With the number of undervalued companies declining, there will be implications for future returns, writes Richard Beddard.
This piece was written in early February, before the coronavirus severely impacted markets.
There has been something of a melt-up in the valuations of the 30 shares I score and rank using my Decision Engine spreadsheet. Because prices have gone up, the engine is producing fewer and fewer recommendations.
I score the shares using five criteria. Four of them determine whether a business is of sufficient quality for investment by evaluating profitability, risks, whether the firm’s strategy addresses the risks, and whether management shares the spoils fairly. The fifth criterion is the company’s valuation. The maximum score for each criterion is 2, giving a total score out of 10. The minimum score for each of the four quality criteria is 0, but the minimum valuation score is -2. So businesses with high valuations, over 20 times adjusted profit, are punished.
I consider companies that score 7 or more out of 10 to be undervalued, companies that score between 5 and 7 to be fairly valued, and companies that score 5 or less to be overvalued. These levels are arbitrary, and the probability of error is considerable, but the Decision Engine helps me to clarify my thoughts and decide which shares to buy, hold or sell.
Currently only seven shares score 7 or more out of 10 (you can see the top five in the table) and one company scores less than 5. It is James Halstead, which scores 4.6. James Halstead, a global supplier of vinyl flooring, is a good business. I give it a score of 6 out of 8 in terms of quality. In terms of value though, it scores -1.4.
Many of the good-quality companies I follow are highly prized at the moment; the majority are fair value, and as best I can tell, not obviously cheap. That has implications for future returns from portfolios I construct – they’re likely to be lower – and also for my workload, which is likely to be higher as I scrabble around to find alternative, equally good companies (or better) on lower valuations to invest in!
Although I have been using the Decision Engine and its precursors for years to guide the creation of portfolios like Share Sleuth, we first published its raw output seven months ago in the August edition of Money Observer. The Favourite Five table that month was headed by XP Power on a score of 9.5. My appraisal of the business has not changed since then, but other traders’ perceptions have and its score has slipped from 9.5 to 7.7. XP Power’s share price has risen 75% since I wrote that article, but it is not the biggest gainer of the shares tracked by the Decision Engine (Dart has doubled).
Two of the shares I have evaluated since last month trade on lofty enterprise multiples. Avon Rubber shares cost 31 times adjusted profit, and Treatt shares 28 times adjusted profit.
(Full analysis on Avon Rubber is here)
Avon makes gas masks, respiratory equipment and, following the acquisition of another company, body armour for military and law enforcement personnel. It also makes milking equipment for dairy farmers. It’s a good business that is getting better as the company invents and acquires more products to sell to more customers, and it scores 6.3 despite its heady valuation.
(Full analysis on Treatt is here)
Treatt is sitting on the minimum 5.0 fair value threshold. I admire it for what it is trying to do and the way it is doing it. Formerly a supplier of commodity citrus oils, Treatt is transforming itself into a developer of specialist flavours. It is achieving this by mobilising its employees, and the scale of its ambition is reflected in a huge investment in a new science-led headquarters. There are big financial risks, but I believe the investment is justified by the progress the company has already made.
I have also re-evaluated Victrex and Dewhurst (See Share Sleuth), which trade on slightly more modest multiples.
Share Sleuth’s favourite five
|Score||Name||Description||Interactive Investor link|
|8.0||Anpario||Manufactures natural animal feed additives||http://bit.ly/swANP2019|
|8.0||Victrex||Manufactures PEEK, a tough, light and easy-to-manipulate polymer||http://bit.ly/swVCT2019|
|7.8||PZ Cussons||Manufactures personal care and beauty brands, in the main||https://bit.ly/swPZC2019|
|7.7||XP Power||Manufactures power adapters for industrial and healthcare equipment||http://bit.ly/swXPP2019|
|7.1||Goodwin||Casts and machines steel. Processes minerals for casting jewellery and tyres||http://bit.ly/swGDWN2019|
Note: Shares are scored out of 10, according to five criteria: profitability, risks, strategy, fairness and value.