Interactive Investor

Two new shares for the future

20th May 2016 16:35

Richard Beddard from interactive investor

An old school friend who emigrated decades ago plays a disreputable game on his infrequent returns to the UK. At reunions, he compares our athletic and intellectual performance to previous visits and may award us "a point off mental", or "a point off physical", or both, keeping tally as we age...

Since April's update I've improved the way the Decision Engine scores businesses. The old way was blunt. Either I was confident a company would remain just as profitable for at least a decade or so (score 10), or I recognised challenges that could get in the way (score 5), or I thought there was palpable risk the firm would not prosper (score 0).

These scores were combined with a firm's market valuation (also scored zero to ten, the shares on the lowest valuations scoring highest) and I used the combined score to rank the 60 or so shares I follow closely. Fortunately, much of this procedure is automated in a gargantuan spreadsheet.

The aim was, and remains, to find good companies, suitable for long-term investment, at favourable valuations.

Cutting out self-deception

My new method for scoring businesses should reduce the opportunity for self-deception. It requires me to be explicit. There are seven tests, and a firm can score "points on" or "points off" each, up to a maximum of ten and a minimum of zero.

The tests are inspired by the US fund manager Peter Lynch, who wrote that investors should "buy what they know" and Michael Porter, the US academic and management consultant, who developed methods of identifying competitive advantage - what makes one business more profitable than another.

To score highly, it must be clear how a firm makes money. I must be confident the accounts describe a profitable firm capable of funding itself, and that normal developments outside the company, recession or movements in raw material prices, for example, won't sink it.

The remaining tests identify the combination of activities (aka the "value chain") that determine profit, and, crucially, distinguish the firm from others. If these activities can continue unmolested by competitive forces, another judgement, the company should prosper.

Not without problems

There are two problems with this approach.

As Joan Magretta, author of Understanding Michael Porter, an excellent synthesis of Porter's work, warns: "Unless you're an insider, it's very difficult to untangle what is going on."

But we can learn a lot from doing things that are difficult, which is why I read annual reports, go to Annual General Meetings, and ask directors a lot of questions. I may never fully identify a firm's competitive advantage, but I can learn enough, for some companies, to have confidence there is one.

Previously the table accompanying this article has included only those shares that score more than 15 out of 20 when the rankings are combined. Starting this month, I will include the top 20 shares, even though some near the bottom of the list may not meet my arbitrary hurdle.

The ranking is not precise. A share with a score of 14 may not be worse than one with a score of 16. The near-misses are still interesting and, should the market's judgement about valuations change, or my judgements about businesses change, they may rise up the rankings in future.

This month, the top 18 shares scored 15 or more out of 20:

RankNameDescription
1GoodwinCasts and machines large components for the oil and gas, construction and defence sectors. Also processes minerals for casting jewellery and tyres.
2ScienceDoes scientific research and product development for customers in medical, industrial, consumer and energy industries. Provides strategic advice.
3CastingsManufactures cast iron parts for commercial vehicles: exhausts, transmissions and gearboxes for example.
4NextRetails clothes and homeware.
5DewhurstManufactures components for lifts, keypads and railway rolling-stock, particularly pushbuttons.
6MS InternationalManufactures naval gun systems, forklift blades and petrol station forecourt structures.
7WynnstayManufactures and trades feed, grain and fertiliser. Operates country stores and pet shops.
8BrainJuicerUses proprietary market research techniques to test people's emotional response to advertisements and concepts.
9Intercontinental HotelsFranchises InterContinental brand, Holiday Inn and others. Provides management services to hotel owners.
10XP PowerDesigns, manufactures and distributes power adapters for industrial and healthcare equipment.
11Sprue AegisDesigns and distributes smoke alarms and carbon monoxide detectors.
12ITEOrganises trade exhibitions and conferences, especially in Russia, Eastern Europe, central Asia and other emerging regions.
13RenishawManufactures probes, sensors, gauges and fixtures enabling other manufacturers to calibrate, test, control and automate their machines.
14SThreeSpecialist recruiter providing skilled scientists, engineers and technicians to ICT, engineering, banking, energy sectors.
15N BrownInternet and catalogue retailer of plus size and over-50 fashion
16VictrexManufactures and develops applications for PEEK, a polymer often used in place of metal where durability and lightness are paramount.
17Solid StateManufactures and distributes specialist electronic components and computer systems, often custom solutions used in harsh environments.
18World Careers NetworkDevelops recruitment software.
19TreattSources and processes essential oils, which are ingredients used in flavours, fragrances and cosmetics. Develops flavours.
20UniverseDesigns and supplies payment and loyalty systems for petrol stations and retailers.

A high-tech manufacturer in transition

Victrex reported first-half profits down 12% on Monday. The company explained that revenues from the depressed oil and gas and volatile consumer electronics sectors fell sharply. Victrex makes high performing polymers used in speakers, and seals and connectors used in sub-sea oil drilling equipment, as well as medical implants and brackets for aeroplane fuel tanks for example.

The company expects demand from consumer electronics manufacturers to pick up later in the year due to new smartphone launches and, while a recovery in the oil and gas market is a longer-term prospect, it is expecting to start earning revenue from Magma m-pipe this year. By combining polymer, with carbon and glass-fibre Victrex has helped Magma Global create, Magma claims, the world's most reliable subsea oil pipe.

Magma m-pipe is one of Victrex's six mega programmes, new applications the company believes will earn more than £50 million in annual revenue when adoption peaks. In 2016, revenue from m-pipe is more likely to be £1-2 million.

Victrex is unique. It's the only specialised manufacturer of PEEK, which it invented decades ago. The polymer is so tough and light it is increasingly used instead of metal where weight and reliability are critical. In 2015, the company estimated it had the majority of global manufacturing capacity. It also has much more experience producing variants of PEEK for specific applications.

A stock exchange announcement in April reveals a threat to Victrex's dominance, though.

A complaint from the US Federal Trade Commission (FTC) forced the company to agree not to compel medical device manufacturers to buy PEEK from its subsidiary Invibio. The FTC accused Victrex of "an all or nothing negotiating strategy", which had prevented two European rivals, Evonik and Solvay from entering the market. Evonik and Solvay are large suppliers of a wide range of polymers.

Victrex says the agreement shouldn't have much effect, but that's because it was already moving away from supplying PEEK as a raw material to co-developing and part manufacturing products made from it. The FTC agreement contains "important exceptions", allowing Victrex to enter exclusive agreements in these situations.

At Victrex's Annual General Meeting earlier this year, longstanding chief executive David Hummel told me he didn't like the word "commoditisation", but I don't recall him denying it is happening.

PEEK's original patent protection has expired and, as other companies increase production, Victrex must develop new variants for new applications that it can patent or supply exclusively, to defend profitability. The company expects lumpier profit growth as developing and making money from new products is uncertain.

Victrex's shift from supplier to partner is an attempt to move up the value chain, where it should continue to make outsized profits. I think the strategy will be profitable, which is why Victrex scores 8/10, after taking a "point off competitive position" and a "point off continuity".

Next and N Brown are new to the Decision Engine. The two retailers have gone straight into the top twenty due to recent share price falls. Their ranking is somewhat speculative, though, as I know less about them, and the fierce retail environment they inhabit, than companies and sectors I've been following more closely and for longer.

Sprue Aegis and Solid State are more familiar entrants in the top 20, although Sprue faces challenges that also make it a somewhat speculative inclusion.

A trip to BrainJuicer has reassured me about its position in the top 20.

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.

 

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.

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