Specialise to maximise

Last week's article on the O'Higgins system made me reflect on share selection systems in general. There are a large number of investment approaches and, not surprisingly, it usually pays an investor to specialise in one or two of them.

Here are the main methods that come to mind:

A low price/earnings ratio in relation to the growth rate - hoping for further substantial growth and a status change in the multiple.

A discount to net asset value - hoping for better management to arrive and utilise the assets or for a recovery or takeover. This method can be refined further by selecting only those shares that stand at a discount to their net current asset values - very rare birds nowadays.

A high yield - hoping that dividends will be at least maintained or increased and that the share price will rise to eliminate the anomaly.

Cyclical stocks - seeking out companies languishing at the bottom of the cycle in their industry, in the hope that they will benefit disproportionately when the upswing finally comes.

Recovery stocks - very similar to assets at a discount and cyclical stocks; investing in companies that have suffered in some way and hoping that they will quickly make a substantial recovery. Sales per share is often used as a measure of recovery potential and can also be used as a method of investment in its own right.

Technical analysis - ignoring fundamentals in the belief that chart patterns, the number of advances and declines, highs and lows, relative strength and deviations from moving averages, are more indicative of the future direction of the share price.

A high return on capital employed - seeking out businesses with well-above-average returns on capital employed in the belief such companies enjoy a competitive advantage and that management will be able to employ very effectively any profits ploughed back into the business.

Directors' dealings - believing that the directors ought to know whether or not their companies are a good investment. Recent evidence appears to support the argument that following the directors will beat the market averages.

Improving news-flow - waiting until the news begins to improve and then investing almost in spite of very poor fundamentals. The argument is that if the news-flow continues to improve, the shares should outperform the market.

Many of the approaches overlap. It is often possible to find a share with a low p/e ratio in relation to the growth rate that is also the subject of directors' buying, has an excellent chart pattern, high return on capital employed and is enjoying an improving news-flow. Similarly, a recovery stock is quite likely to stand at a discount to net assets and have a promising chart pattern supported by recent directors' buying. I always draw comfort from my criteria dovetailing with each other in this way.

A friend of mine who manages one of the most successful recovery funds works on improving news-flow as his main guiding criterion. In recent years he has, for example, made substantial profits from Next and has run most of them all the way. He has also enjoyed large profits on Cookson, but the news-flow no longer remains so positive and some recent minor downgrades of brokers' profit forecasts have encouraged him to take profits.

British Steel is one of his recent favourites and his fund has been invested in it for some months now. You can see that the chart pattern is promising and there is likely to be a continued flow of good news as the European steel industry continues to be rationalised. British Steel is the most efficient European producer with a cost advantage of about pounds 35 per tonne. Capacity in Europe is now being voluntarily reduced, with British Steel having already done its share with Ravenscraig. European ministers have also stated that the steel industry will receive no further state aid and no more public money will be invested in new capacity. Consumption seems to be rising, so British Steel should be a big beneficiary as Europe gradually recovers from the recession.

The financial fundamentals are less convincing. Kleinwort Benson, which has researched the company in detail, is now forecasting pounds 250m- pounds 300m for 1994/5 with the potential for pounds 500m- pounds 600m for 1995/6. So two years out, prospective earnings per share could be 24p. At the present price of 125p, this represents a multiple of only 5, but 1995/6 could be near the top of the cycle. British Steel may only merit a relatively low multiple then and a lot of very nice things have to happen to the company first.

I hasten to tell you that I do not own any shares in British Steel and I am not recommending them to you. They have already had a very good run. The main point of interest to me is the concept of buying a share with improving news-flow as the main criterion. British Steel fits this bill to a nicety, so it will be interesting to see the future news-flow and how the shares perform during the year ahead.

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.

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