Shares for the future: five factors I use to score shares

What makes you invest in one company and not another? Columnist Richard Beddard explains his approach to scoring companies and reveals a list of shares he considers good value. 

How do you weigh a global smartwatch and instrumentation company such as Garmin Ltd (NYSE:GRMN) against a local timber distributor like Latham (James) (LSE:LTHM)? It is not easy, but implicitly that is the kind of decision we make every time we choose to invest in one company and not to invest in another.

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I get around this problem by scoring shares according to five factors I believe determine the potential of an investment for the long term. These factors carry near-equal weight in my spreadsheet, the Decision Engine, but that is not because they are of equal importance.

Where is the value?

The five factors are Profitability, Risks, Strategy, Fairness and Price. With the exception of price, each factor has an equal weight (they can score between 0 and +2).

Price works a bit differently, it can score between -2 and +1, which is why the maximum score for a share is 9 (2+2+2+2+1).

I chose this idiosyncratic system so price would have a bearing on trades, but it would not outweigh quality.

My main concern was to avoid paying too much for companies that scored highly on the four factors that determine the quality of the business, hence high prices are penalised more than low prices are rewarded.

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When I rewarded the lowest priced companies with a score of +2 instead of +1, I found that cheap companies of dubious quality could leapfrog good businesses at reasonable prices in the Decision Engine list. Since I was after the latter, not the former, this was unhelpful.

Originally, I weighed the other four factors equally because it was easy, and although we are many years into this project now, I have no inclination to change things.

But, as I said, that is not because I believe they are equally important.

Investing through the rear-view mirror

Price and profitability are easy to analyse.

The price score only requires me to make one judgement: what period to use to normalise the earnings yield. Profit in one year is not necessarily indicative of what a company might earn in a typical year, so I try to incorporate good times and bad in my calculation.

The profitability score requires me to consider return on capital, profit margin, and cash flow over the same period, but I am just comparing them to benchmarks. I prefer the shares I invest in to be able to sustain a 10% return on capital through thick and thin, converting 75% of that profit into cash on average.

These factors are quantifiable, they are derived from audited data. There is a high level of standardisation in the data and how it is presented, and once the data is in the spreadsheet the scores take me seconds to determine.

The amorphous future

Risk, strategy, and fairness are, by comparison, very difficult to analyse. Companies have much more discretion about the information they present to us and much of it is anecdotal.

The biggest risks are the ones we cannot imagine, strategies are, or should be, unique to each business, and fairness, how a business treats its employees, suppliers, customers, and the rest of us, is perhaps hardest of all to determine.

Often, we are reliant on statistics produced by the company itself on, for example, employee retention and customer satisfaction. At worst, companies tell us nothing more than the boilerplate affirmations most of them sign up to.

Somewhere between are the ESG (environmental, social, and corporate governance) and remuneration reports. They hold the promise of disclosure, but they are so bloated it is hard to see the wood for the trees.

The level of judgement is much higher. Kicking the tyres, company visits, reading online reviews, and so on, can help but this is not hard data and our degree of confidence in the scores must be lower.

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You might well ask why bother? I am not sure many investors get past price and a smattering of fundamental data. Life is a lot easier if you stick to the data, but I do not think it is more profitable.

Financial data is a commodity. It is readily available on websites and through specialist data providers. The diligent private investor can clean it up a bit, but I do not think we can get an edge against, say, quantitative funds.

Also, financial data is backward looking, and the future does not always repeat itself. We can extrapolate from it, there is a link, but it is weak, and although portfolios following simple quantitative analysis have been shown to perform modestly well over long periods of time, most of the value in companies is not apparent in the data.

It is hidden in the strategies and cultures of companies, which is where the other three factors come in: how a company intends to make more money, what could get in the way, and whether the spoils will be shared fairly.

These criteria are intangible, business people talk about them but they do not necessarily commit to them. They are also future-looking.

Scoring them is almost entirely about judgement, but get it right and these scores will have the most impact.

By keeping the scores equal in weight, I am hedging my bets, between what we know that is only modestly beneficial and what we can only impute but is highly significant.

Beyond the commodification of data, and the hidden value in strategy and culture, one more reason I am not solely guided by the numbers is personal.

To people with more mathematical minds, charts, patterns, and numbers are interesting enough in themselves. I, though, am fascinated by how we organise ourselves into groups to profit. I think it is one of the many amazing things about human beings.

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, 4imprint Group (LSE:FOUR), Next (LSE:NXT), and Macfarlane Group (LSE:MACF) 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.

Advanced Medical Solutions Group (LSE:AMS), Churchill China (LSE:CHH), and Bloomsbury Publishing (LSE:BMY) have all published annual reports and are due to be updated.

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.

Scores and stats: Richard Beddard. Data: SharePad and annual reports

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. 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