Interactive Investor

Shares for the future: taking on the Decision Engine critics

3rd September 2021 14:28

Richard Beddard from interactive investor

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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.

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.

0

Company

Description

Score

1

Goodwin

Casts and machines steel. Processes minerals for casting jewellery, tyres

8

2

Dewhurst

Manufactures pushbuttons and other components for lifts and ATMs

8

3

Victrex

Manufactures PEEK, a tough, light and easy to manipulate polymer

7

4

XP Power

Manufactures power adapters for industrial and healthcare equipment

7

5

Howden Joinery

Supplies kitchens to small builders

7

6

Portmeirion*

Designs and manufactures tableware, candles and reed diffusers

7

7

Cohort*

Manufactures military tech. Does research and consultancy

7

8

Bloomsbury Publishing

Publishes books and online resources for academics and professionals

7

9

PZ Cussons

Manufactures personal care and beauty brands

7

10

Next

Retails clothes and homewares

7

11

Porvair

Manufactures filters and filtration systems for fluids and molten metals

6

12

Judges Scientific

Acquires and operates small scientific instrument manufacturers

6

13

Quartix

Supplies vehicle tracking systems to small fleets and insurers

6

14

Games Workshop

Manufactures/retails Warhammer models, licenses stories/characters

6

15

Bunzl

Distributes essential everyday items consumed by organisations

6

16

James Latham

Imports and distributes timber and timber products

6

17

RM*

Supplies schools with equipment and IT, and exam boards with e-marking

6

18

Trifast*

Manufactures and distributes fasteners and other low cost components

6

19

Anpario

Manufactures natural animal feed additives

6

20

Avon Rubber*

Manufactures respiratory protection equipment and body armour

6

21

Solid State

Manufactures rugged computers, battery packs, radios. Distributes electronics

6

22

Churchill China

Manufactures tableware for restaurants and eateries

6

23

James Cropper

Manufactures specialist paper, packaging and high-tech materials

6

24

James Halstead

Manufactures vinyl flooring for commercial and public spaces

6

25

FW Thorpe

Makes light fittings for commercial and public buildings, roads, and tunnels

6

26

Renishaw

Whiz bang manufacturer of automated machine tools and robots

6

27

D4t4*

Develops and integrates Customer Data Platforms

5

28

RWS

Translates documents and localises software and content for businesses

5

29

4Imprint

Sells promotional materials like branded mugs and tee shirts direct

5

30

Tracsis

Supplies software and services to the transport industry

5

31

Treatt

Sources, processes and develops flavours esp. for soft drinks

5

32

Tristel

Manufactures disinfectants for simple medical instruments and surfaces

5

33

Softcat

Sells hardware and software to businesses and the public sector

5

34

Advanced Medical Solutions*

Manufactures surgical adhesives, sutures, fixation devices and dressings

5

35

Focusrite

Designs recording equipment, loudspeakers, and instruments for musicians

5

36

DotDigital

Develops marketing automation software

5

37

Castings*

Casts and machines parts for vans and trucks, primarily

5

38

Hollywood Bowl*

Operates tenpin bowling and indoor crazy golf centres

5

39

Volex*

Manufactures connectivity components and power cord

4

40

Jet2

Flies holidaymakers to Europe, sells package holidays

4

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.

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.

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

These articles are provided for information purposes only.  Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties.  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

We use a combination of fundamental and technical analysis in forming our view as to the valuation and prospects of an investment. Where relevant we have set out those particular matters we think are important in the above article, but further detail can be found here.

Please note that our article on this investment should not be considered to be a regular publication.

Details of all recommendations issued by ii during the previous 12-month period can be found here.

ii adheres to a strict code of conduct.  Contributors may hold shares or have other interests in companies included in these portfolios, which could create a conflict of interests. Contributors intending to write about any financial instruments in which they have an interest are required to disclose such interest to ii and in the article itself. ii will at all times consider whether such interest impairs the objectivity of the recommendation.

In addition, individuals involved in the production of investment articles are subject to a personal account dealing restriction, which prevents them from placing a transaction in the specified instrument(s) for a period before and for five working days after such publication. This is to avoid personal interests conflicting with the interests of the recipients of those investment articles.

Related Categories

    UK shares
    Consumer goods and services
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