Fleas can bite you

Last week I suggested weeding out highly speculative shares when reviewing your portfolio. I mentioned in particular shells and bio-tech companies, and asked: who wants to know that Timothy Bloggins is going to do great things with a company, if the shares are four times asset value, there are no earnings and fear is in the ascendant in a bear market?

Since then, a few people have asked me how the share prices of shells reach such dizzy heights, even in a raging bull market. There are a number of reasons, but the main one is unquestionably the relatively small size of a shell.

Even when selecting a conventional growth share, all other things being equal, I prefer small capitalisation companies. I work on the principle that doubling a market capitalisation of pounds 100m is a great deal easier than doubling a capitalisation of pounds 10bn. To illustrate this, I coined the phrase 'Elephants don't gallop'.

A shell is an extreme example of this basic principle. The very small market capitalisation and the fact that the company is quoted are usually the only attractions; the underlying business is often nondescript. One of the Oxford Dictionary definitions of the word 'shell' is 'Unimportant firm made the subject of a takeover bid because of its status on the Stock Exchange'. Another, more amusing, meaning is 'Outward show, mere semblance'.

To contrast a shell with an ambling, elephantine leading stock, the best analogy I can offer is a flea, which can jump 200 times its own body height - equivalent to a man jumping over St Paul's Cathedral.

In addition to the small market capitalisation of a shell, the float of shares available to the market is invariably very restricted. Most of the shares are usually held by friends and business associates of the incoming entrepreneur. Dramatic changes in management and prospects are nearly always seen as positive developments that result in more buyers than sellers.

A typical shell company with a market capitalisation of, say, pounds 5m and underlying assets of half that might easily double with as little as pounds 250,000 worth of shares changing hands.

In the eyes of many investors, a further factor adding to the attractions of shell shares is that they are usually penny stocks. Not only is the market capitalisation small, but many people believe (and they may be right) that it is far easier for a 5p share to reach 10p than for a 500p share to reach 1,000p.

If the shares of my pounds 5m typical shell doubled, the market capitalisation would rise to pounds 10m leaving well behind the underlying assets of pounds 2.5m. At this point, an important deal might be announced, financed by an issue of shares for, say, another pounds 10m. The business being acquired would probably be backed by assets or earnings of about that amount.

If the share price remained the same, the market capitalisation would rise from pounds 10m to pounds 20m and the underlying 'worth' to pounds 12.5m. The 'hot-air' gap of pounds 7.5m would still need filling in, but the share price would probably rise again as the market sniffed another deal in the offing.

More assets might then be acquired by the issue of shares on a lofty multiple or standing at a high premium to net asset value.

FILLING THE GAP

At some point, the shell might manage to buy a company with exceptional earnings prospects or one standing at a vast discount to its probable worth. Berisford International's acquisition of Magnet fell in this category. With one bound, Alan Bowkett filled the hot-air gap in Berisford's price and gave investors the hope of more.

Berisford International, like Wassall before it, was a large shell operation. Many shells go on to become great companies; Hanson Trust and Williams Holdings are wonderful examples. A few, like Polly Peck and Parkfield, fall by the wayside. Shells have a high risk/reward ratio: if you are right, you can make a lot of money by investing in them; if you are wrong, you can lose it all.

Next week, I will set out a number of criteria that should help you to decide whether or not to invest in a particular shell. Meanwhile, you can readily see that shells are very susceptible to the music stopping and to swings in market sentiment.

This is, first, because they are often priced at well above their underlying fundamental value, and second, because the market in the shares is usually very narrow and there is always the risk of getting trampled underfoot in the rush for the exit.

The author is an active investor who may hold any shares he recommends in this column. Shares can go down as well as up. Mr Slater has agreed not to deal in a share within six weeks before and after any mention in this column.