part0020

The preceding chapters have covered a large number of investment criteria for selecting growth shares. Some are mandatory, others are highly desirable and the remainder can best be looked upon as attractive bonuses. As a first step, I will list all of the criteria and group them into categories:

Less than half of the shares in the FT-SE All-Share index have a PEG, so if a company has been awarded one it is an immediate and major plus point. It at least means that the company has a four-year pattern of growth, even if future prospects need to be combined with the past record to achieve that minimum requirement.

A compromise can sometimes be made when it is obvious that a company will have a PEG within a year or has just missed having one by a whisker. In most cases, however, an existing PEG is essential.

In The Zulu Principle , I suggested, as a mandatory requirement, that the chairman’s statement should be optimistic. The fact that a company possesses a PEG provides some assurance that brokers believe there is unlikely to be a setback in EPS growth. However, any statement on future prospects in the annual report or the chairman’s comments at the AGM (both synopsised in REFS) should still be checked together with newsflow to ensure that no clouds are lurking on the horizon.

A PEG cut-off level has to be established in relation to the market average. In April 1996, the market as a whole was on a PEG of about 1.5, which was historically quite high. In that climate, any share with a PEG of under 1.0 was superficially a very attractive investment. A PEG of 0.75 was twice as attractive as the market as a whole and the few shares with PEGs of under 0.6 were 2.5 times as appealing.

The level of PEG cut-off varies with the size of funds under management. A cut-off of 0.6, with other sieves, often results in a universe of only ten companies, which is sufficient for most private investors. For really significant funds, a PEG of under 1.0 would be a good starting point and should result in a much wider universe, with some of the companies in question being in the highly marketable FT-SE 100 index and a substantial number in the Mid-250.

To command a low and attractive PEG, a share with a PER of over 20 would require a very high and probably unsustainable rate of future growth. The most reliable and recommended range of PERs and growth rates is a prospective PER of 10-20 with a forecast growth rate of 15-30%.

As you will have seen, the cash flow sieve has not, as yet, resulted in improved performance. However, it is reassuring to nervous investors (I put myself in this category) and may well come into its own in a bear market.

For my money, strong cash flow is essential. I want to see EPS converted into cash year after year and to see it translating into strong cash balances or, at the very least, rapidly reducing gearing. Cash flow per share for the last reported year should exceed EPS. Sometimes a compromise can be made if the difference is mildly negative, provided that there is a good reason (e.g. very rapidly increasing sales with a consequent increase in working capital). However, if the last reported one-year figure is adverse, the average cash flow per share for the previous five years must substantially exceed EPS for that period.

Also, capital expenditure should not exceed cash flow for the latest year and should, on average, be significantly less over the preceding five. Again, a compromise can sometimes be made for the latest year, if there is a good explanation. Ideally, though, one is looking for companies that generate plenty of cash and do not need to spend it all on capital expenditure just to stay alive.

When gearing exceeds 50%, caution is needed. In practice, I am prepared to increase this limit to about 75%, provided cash flow is strong. For example, Frank Usher Holdings had gearing of over 75% in early 1995, but by April 1996 it had been reduced to 25%.

Positive cash balances remain one of the best signs of a great growth company. In June 1996, Rentokil, Next, Carpetright, Eurotherm, Logica, Parity and JJB Sports, for example, all shared this endearing characteristic. A strong cash balance is often the most convincing evidence that a company’s growth is real and that it can convert its increasing EPS into cash. This is essential to fund capital expenditure and acquisitions, buy in shares or pay increasing dividends to shareholders.

The only compromise I recommend is on the relative strength of the previous month, which may sometimes be mildly negative while a great growth share pauses for breath. In this event, I check the relative strength for the previous three months. If that is negative too, I give the shares a miss and look elsewhere.

I usually find the share I invested in by beginning with the whole universe of quoted shares and applying a series of sieves like low PEGs, strong cash flow and high relative strength. I then examine the shares that find their way through the sieves and try to identify the competitive advantage that they must be enjoying to possess such outstanding financial characteristics. In late 1995, my sieves helped me to find Forth Ports and Rutland Trust. The common feature of these two companies is that they both own ports. I had never given much thought to ports before, but it now seems obvious that, like toll bridges, they have a strong competitive advantage in their local area. I can therefore understand why the financial results of these companies were so good and their prospects looked so bright.

I can see that JJB Sports with its sports shops, Carpetright with its carpet stores and Pizza Express with its restaurants all have an attractive formula that they can clone. However, I found them by using REFS and arithmetical sieves. Only then did I try to check their competitive advantage to understand how they had been able to produce such good results.

Chapter 9 highlighted the many different types of competitive advantage that can be the source of a company’s winning formula. High ROCE and good operating margins are usually strong supportive evidence of a company’s competitive advantage.

I would be distinctly put off a share if a number of directors were actively reducing their shareholdings. Buying by directors is highly desirable, but it is not essential. The absence of major selling is mandatory.

The PRR is only a useful measure for companies which engage as a way of life in a substantial amount of research and development each year. REFS shows PRRs in company entries when there has been R&D expenditure of over 1% of market capitalisation as shown by the company’s latest annual report.

The PRR is calculated by dividing the market capitalisation of a company by the total of R&D expenditure. In pharmaceuticals and computer software companies it is always encouraging to see a low PRR indicating that a substantial amount is being invested in the future of the company. More of this in Chapter 17.

I like to think of these criteria as a quiver full of arrows. They do not all need to be fired and some may miss the target. The best way to show you how to use them is to give some practical real-life examples. I would like to stress that any shares mentioned by name are for illustrative purposes only and are not to be taken as current recommendations. I will work from REFS’ December issue dated 27 November 1995 as, by the time this book is published, it will be very much out of date. It is the approach that you should concentrate upon, not the companies used to illustrate it.

The FT-SE SmallCap index is a wonderful hunting ground for finding shares with attractive PEGs, so my first thought on receiving REFS each month is to turn to the table of SmallCap growth shares with the lowest PEGs. Set out below is the top part of the SmallCap table showing the shares with PEGs of under 0.6 on 27 November 1995:

It is essential to realise that, just by possessing a PEG, every share in the table has already passed through an important first sieve. Only 160 companies qualified out of the 400 in the SmallCap index and only 20 of those passed through a second sieve and had a PEG of 0.6 or under.

The third sieve eliminated those shares from the top 20 with cash flow less than their EPS. This ratio is shown clearly in the last column of the table and, as you can see Norbain, Yorkshire Food, Sanderson Bramall, Mayflower, Delphi Group, Regent Inns (a sad loss) and Reg Vardy failed to qualify. You will notice that Independent Insurance remained in the shortlist. The cash flow sieve is waived for banks and insurance companies, because management of cash is their line of business, so REFS does not show the figures, as they tend to be relatively meaningless.

The fourth important sieve is relative strength for the previous year, Pelican Group, Perry, Vardon (bingo interests suffering from the lottery), Hogg Robinson, Frost Group (garages suffering from the petrol price wars), and Hill & Smith were all eliminated.

As a result, the shortlist was reduced to the following shares: British-Borneo Petroleum, Parity, Laura Ashley, Business Post Group, Independent Insurance, Rutland Trust and Brammer.

The further sieve of relative strength during the previous month is less important than over a year so it can be overridden by positive relative strength in the previous three months. British-Borneo’s -5.1% was +3.5% over three months and Laura Ashley’s -12.2% was +16.2%. However, regrettably, Independent Insurance’s -7.3% was still negative at -2.9% and Brammer’s -8.7% also stayed negative at -3.8%.

The shortlist was therefore reduced to the following shares:

We now need to look at the individual company entries in REFS, the annual reports and any available brokers’ circulars to check the companies in question in more detail, ascertain their competitive advantage, confirm that their outlook statements and newsflow are positive, find out if the directors have been buying or selling shares and check the other key statistics.

The company has extensive oil interests in the Gulf of Mexico, generally regarded as one of the safest and best oil plays in the world – both politically and geologically. In December 1995 none of the directors had been buying or selling shares and the outlook statement was reasonably confident. Cash flow of 53.1p was sensational, but offset by heavy capital expenditure to fund major expansion. The PEG unusual in an oil company, was a very attractive 0.43 and the PER only 10, so all the mandatory requirements were in place.

Now for the highly desirable and bonus factors. Most importantly, EPS growth was accelerating – 9% in 1994, 13% forecast for 1995 and 24% for 1996. The market capitalisation was an attractive £130m and there was a useful dividend yield of 3.46%, just below the market average, but good for the sector. Also the price-to-book value of 1.5 provided some underpinning for the share price. All in all it looked very attractive.

The December 1995 REFS’ company entry for Parity is set out below. It is in the old-style half-page format and exemplifies almost all the points I have been making. Parity had a superb graph, positive relative strength, a moderate PER, a very low PEG, a high growth rate, a high return on capital employed, positive cash balances and excellent cash flow. The interim results were excellent and the chairman’s view of the future was confident.

Parity is involved in the computer consultancy business. The company provides skilled personnel and training to computer users, including two-thirds of the FT-SE 100 companies. It has more than 75,000 freelance systems personnel on its books and vets the quality of their work regularly.

The PSR was an attractive 0.74, but margins were low at only 4.55%. This is because they are based on a fixed percentage of their consultants’ remuneration, with Parity acting as the middleman. This is a very difficult business to enter without massive teething problems, so Parity appears to have established for itself a niche in a fast-growing market in an excellent sector. To me the shares seemed to offer a one-way ticket.

Although this company passed through the sieves, I would not have bought it in December 1995 because the prospective PER of 34 was far too rich. The growth rate of 69.7% was very high too, but it contained a large element of recovery and benefits from reorganisation, so it could not be sustained for long.

In the event, this decision turned out to be a real howler as by early May 1996 Laura Ashley shares had risen from 130p to 212p. Many investors developing their own systems of share selection may decide not to rule out stocks with very high PERs or to have a higher PEG cut-off. It is very much a question of developing your own investment style. I do not feel comfortable with shares with astronomic PERS in my portfolio, so I usually eliminate them during my sieving process. I realise that by doing so I occasionally miss a stunning investment opportunity but I feel more relaxed sticking to my strict criteria.

The cluster of black moons in the growth statistics of the December 1995 REFS company entry shows that Business Post combined many attractive characteristics. The PER of 17.4 was on the high side, compared with both the market and the sector. However, the forecast growth rate of 32.1% was near the top of the class and this resulted in a very attractive PEG of 0.54.

Cash flow of 14.1p was healthily above EPS of 12.2p for 1995 and, in the five-year average, 6.8p was just above 6.3p. Capex of 3.5p for 1995 was also well covered by cash flow of 14.1p. EPS growth was slowing down after averaging 53.4% during the previous five years, but the forecast rate of 32.1% seemed to be reasonably sustainable. ROCE was terrific at 47.3% and, according to the chairman, margins had increased again recently to 19%. As a consequence, the PSR was on the high side at 3.52.

Business Post is about the tenth largest parcels and express mail organisation in the UK with a market share of 4%. The company was growing fast and the outlook statement was very positive. A reciprocal link had recently been forged in Europe, which was seen as a major source of future business. The competitive advantage of Business Post rests in its reputation for reliability and the very broad range of services it offers. The company obtained BS5750 accreditation in 1994 and its exceptional growth record and growing margins vouch for its efficiency. In December 1995 it had a network of 16 regional hubs, a national hub in Birmingham and 45 franchised local depots. Although there is plenty of competition, it would be difficult for a newcomer to start from scratch. The shares seemed to me to be a strong buy.

The prospective PER of 13.6 was about average but the growth rate of 23.3% was well above the norm, resulting in an inviting PEG of 0.58. EPS for 1994 of only 2.3p was massively exceeded by cash flow per share of 11.6p giving, at 40p, a very low PCF of only 3.44. The future outlook seemed bright from the chairman’s interim statement, especially as the interim dividend was increased by 10%.

The problem was gearing of 236%, mainly caused by Rutland buying Thamesport during 1995. To help fund the purchase it sold off Leasecontracts, one of its most profitable subsidiaries. Thamesport can be substantially expanded and, as a port, possesses a strong competitive advantage. It also brought with it extremely useful tax losses of £60m plus a further £60m of capital allowances. The deal seemed to me to be a brilliant one and I much admired the courage of Michael Langdon and the board in making such a sweeping change. It would not take long for gearing to be reduced to more normal levels, as exceptionally strong cash flow helped by a much reduced tax charge began to eat into it. By my calculations gearing would be reduced to below 75% before the end of 1996. Rutland Trust therefore had my vote as a strong buy and was an excellent example of the kind of compromises that are often made when making final selections.

In this context, it is interesting to note that I included Independent Insurance in my New Year portfolio for the Financial Mail on Sunday , although it was rejected in our early analysis for this portfolio on the grounds of poor relative strength for the month and three months. During December, the shares forged ahead and quickly became a buy on my criteria as relative strength for the previous 12 months turned positive.

I double-checked Independent Insurance with two relatives who happen to be insurance brokers. Both had a very high opinion of the company and one of them had already purchased some shares for his portfolio. It was included in my Financial Mail portfolio at 375p and by June 1996 the shares had risen to 461p, after flirting with 500p in Aril and May.

The examples of Rutland Trust and Independent Insurance illustrated an important principle. REFS is an invaluable sieve for highlighting the shares with the lowest PEGs in each index at the end of every month. It also shows, in the accompanying columns, cash flow in relation to EPS and relative strength for the previous year and previous month. However the company entry, the annual report, profiles in Analyst , reviews in the Investors Chronicle and in newsletters and brokers’ circulars help to flesh out the pure arithmetic.

REFS’ evidence to date indicates that you would beat the market by simply taking the top shares in the tables and applying the sieves without using any further supplementary information. However, I believe that you should fare even better if you learn to compromise when necessary. The confidence to do this will come gradually.

It is important to monitor your success or failure in departing from a strictly arithmetical approach. It would therefore be worthwhile to record carefully any departures from sticking to the basic formulae. The results of your initiatives can then be evaluated and compared. If over a period they do not pay off, there is a simple remedy.

As you can see, by the end of May 1996, the four shares in the portfolio had appreciated in price substantially:

During the six months the market measured by the FT-SE All-Share index rose by only 5.84% and the more appropriate measure the FT-SE SmallCap index, rose by 14.2%. British-Borneo was, of course, the best performer by a very wide margin but, in any portfolio, there is usually one star and investment is essentially a business of averages. It is pleasing to note that every share in the portfolio beat the SmallCap index substantially and the average performance was about 4.5 times that of the index and 11 times the market’s miserable 5.84%. Costs have been ignored but these would have been relatively trivial and would have hardly affected the overall results.

In the above analysis we only worked from the FT-SE SmallCap index. In the same December 1995 issue of REFS there were some very inviting shares in the Fledgling index. There were also a large number in the table of non-index companies, which is usually full at the end of the year, before the Review Panel promoted most of the shares to an index, usually the Fledgling.

In particular, in the non-index table, JJB Sports at 520p (June 1996 – 818p) was at the top with a PEG of 0.32, Photobition was second at 320p (June 1996 – 370p) on a PEG of 0.39 and Oasis Stores at 222p (June 1996 – 404p) was a little lower down with a PEG of 0.75. I held all of them in my portfolio.

In the Fledgling index I held shares in Azlan Group at 495p (June 1996 – 665p) with a PEG of 0.65, and Pressac at 142p (June 1996 – 177p) with a PEG of 0.75 and extremely high cash flow.

Forte, at 347p was still at the top of the FT-SE 100 index with a PEG of 0.78, even after the Granada bid. Bank of Scotland, GKN, Asda Group, NatWest, Rentokil and British Airways all had PEGs of under 1.0. Interestingly, Forte had been at the top of the October tables too, when the price was only 248p and the PEG only 0.52. (Maybe fewer institutions were subscribing to REFS in those days.)

Shares with low PEGs are always quite well represented in the Mid-250 Index. IMI at 312p (June 1996 – 361p) was at the top with a PEG of 0.30 and Lucas was second at 185p (June 1996 – 241p on bid rumours) with a PEG of 0.53. In the top 15, an old favourite of mine, Carpetright at 394p (June 1996 – 613p) had a PEG of 0.69, Stagecoach Holdings at 279p (June 1996 – 444p) had a PEG of 0.72, BBA at 284p (June 1996 – 328p) had a PEG of 0.67 and Matthew Clark, at 647p (June 1996 – 801p) had a PEG of 0.66.

I have shown the closing prices on 3 June 1996 in brackets in each case to highlight the attractiveness of the shares featured in the low PEG tables only six months earlier . There are usually plenty of shares with interesting PEGs in every monthly issue of REFS. The more marketable the shares in the index, the higher the average PEG. In the FT-SE 100 index, there were only eight shares with PEGs below 1.0, in the Mid-250 there were 28 and in the prolific FT-SE SmallCap a whole page of 55 companies ended on a cut-off of 0.85. There were only 40 companies with PEGs of under 1.0 in the Fledgling, for the reasons I have already explained.

There were 18 companies with PEGs of under 1.0 in the table of non-index companies, which has proved to be another very attractive hunting ground for cheap stocks. Quite often new issues take a few months to find their proper level in the market.

The buying of shares is, of course, of vital importance, but the question I am most often asked at conferences is when they should be sold. The answer is complex, involving capital gains tax and other general portfolio management considerations, all of which will be covered in the next chapter.

1. A PEG with a relatively low cut-off such as 0.75.

2. A prospective PER of not more than 20. The preferred range for PERs is 10-20 with forecast growth rates of 15-30%.

3. Strong cash flow per share in excess of EPS, both for the last reported year and for the five-year average.

4. Positive cash or gearing of below 50%, other than in exceptional circumstances (such as really massive cash flow per share or impending sales of major assets).

5. High relative strength for the previous twelve months.

6. A competitive advantage, which will usually be evidenced by a high ROCE and good operating margins.

7. No selling of shares by a cluster of directors.

1. Accelerating EPS, especially if it is a result of activities being cloned.

2. A cluster of directors buying shares.

3. A small market capitalisation in the £30m-250m range.

4. A dividend yield.

4. A reasonable asset position.

Very few shares will satisfy all of the mandatory and highly desirable criteria. A share may meet almost all of the criteria very strongly indeed, but just fall short on one of them. In these kinds of instances, it is necessary to compromise a little.