'The Magnificent Seven' for your Isa

Seven on fire

Like many professional and private investors I keep tabs on a large number of shares, shares that have particular qualities that should make them good investments. Our success as investors depends on the criteria we use to select the shares, and whether we have used them correctly.

Fund managers often refer to their 'investment universe' but a football squad may be a better analogy. All of the members of my squad are eligible to play for the team, but some of them may not currently be fit for selection.

I'm continuously scouting for new squad members, and considering whether existing members still belong.

My squad has about 50 members, listed in this spreadsheet. The list is divided into four categories describing their status: 'add', 'watch', 'review' and 'remove'.

GOOD COMPANIES AT CHEAP PRICES

In this article I'm sharing the 'adds', the shares suitable for selection now. They are shares in good companies at cheap prices.

But first you need to understand what I mean by good and cheap. Some investors, and most traders would disagree about the potential of these companies. That might be because I am wrong, but more likely we're thinking about different timescales over which the investment must pay off.

I'm thinking long term. Some of these companies are not performing particularly well now, and some have gloomy immediate prospects. If you're looking to flip a share for a quick profit, my list would not be a particularly good place to start.

The enduring qualities of the companies in this list should eventually trump transitory issues troubling other investors and traders. Low demand for the shares means they are available at an attractive price.

My yardstick for value is an earnings yield (EY) of 8 per cent. That is a sustainable level of profit that is at least 8 per cent of a company's market price, including the value of its debt. It implies a minimum average annual return on investment of 8 per cent and hopefully more if the company can successfully reinvest profit. If the price is higher, and the yield lower, I can probably get better returns elsewhere.

These shares are indefinite holds, for as long as they continue to be good companies and as long as they are not so overvalued that other, more reasonably priced shares, are obviously better investments.

So what do I mean by good? Goodness starts with profitability. A good company must be able to earn a reasonable return on the money it invests over the long term. My yardstick is, again, at least 8 per cent return on capital in all but the most exceptional years. Below that and the capital would almost certainly be better used by another company.

Weighing a company's prospects means examining its finances and past profitability, indicators of how well it has done, its business model, which explains how it is making money, and its strategy, how it will make more. It also means evaluating the accounts, and management, to form an opinion on whether its annual reports can be trusted.

It's tempting to call these shares 'The Magnificent Seven', there are seven 'adds' currently, but we'll only know for sure they're magnificent in five or 10 years' time. That is the nature of investment.

Brainjuicer

Share price (SP): 385p, EY: 7 per cent

Brainjuicer uses behavioural science techniques to conduct market research. It specialises in measuring people's emotional response to advertisements, products and concepts, which, it says, is more predictive of their marketability than traditional methods.

The company is unique, profitable, financially strong, committed to long-term investment, and explains itself well. An earnings yield of 7 per cent (probably 8 per cent based on 2014 profits already trailed in a trading update) is not obviously cheap unless the company lives up to my modest growth expectations.

Castings

SP: 390p, EY: 11 per cent

Castings manufactures iron castings in foundries in the Midlands, which it also machines into axle, suspension, exhaust, transmission and gearbox parts for big European truck and car manufacturers.

It sounds like an old fashioned business, but it's thoroughly modern and through financial prudence and continuous investment the company has found a way to prosper in most years, even when its customers can't.

Profit in the year to March 2015 is likely to be lower than it was in the year to March 2014, but that is a feature of the industry and not a flaw in the business itself, which over the long term has proved to be a steady grower.

Dewhurst

SP: 575p, EY: 15 per cent

Dewhurst may be the most undervalued company in the squad. It manufactures push-buttons and components for lifts, ATMs, and railway carriages, as well as bollards and signage for roads.

Although its illiquidity is off-putting for some, in common with other members of this list most of the shares are owned by family members, it shouldn't be off-putting for long-term investors.

Dewhurst's stable management and expertise won over decades of invention and customer service probably explains its record of high profitability, maintained in the year to September 2014.

FW Thorpe

SP: 140p, EY: 8 per cent

FW Thorpe is a stalwart, a company that owes its prosperity to consistent management operating a financially prudent firm with a good reputation for producing reliable commercial and industrial lighting systems.

It passed a significant milestone in 2014, when sales of LED lighting exceeded sales of older technologies like fluorescent lighting, vindicating the heavy investment the company has made.

Although Thorpe has yet to achieve the levels of profitability it would like from LED sales and finds the cost of maintaining two product ranges 'gruelling', it's maintaining profitability at impressive levels.

Goodwin

SP: 2,830p, EY: 9 per cent

From the incentives it pays executives to its commitment to investment, Goodwin, another family owned firm, is built for the long term. In the short-term, low oil prices are likely to bring its long run of growth to a halt as Goodwin manufactures valves for oil and gas pipelines, rigs and refineries.

Those customers are cutting back investment, but Goodwin valves are also used in the energy, chemicals, fertiliser, and water industries and other subsidiaries provide some diversification.

Rolls-Royce

SP: 944p, EY: 8 per cent

Being a much larger company than the others in this list, Rolls-Royce provides more guidance about its immediate prospects. They're not good. Although its most important business manufacturing long-haul aero engines is growing, the company contracted in 2014 due to low NATO defence spending, and, like Goodwin, it will be affected by low oil prices in 2015.

Rolls-Royce supplies engines, components and other machinery for offshore boats and rigs. There are very few companies with the intellectual property, engineering expertise, and financial discipline to design efficient engines and commit to servicing them for decades, though, and I expect these qualities to prevail over the long term.

Sagentia

SP: 134p, EY: 11 per cent

Sagentia may be the riskiest company in the list because of its relatively short record of profitability. The research and development consultancy has transformed itself from a jam tomorrow company to a jam today one by switching to a contractual model.

It earns most profit in North America and Sagentia has indicated profit in 2014 will be lower than profit in 2013 because of the strong pound. It remains highly profitable, though, and a braodening base of clients from across the healthcare, consumer goods and oil and gas industries, augers well.


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