Share Sleuth's March Watchlist

Each month Richard Beddard trawls through annual corporate results for his Watchlist and the Share Sleuth portfolio - companies that satisfy key valuation metrics such as earnings yield and return on capital - and profiles the most interesting candidates.

In this month's article, he explains that it is difficult to judge how representative 2013, a year of falling turnover and profit, is for Chemring, as the munitions manufacturer and its markets are rapidly changing. It could, though, be a good investment and is worth watching.

Elsewhere, baker and cakemaker Finsbury Food moves from the "watch" category to the "add" one, after a reappraisal due to a previous calculation error, and synthetic yarns and fabrics manufacturer Low & Bonar is solid but unexciting.

Watch: Chemring

Even ignoring all the exceptional costs in munitions manufacturer Chemring's accounts, turnover and profit fell 16% in 2013. Stockpiles are high and demand for munitions is low as the company's biggest customers withdraw their armed forces from Afghanistan.

In response, Chemring introduced a performance recovery programme at the beginning of 2013, targeting operational and financial efficiencies. It's also sharpening its strategic focus on the countermeasure and munitions technologies in which it leads or can achieve leadership. A vigorous recovery plan could mark the beginning of a turnaround.

However, although Chemring expects to grow revenues from non-Nato markets, pressure on military budgets means it expects no growth from its biggest customers in the medium term.

The disposal of businesses not in the company's strategic plan may raise cash and enable it to repay debt, but Chemring's overall level of debt remained high and stable in 2013. On an earnings yield of 8%, the market values Chemring at about 13 times 2013's adjusted earnings. It could be a good investment, but, because the company and its markets are changing rapidly, it's difficult to judge how representative 2013 is.

Add: Finsbury Food

A calculation error in the January edition of Share Watch, which made Finsbury Food look less profitable than it is, consigned the company to the "watch" category.

On reappraisal, it's more attractive than that. Having sold off one of its businesses and raised funds for investment, the cake and bread baker is emerging from a financial quagmire induced by recession and expansion. In 2013 the company halved its debt and raised profit by 7%. Revenue was flat.

Finsbury supplies UK supermarkets and grocery chains with cakes they can brand as their own, and it manufactures and sells cakes under brands licensed from companies such as Disney, Nestlé, Thorntons and Weight Watchers.

Profits fell during the credit crunch. They have recovered, but the company's debt burden, incurred as it grew through acquisitions, proved persistent until it sold gluten-free bread and snack maker Free From for £21 million in February 2013. With that money, and £3.8 million from a fundraising in November 2012, Finsbury reduced debt, and it may be in a better position to invest and grow.

It's a tough business. Supermarkets drive a hard bargain with their suppliers. The company faces pressure on what it can charge, but is not in control of some of its costs. High sugar, flour and butter prices are holding Finsbury back in 2014.

That said, several company subsidiaries are extremely competitive: Lightbody is the largest supplier of celebration cakes; Memory Lane Cakes is the leading baker of supermarket own-label cake ranges; and bread-maker Nicholas & Harris is the UK's largest organic baker.

The company reports that its speciality bread brands are growing as they tap into trends to reduce unhealthy ingredients. Vogel's has no artificial additives, Cranks bread is organic and The Village Bakery specialises in rye bread. LivLife, a new bread brand, has half the carbohydrates of a normal loaf.

On the negative side, it's difficult to envisage how Finsbury might grow. Its cake business is already significant, so increasing its market share may prove difficult. Sales of licensed bread brands grew 17% in 2013, perhaps indicating the firm is a beneficiary of a broader healthy eating trend.

Finsbury could grow through acquisitions. But, while it has acquired good businesses in the past, its debt record suggests it couldn't afford them. Hopefully, chairman Martin Lightbody, who owns 11% of the shares, will encourage a circumspect strategy. He may be more builder than buyer, having grown Lightbody, in the words of his biography, from "nowhere". The shares cost only nine times adjusted 2013 earnings, an earnings yield of 11%.

Watch: Low & Bonar

The tenure of the retiring Steve Good, chief executive at Low & Bonar since 2009, was a period of stability for the firm, which had accumulated too much debt and, in 2008, sold off its flooring business to focus on manufacturing synthetic yarns and fabrics. In 2013 turnover increased 6% and profit 5%, while debt also rose slightly.

Its yarns and fabrics are components in membranes, tarpaulins and geotextiles used by the construction, horticultural, transport and carpet industries. The company's proprietary technologies, which turn polymers into fabrics for niche markets, could give it a competitive advantage.

Such quality isn't obvious from the company's results in 2013, which indicate a reasonably profitable company with considerable debt. Years of humdrum results could be the result of temporary factors: polymer prices and the uncertain global economic environment of the past five years. But it's also possible that Low & Bonar's technologies don't differentiate its products enough to dominate their markets. The share price values the company at 17 times adjusted profit, an earnings yield of just 6% - another reason to stay on the sidelines.

Watch: Porvair

Specialisation is Porvair's route to profit. Eighty per cent of its revenues come from consumables: filters that protect expensive equipment as diverse as furnaces and hydraulic systems, and are often replaced during routine maintenance. The company claims its microfilters are specified in "almost all commercial airframes".

Such utility and ubiquity are hallmarks of a champion, a business so essential to the running of other businesses that it occupies a stable and profitable niche. That impression is reinforced by Porvair's accounts, which reveal a highly profitable company with strong finances. The company increased revenue 10% and profit 19% in 2013, while reducing its modest level of borrowing and other financing.

Porvair is tripling investment in factories in the US, UK and China, in part to meet demand from major new contracts.

The Porvair story is attractive because its filtration technology is in demand and likely to remain so. Unfortunately, its shares are too, valuing the company at about 19 times adjusted earnings - an earnings yield of 5%.

Watch: SThree

SThree is a recruitment company. It has grown by nurturing and retaining staff, the principal asset of a recruiter.

The other plank of SThree's strategy is specialisation. It started as a UK recruitment consultancy for IT professionals, but most revenue now comes from placing specialists in a wide range of other industries, and SThree does more business abroad than in the UK. It is focusing on the energy and life science sectors, which the company says are growing.

The cost of opening new offices combined with the recession has made SThree, temporarily at least, less profitable. Although turnover grew 10% in 2013, adjusted profit fell 18%, and the company had a small amount of bank debt at the year end. Moreover, the fundamentals are trending in the wrong direction. At the end of 2013 it had about £8 million net cash on the balance sheet, as opposed to £55 million two years earlier.

On an earnings yield of just 4% the share price values the company at about 27 times adjusted profit. Investors are expecting SThree to recover. It may, but the company is bigger and more diversified than the highly profitable IT recruiter of yesteryear, and the combination of the high valuation and SThree's expansion into industries and territories it did not make its name in makes it a risky investment.

SLUSH PILE

Three companies that didn't make it onto the Watchlist

Joining the slush pile this month is a group of companies under such pressure that it's difficult to imagine what they will be doing in five years' time, let alone put a value on them.

The government wants William Sinclair, along with other peat growers, to switch to manufacturing alternative composts because of the environmental damage caused by peat harvesting.

Educational IT supplier RM is withdrawing from the hardware market where it can no longer compete. Meanwhile, the software market is changing and so too is the way schools purchase IT.

Ship owner Goldenport reports that ship prices and charter rates have bottomed out. After years of losses, the company is anticipating recovery, but shipping recoveries sometimes prove ephemeral.