as a result of being part of a large well-financed group.

Solid State gets a Pacer

Solid State (LSE:SOLI) also supplies the defence industry, among many others. It is a manufacturer of electronics, rugged computers, and batteries, mostly for use in harsh environments, and a distributor of components, adding value through customisation and technical services. It acquired Pacer Technologies in November. Pacer is also a value-added distributor. 

Solid State paid £3.73 million, but Pacer also had about £1.5 million in debt, so the value of the enterprise on acquisition was over £5 million, about 10 times the operating profit Pacer earned in its last year as an independent company - a bigger multiple than Solid State has paid before, and equivalent to two years of Solid State's profit. 

Like Cohort. Solid State, says the acquisition will give it access to a new market (the medical sector), but this story is probably also about efficiency. Gross profit margins at Pacer are higher than they are at Solid State Supplies (Solid State's distribution division), but operating margins are less than half of Solid State Supplies'. The difference is administrative costs, those costs not directly related to sales, central functions like accounting, the directors, and rent. 

This too is a medium-sized and not obviously cheap acquisition. To make it work, operating profit margins at Pacer will have to improve, presumably by sharing administrative costs. The good news is Solid State has successfully achieved improvements in its previous acquisitions. The bad news is, it has paid more this time.

As Solid State and Cohort grow bigger, they are targeting bigger acquisitions. But bigger acquisitions tend to be more expensive because other large companies and venture capitalists with bags of cash are also interested. 

As the size and price of the acquisitions rises, companies find it harder to profit just by buying companies cheaply. They rely more heavily on economies of scale: The fact that they will be able to sell more products to more customers and share costs.

Though it would be comforting if the valuations of these acquisitions were so low it would not matter if the management failed to make more of them, I am not inclined to mark Solid State or Cohort down. 

This is evolution, not revolution.

Scores on the doors

Since the last update, I have profiled Quartix Holdings (LSE:QTX)(a growing vehicle tracking business temporarily shackled by a declining insurance market), RWS (LSE:RWS) (a translator with an appetite for big acquisitions), Anpario (LSE:ANP) (a manufacturer of animal nutrition products taking them direct to farmers), and Porvair (LSE:PRV) (a filtration firm with strong positions in lots of niche markets). 

Perhaps unsurprisingly, RWS is hardest to fathom. It does not really tell us what makes it special, though it has an extraordinary record of profitable growth. The "what" without the "why" is not much good to me, which is why its score is so low. 

Here are the scores on the doors (as usual, the businesses in bold score more than seven out of eight for profitability, adaptability, resilience and fairness):

Source: interactive investor

Richard owns shares in Solid State and Cohort, and many of the companies tracked by the Decision Engine (especially the high scoring ones, obs).

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

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