Shares for the future: my best long-term investment ideas

After receiving a question from a reader, should analyst Richard Beddard incorporate a new technique into his scoring and ranking system?

A reader sent me a footballing analogy to describe how he uses a company’s chart to gain an overall impression of a company. He wondered if I could accommodate this technique into the Decision Engine, my scoring and ranking system.

I gratefully declined. To explain why, I will start with the analogy.

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Don’t take your eye off the prize

My correspondent hypothesised that football team managers do not just grade players on individual characteristics such as speed and pass completion rates, they form an overall impression of the player from how he looks.

He does the same with his shares, getting his overall impression from a company’s chart. He calls this the “eye test”. He chose to illustrate this technique with a couple of shares in the Decision Engine: “I like to do this with a share by looking at its chart over time...If I compare two shares, Judges and PZ Cussons, they have very different charts. Judges growing over time and PZ Cussons comparatively flat.

“If I think forward into the future, one year, five years, 10 years...Can I see Judges continuing to grow? Probably yes over the long term.  I look at PZ Cussons and ask, can I see something that will make their chart break higher into long-term growth? Probably not.”

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The chart depicts the company’s share price over time, so what my correspondent is saying is that a rising share price gives him confidence and a falling share price robs him of it.

Traders call this momentum. It means that if a share price has gone up today, other things being equal it is more likely to go up tomorrow, probably because other traders are gaining confidence too.

From my perspective, the problem with momentum is that it is a short-term trading strategy. It works for a while and then it breaks down. You need signals to tell you to sell a share when the momentum is broken.

Trading shares like this is incompatible with the objectives of a long-term shareholder who wants to profit from a company’s strategy and culture. It takes years or decades for a strategy to play out and cultures can last centuries.

I know of no evidence that shows share price trends persist for, say, five or 10 years. In fact, the opposite seems to be true. There is evidence that, over the long term, gravity weighs on prices of formerly high-flying shares, a process known as mean reversion.

This is why fund managers must include a disclaimer on their advertising that past performance is no guarantee of future results.

Past performance is not a guide to future performance.

If we had been looking at PZ Cussons (LSE:PZC)' 10-year chart in 2010 (see above), the “eye test” would have given us a lot of confidence, but the share’s performance over the following decade would have been a massive disappointment.

Notes: the green “B” is for “Buy”. It shows when I added PZ Cussons to the Share Sleuth portfolio. It was obviously not a momentum trade, but I was not betting on mean reversion either. I examined the company’s financial situation and its strategy and concluded it probably would be a good long-term investment. Come back in 10 years’ time for the conclusion!

Past performance is not a guide to future performance.

My correspondent was not suggesting that the eye test is infallible, so picking one chart to illustrate its fallibility is unfair, but we should question what the eye test is examining.

The eye test does not help us form an impression of the business. Instead, it reveals what everybody else trading the share thinks about it.

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We have taken our eyes off the player and we’re taking our cues from the crowd, who are booing and worse because they have just scored an own goal (even though, but for this mistake, in every other respect they have performed like a great player).

Having examined a business, its financial record and status, and how it makes money, how it plans to make more and what could stop it, our general impression is useful, I think.

I often rely on instinct about the business, informed by what I have learned by reading its annual reports, when choosing between shares on similar scores.

But I try not to let the baying crowd influence me.

Decision Engine

Since the last update in late July, I have added Macfarlane Group (LSE:MACF), a distributor and manufacturer of protective packaging, to the Decision Engine at the expense of Castings (LSE:CGS), a manufacturer of lorry parts.

I have also re-scored timber importer and distributor James Latham (LSE:LTHM), leisure airline and package tour operator Jet2 (LSE:JET2), and Solid State (LSE:SOLI), a manufacturer of rugged technology and distributor of electronic components.

A brief word of warning about Hotel Chocolat Group (LSE:HOTC)’s score of 7. The chocolatier announced a wholesale change of strategy in July, which has considerably curbed its growth aspirations in the US and Japan at some cost.

I will not be updating my Hotel Chocolat score until the company has published its annual report, probably in October, but since overseas growth was one an important strategy, the score is likely to change.

To indicate that the share is a more speculative investment, I have put an asterisk next to its name in the table, pending re-evaluation.

As always, if my judgements and calculations are correct the companies with the highest scores will be the best long-term investments.

• 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 or are likely to be re-evaluated. 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. He weights his portfolio, so he has bigger holdings in the highest-scoring shares.

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