Why Share Sleuth just sold Rolls-Royce

In comes XP Power, out goes Rolls-Royce. It's the will of the Decision Engine.

Every month we publish the top 20 shares ranked by the Decision Engine. Unusually, for a ranking system, the Decision Engine incorporates qualitative information, judgements about the shares I follow most closely as well as financial statistics.

Shares near the top of the list may trade on low valuations, but I must also be confident in the prospects of the business and the intentions of management.

This month is an exception. These are the bottom 20 shares, albeit of a relatively good bunch. They're the shares I'm tracking that, frankly, I'm least likely to invest in now:

Increasingly, the Decision Engine guides the trades in the Share Sleuth portfolio, a model portfolio I run that invests in good companies at reasonable prices for the long-term.

The aim is to gradually shift the portfolio's balance so it's invested in highly ranked shares, funding purchases from dividends that build up over time, and, reluctantly, sales of lowly ranked shares.

The guiding principle, when disposing of a share to add another, is that there must be a big gap between their rankings; a difference of even ten places is neither here nor there.

Last week I wrote up XP Power, a manufacturer of power converters for industrial and medical equipment. It meets all of the Decision Engine's criteria comfortably with the exception of valuation, which it meets only narrowly.

Never one to enjoy the possibility of paying full price for a share, I wrestled with myself for a while, before accepting the Decision Engine's verdict that XP Power's strengths mean it will more than justify the asking price, given time.

The Share Sleuth portfolio's cash balance was too low to fund the purchase, though, necessitating more hand-wringing.

The three lowest ranked shares in the Share Sleuth portfolio were Trifast (44), Tristel (42) and Rolls-Royce (40). Deciding which of these is the worst long-term investment (of, I believe, a pretty good bunch) requires a real apples-to-oranges comparison.

Rolls-Royce may well be a temporarily beleaguered goliath. Tristel and Trifast are much smaller companies. They've had troubles too, but they are already resurgent. The reason that Rolls-Royce doesn't stand alone at the bottom of the list is its low valuation. The reason Tristel and Trifast don't rank more highly is their high valuations.

On an earnings yield of 4%, Tristel's enterprise value is about 24 times adjusted profit. It's rated so highly by the stockmarket, its valuation counts against it in the Decision Engine's estimation.

The three companies share some qualities though - they are manufacturers, and they supply products around the world. Rolls-Royce manufactures jet engines and power systems. Tristel manufacturers disinfectant for hospitals. Trifast manufactures nuts, bolts, rivets and screws for cars, washing machines and electronics.

Losing faith in Rolls-Royce?

When I added shares in Rolls-Royce to the Share Sleuth portfolio in February 2014 and March 2015, I recognised there was much about the company I didn't know. As time has gone on, the list of unknowns has grown.

I don't understand how the company accounts for long-term jet engine service contracts, which are responsible for much of its profit. I don't understand defined benefit pension accounting, and the company has a whopping pension obligation.

I still believe in the company and its CEO and the shares may be a good bet - I just don't like gamblingWhen Rolls-Royce makes the huge investment it must to develop new engines, it relies on earnings from service contracts for decades, but, unlike Meeson, I don't have much of an inkling about the future of flight, or climate and energy, the interlinked environmental factors that could impinge on flight, or indeed create opportunities in the future.

I put my faith in a famous brand, a huge body of expertise, a duopolistic market for wide body jet engines shared with GE, and, once he was appointed, a new chief executive whom I admired because of what he had achieved at ARM, a hugely successful technology company.

I still believe in the company and its chief executive and the shares may well be a good bet, but I'm unenthusiastic about gambling.

Don't rely on instinct

The purpose of the Decision Engine has been to reduce my reliance on instinct and turn the process of buying and selling shares into a reasonably simple and repeatable one.

The Decision Engine judges shares using five criteria, rating each factor from zero to two for an overall score out of ten. Many of the factors require human judgement, but my judgements about Rolls-Royce are built on especially thin foundations. The ranking of Rolls-Royce could just be random, a case of garbage in, garbage out.

You might ask, why not just learn about the confounding accounting? Especially as Rolls-Royce is trying to help investors understand it. Why not study trends in aviation? I've thought about it.

Rolls-Royce is too much work for me to analyse successfully now, when I need to be analysing lots of other companies as well. The annual reports are so much fatter, the executives so much more inaccessible.

Much as I yearn to hold on, because I'm a long-term investor, and there's an element of pride in owning a share like Rolls-Royce, which is a symbol of past and perhaps future greatness, I've made the tough fold.

The first criterion of the Decision Engine is:

Straightforward business

This means it's apparent how the company makes money. The business model should be comprehensible, and the accounting should be clear.

Rolls-Royce scores zero, which probably should rule it out whatever its other attractions.

Tristel and Trifast aren't out of the firing line. While I understand the companies much better, the businesses are performing well, and I can identify things about them that make them special, investors are prepared to pay high prices for the shares.

That makes me nervous, particularly about Trifast, which supplies cyclical industries and probably won't always experience the levels of profitability it does now.

On Wednesday 9 November, Rolls-Royce exited the portfolio at a price of 756p and XP Power joined it at a price of £17.11p. As always, I paid the price quoted by a broker and deducted £10 in lieu of fees for each trade from the portfolio's cash balance.

Here's the new-look Share Sleuth portfolio:

Contact Richard Beddard by email: richard@beddard.net or on Twitter: @RichardBeddard

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.