Shares for the future: why I’ve downgraded a former top stock

Two profit warnings in July from two high-scoring companies in the Decision Engine have made me reconsider scores only recently bestowed. They come after serial warnings from winged favourites such as Focusrite (LSE:TUNE) and Solid State (LSE:SOLI). The latter is the subject of next week’s article.

A decline in profit is not a particularly remarkable event to me. My goal is to own shares for more than a decade. Over that period, it is a fair bet that most shares will have off-years.

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Generally, my understanding of what the company does, how it is trying to get better, and what could stop it, gives me confidence to hold shares for the long term, not year-to-year changes in profit or share prices.

However, since the pandemic, shares that performed very well for much of the 2010s and won my confidence, have experienced multi-year declines in profit. The latest is Churchill China (LSE:CHH), which last week warned that profit in the year to December 2025 will be significantly below 2024, which was 22% below 2023.

Something has changed that means the qualities in these companies may no longer be sufficient to ensure they profit sufficiently through thick and thin. My rough-and-ready indicator for whether a company’s profits are robust is a return on capital of at least 8-10%, even in bad years.

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Both Churchill China and Macfarlane Group (LSE:MACF), which warned earlier in the month, might breach this informal benchmark when they next publish full-year results. Now that I have simplified the Decision Engine to make it more responsive, I must incorporate this information into their scores.

I must also consider what has changed, and this is where things get difficult because I believe these are good companies, it’s just harder to make money in the current economic climate.

Churchill China

Last week, Churchill China announced that profitability for the half year ending in June was significantly below the same period in 2024.

Despite bringing forward investments to reduce costs and the introduction of new products, revenue and profit for the full year to December 2025 will be significantly below 2024 as well.

Profit will fall more than revenue because factory overhead costs are relatively fixed, and Churchill China’s broker forecasts a decline of about 30% in pre-tax profit, from £8.5 million to £6 million.

Churchill China tells me a fall in demand in Europe has resulted in about 6% lower sales compared to the same period in 2024, with Germany experiencing the biggest decline. Sales were also weak in the small Rest of the World segment, but relatively robust in the UK and US.

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Weakness in Europe is concerning, as I noted in May. Until Brexit and the pandemic, Europe had been Churchill China’s growth engine. In 2024, it contributed 39% of revenue, one per cent less than the UK, where it has long been a market leader.

Germany is experiencing a mild recession. Demand has also been weakened by the reintroduction of the standard 19% VAT rate on food served in restaurants. VAT was reduced to 7% during the pandemic, and it will be reduced to that level again in January.

Cost pressures at restaurants mean the hospitality market has contracted, reducing demand for new installations of tableware. Repeat customers are also selecting cheaper products from the same ranges, round bowls instead of more expensive pressure-cast triangular bowls, for example.

These developments have caused me to reconsider my score because:

• Europe is a much bigger market than the UK, so Churchill China has a much smaller share of it. During downturns, I had expected that the company would be able to grow market share there, and perhaps even grow in absolute terms. It is contracting in Europe at the moment, and Churchill China says it believes it is “defending” market share now, not growing it
• In recent times, Churchill China has only twice earned less than 10% return on capital. Once was in 2020, which we can forgive. The other time was 2013, when profitability was beginning an almost decade-long uptrend. In 2024, return on capital fell from 15% to 11%, so may fail the test in 2025.

I believe Churchill China makes superior plates due to unique materials, proprietary manufacturing processes and commitments to invest in the latest machinery and high levels of customer service.

However, the numbers may be telling us that in the world we live in now, Churchill China is not as robust as I thought it had become.

A reduction of the score by one point reduces the holding size suggested by the Decision Engine to 5% of a portfolio’s total value. Share Sleuth’s current holding is worth 3.4% of its total value, so my minimum trade size of 2.5% will prevent me from adding more shares at the current share price of 450p. 

Macfarlane: market weakness

Earlier this month protective packaging distributor and manufacturer Macfarlane warned that adjusted profit may be about 10% lower in the year to December 2025 compared to 2024. The decline is due to weak demand, competitive pricing, and elevated input, labour and property costs.

A profit warning of this size should not change my opinion of a business held for the long term, but it is disconcerting. It would be the biggest decline in the 12-year period documented in my spreadsheet and comes after a 1% decline in 2024.

These two weak years came after two years of strong growth though, and Macfarlane’s long-term numbers will be respectable in 2025 as long as performance does not deteriorate further.

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If Macfarlane had achieved 10% less profit in the year to December 2024, it would have reduced its 12-year compound annual growth rate (CAGR) from 10% to 9% and its 12-year average Return on Capital from 25% to 22%.

Average Return on Capital of 22% is well above my 10% benchmark, but a 9% profit CAGR is slightly below the level I generally award top marks for growth. These benchmarks are rough guides, and since it is a borderline result and has yet to materialise, I have chosen not to penalise Macfarlane’s score.

Further profit warnings might force me to intervene and reduce the score before Macfarlane publishes its next annual report.

I last scored Macfarlane in May.

22 Shares for the future

Here is the ranked list of Decision Engine shares. I review the scores at least once a year, soon after each company has published its annual report. The price scores are calculated using the share price prior to publication.

Generally, I consider shares that score more than 7 out of 10 to be good value. Shares that score 7 or less are good businesses that are not obviously cheap at the moment.

Jet2 Ordinary Shares (LSE:JET2) has published full-year results, and I expect to re-score it after the publication of its annual report in August.

Solid State and Keystone Law Group Ordinary Shares (LSE:KEYS) have published annual reports and are due to be rescored.

Click on a share's score to see a breakdown (scores may have changed due to movements in share price). Key: qual is the share’s score out of 9 for the three quality factors (capabilities, risks, and strategy), price is the price score from -3 to +1, and ih% is the suggested ideal holding size as a percentage of the total value of a diversified portfolio.
 

Richard Beddard is a freelance contributor and not a direct employee of interactive investor.  

Richard owns shares in Churchill China, Macfarlane and many shares in the Decision Engine. He weights his portfolio so it owns bigger holdings in the higher-scoring shares.

For more on the Decision Engine, please see Richard’s explainer.

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