Six shares for the future

In recent weeks I've overhauled the Share Sleuth spreadsheet to make it easier to make decisions about the portfolio. Those decisions are still based on a combination of the financials, gathered from company accounts, and my judgement of the risks, gathered from financial reports, correspondence with management and Annual General Meetings and company visits. Now though, the spreadsheet produces a description of valuation and business risks, which is tantamount to a recommendation. This process, I expect, will be more objective than taking the decision based on facts whirling in my head.

The result is a very similar list of good companies at cheap prices, companies whose immediate circumstances may be difficult, hence the cheap prices, that should prevail over the long-term, five years or more.

The list has shrunk because a number of shares that formerly qualified are now sufficiently highly valued to be excluded: Animalcare, BrainJuicer, Sprue Aegis, Treatt, and FW Thorpe remain good companies, and the shares are not obviously expensive.

Other shares tracked in the spreadsheet teeter on the cusp of good value. Alumasc, which has finally sold off a troublesome engineering business, Colefax, Cohort, which recently announced impressive results, and Dart, are not quite cheap enough to single out now. Neither is Universe, which I profiled recently, Latchways, also profiled recently, or Xaar, which I visited last week.

While these "maybe's" generally trade on current or average earnings yields of 6 or 7%, this month's top six have earnings yields of 8% or more. All of them have performed well in the past, and display the characteristics one might expect: financial strength, strategies that should cope with the difficulties the companies face, and reputable management.

My method is to gather companies like these and probe them for weakness, so unlike almost any other list of top stocks, this one's full of faults.

Two of the companies have a weakness in common. Goodwin, and Rolls-Royce are susceptible in varying degrees to low oil prices. Rolls-Royce manufactures engines and other parts for boats and equipment for the offshore oil and gas industry and Goodwin manufactures check valves that ensure liquids only flow one way in pipelines.

My method is to gather companies like these and probe them for weakness, so unlike almost any other list of top stocks, this one's full of faults"

In a profit warning on Monday Rolls-Royce also reported lower-than-expected demand for some jet engines, principally for businesses jets and the Trent 700 engine, which powers the majority of Airbus A330 airliners. Customers, it says, are waiting for the engine’s successor, the Trent 7000, which Rolls-Royce is in the early stages of testing. It expects to start delivering the engines in late 2017. Since one of the reasons to buy new engines is improved fuel efficiency, operators and airlines may also feel less pressure to upgrade while fuel is relatively cheap.

The issue of oil prices is troublesome for Rolls-Royce and Goodwin because the ratios used in my valuations are based on earnings when oil prices were rising most of the time. Historic earnings have the advantage of being real figures, rather than estimates. They usually prove to be conservative benchmarks for the future earnings of successful companies. But the longer low oil prices persist, the more incongruous those valuations may become. The shares may not be as cheap as I think they are. In extremis, they may not be cheap at all.

The four other companies in my contrarian six are:

Castings Castings casts and machines parts for commercial vehicles; engines, transmissions and exhausts for example. Heavy investment weighs on cash flow, but for many years investors have been rewarded by good returns in all but the very worst economic conditions.

Dewhurst The manufacturer of pushbuttons for lifts and ATMs is a regular in this list, and except for one or two dubious acquisitions in the last decade that may indicate its struggling to find new niches, it’s a difficult company to fault.

Games Workshop The shares have drifted down into value territory as the fantasy model and gaming company’s adopted a low-cost one-man store format. Temporarily at least, the change to the new format has lowered profit too, raising questions about whether the company made the right decision.

Science Science Group is the new name for Sagentia, a research and development consultancy. The main concern with Science relates not to how much money it will make, but how to get the money out of the company.

Shares in Dialight, which manufactures industrial LED lighting systems, may also have fallen into value territory. Last month it reported that it expects operating profit in 2015 to fall significantly below expectations, partly due to lower sales to oil and gas producers, and partly due to unspecified operational inefficiencies. Having launched an operational review in April, its new chief executive is now leading a strategic review as well. The findings of these reviews may dictate whether Dialight joins the list of shares for the future.