Seven shares for the future

I’ve analysed three companies this month that have been tremendously profitable for a long period of time and have the potential to remain profitable for much longer. They are Dunelm, a retailer of homewares, James Halstead, which manufactures vinyl flooring, and Renishaw, which manufactures instruments that test, calibrate and automate machines used in manufacturing.

In theory, high levels of profitability are unsustainable. Other companies, also hungry to profit, seek to gain a piece of the pie, increasing competition.

Firms can only resist competition over the long-term if they are special, if they do something very valuable that is difficult for other companies to replicate. Often it will not just be one thing that makes them special, but many, and often those competitive advantages are difficult for investors to identify, but we must try because special companies are capable of generating enormous returns for patient shareholders.

Identifying profitable companies is the easy bit, but profit is often ephemeral. Identifying companies that will remain profitable means establishing what makes them entrenched in the activities of other businesses and organisations or in the minds of individuals, customers in other words, and what makes them adaptable so they can shrug off new competitive threats.

Thinking about Dunelm, James Halstead and Renishaw has enabled me to reflect on what makes companies great. I’ve documented what I’ve learned so far about the unique qualities of this trio in my articles about them (the company names are linked to these articles).

I’ve also tweaked my decision engine, the spreadsheet that tracks and ranks shares in good companies and helps me decide when their market valuations are attractive.

Before, the decision engine assumed all the shares it tracked were equally good, and that the most attractive were the cheapest.

Now the companies are graded on a three point scale and the aggregate of the quality of the business, how confident I am profitability will be sustained, and valuation determines the ranking.

As always, the intention is to discover good companies at attractive valuations. I’m slightly skittish about the valuations of James Halstead and Dunelm, but the decision engine tells me Renishaw is good value, and I agree.

Sometimes investors have to look beyond current weakness to see the value building in a company. Renishaw’s profits in 2016 will be lower than they were in the financial year ending in March 2015 because exceptionally large orders placed by Asian consumer electronics manufacturers are unlikely to be repeated.

A declining share price means the shares are more affordable, though, not just compared to Renishaw’s bumper profit in 2015 but to normalised profit, based on the company’s average return on capital over a long period of time.

Meanwhile, there’s been no significant news about the six companies identified by the decision engine last month (and in previous months), so they still meet my criteria for quality and value.

They are: BrainJuicer, a market research company that measures our emotional responses to advertisements and concepts, motor vehicle part manufacturer Castings, lift push button manufacturer Dewhurst, Goodwin, which manufactures valves, pumps and other components for heavy industry, jet and diesel engine manufacturer Rolls-Royce and research and development consultancy Sagentia.

Although I don’t think its valuation is particularly attractive, from this month I’m tracking WH Smith in the decision engine. The retailer has established a growing niche in railway stations, airports, and hospitals, despite a long-term decline in demand for many of the products it sells; books, newspapers, and stationery.

Animalcare, which develops and markets pet medicines primarily, and Tristel, which designs and manufactures disinfectant products for hospitals, laboratories and veterinary surgeries, are also developing potentially unique capabilities.

Both companies have reported full-year results, allowing me to update the decision engine. They’re middle ranking, promising businesses trading at not especially attractive valuations.

Sliding down the ranks because of their rising market valuations are Alumasc, which makes premium building products, and Cohort, which manufactures and sells defence technology and consultancy.

One company has moved conspicuously down the decision engine’s ranks this month. LED lighting system Dialight, under new management, has revealed its recovery strategy. The strategy is bold and exciting, but involves radical changes to the way the company manufactures and sells its products.

While adaptability is essential if good business are to prosper over the long-term, too much change calls into question a firm’s fundamental strengths.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. 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.