How the Beansprout conviction rating works

When we publish research on a stock, we do not stop at saying whether we like the company.

After assessing the quality of the business, management team, growth catalysts, risks and valuation, we bring these findings together to determine how strong we believe the investment case is.

We express this through our Beansprout conviction rating, from one to five sprouts.

The conviction rating is the output of Stage 3 of our Opportunity Pot investment process. It summarises the conclusion of our research and gives us a common way to compare different investment opportunities.

It is also one of the inputs we use in Stage 4, when deciding how much capital an idea deserves within the broader Opportunity Pot.

What does the conviction rating mean?

Our conviction rating reflects how attractive we believe an investment opportunity is based on our research.

A higher rating generally means we see a stronger investment thesis, more attractive potential upside and greater confidence that the catalysts supporting our view will materialise.

A lower rating may mean that the investment case has weakened, the risks have increased, the potential upside has narrowed, or there is simply too much uncertainty for us to have strong conviction.

We use five levels:

How do we arrive at the rating?

The conviction rating comes after we have completed our research on the company. There are four main areas we assess.

1. Business quality

We look at whether the company has a high quality business that can continue creating value over time.

This includes understanding how the company makes money, why customers choose it over competitors and whether its competitive advantages are sustainable.

The stronger and more durable these advantages are, the more confidence we can have in the company's ability to grow over the long term.

2. Management quality

We assess whether management has demonstrated an ability to execute and allocate capital sensibly.

This includes whether management has delivered on previous plans, how it balances reinvestment, acquisitions, dividends and share buybacks, and how it responds when business conditions become more difficult.

3. Growth catalysts

We identify what could cause earnings or the market's view of the company to improve.

Catalysts may include stronger earnings, margin recovery, new products, market expansion, restructuring, asset sales, capital returns or changes in industry conditions.

The clearer and more visible these catalysts are, the greater the confidence we may have that the investment thesis can play out.

4. Valuation

Finally, we ask whether the potential return is attractive relative to the risks.

A great business does not automatically deserve a high conviction rating if the share price already reflects an extremely optimistic outcome.

Likewise, a cheap stock does not automatically deserve a high rating if the business is weak or there is no clear catalyst for the valuation gap to close.

We therefore consider valuation together with business quality, catalysts and risks rather than looking at any one factor in isolation.

Is the rating calculated using a formula?

No.

We do not assign a fixed number of points to business quality, management, catalysts and valuation and then calculate an average score.

The rating is a judgement based on the investment case as a whole.

For example, I may think a company has an excellent business and management team, but still assign it a moderate conviction rating if its share price already reflects most of the potential upside.

Another company may look statistically cheap, but receive a low conviction rating because earnings are deteriorating or I cannot identify a clear catalyst that could change the market's view.

The rating therefore reflects both how attractive the opportunity is and how confident we are in the assumptions supporting it.

How does the target price affect the rating?

Our target price is an estimate of what we think the stock could be worth based on our investment thesis.

It gives us a way to compare the current share price with our estimate of fair value and assess whether there is enough potential return to justify the risk.

However, the target price is only one input into our conviction rating.

For example, a company may continue delivering strong results, but its share price may rise to the point where most of the potential upside has already been realised. In that case, our conviction rating could fall even though our view of the underlying business remains positive.

The opposite can also happen. If the share price falls while the investment thesis remains intact, the potential upside may become more attractive and our conviction could increase.

Our published target prices generally reflect our assessment over a 12 month horizon.

What could cause the conviction rating to increase?

Our conviction may increase when the investment thesis becomes stronger.

For example:

1. Earnings grow faster than we expected.
2. Management executes better than expected.
3. A key catalyst becomes more visible.
4. The company's competitive position improves.
5. Risks that previously concerned us become less significant.
6. The share price falls and the potential upside becomes more attractive.

The important point is that something in the investment case has changed, and not simply reflect a rising share price or positive market sentiment.

What could cause the conviction rating to fall?

Likewise, our rating can fall even before the share price falls. This may happen when:

1. Earnings or cash flows disappoint.
2. Management execution weakens.
3. A catalyst is delayed or no longer looks likely.
4. Competitive pressures increase.
5. The balance sheet or risk profile deteriorates.
6. The share price rises enough that the expected return is no longer attractive.

We therefore continue reviewing the investment thesis after publishing our research to assess whether the facts supporting our original view have changed.

Can a highly rated stock still fall?

Yes.

A conviction rating is not a prediction of what a stock will do over the next few days or months.

Share prices can fall because of broader market conditions, changes in investor sentiment or developments that have little to do with the long term prospects of the company.

A high conviction rating means that, based on the information available to us, we believe the underlying investment case is attractive.

It does not mean the share price cannot fall or that our investment thesis will always turn out to be correct.

This is why we continue monitoring the thesis and why position sizing remains important.

Does a higher conviction rating always mean a larger position?

Not necessarily.

The conviction rating provides a starting point for thinking about position size, but it does not determine the final allocation on its own.

Within the Opportunity Pot, our typical allocation ranges are:

These ranges are guidelines rather than fixed allocations. Two stocks with the same conviction rating may still receive different position sizes depending on company specific risk, liquidity, how much remains uncertain, our existing portfolio exposures and the broader market environment.

The rating answers: “How strong is our investment view?”

Portfolio construction answers: “How much capital should we actually put behind that view?”

Where does the conviction rating fit into our investment process?

We use a four stage process for investing through the Opportunity Pot.

Stage 1: Find ideas from macro themes, industry developments and company specific catalysts.

Stage 2: Screen the ideas based on earnings momentum, balance sheet strength and returns.

Stage 3: Research the strongest candidates by assessing business quality, management, catalysts, risks and valuation. We develop an investment thesis and translate that research into a conviction rating.

Stage 4: Invest using a portfolio approach. We use the conviction rating alongside company risk, diversification, existing exposures and the market environment to decide how much to invest and how the position should be managed within the broader Opportunity Pot.

The rating is therefore the bridge between research and portfolio action.

It summarises how strongly we believe in an investment idea, while the next stage determines how much capital that idea ultimately deserves.