November 2005 | STOCK-SCREENING NEWSLETTER |1

W E LCOME TO ISSUE THREE OF OUR BI-MONTHLY STO C K-SCREENING NEWSLETT E R.Having sta rted out by looking at ways to screen shares like legendary USi n vestors, in this issue we stay closer to home – by showing you twotechniques that were designed to pick shares in small-t o- m e d i u m -sized UKcompanies. And just like the stock-screens we covered in the past twoi ssues, these techniques have been rigorously tested over a number ofyears. We ’ ve wo r ked out how the shares they picked in the past havep e rformed to date – and we give details of the shares they’re identifyingn ow. We also give you our promised update on the shares identified by ourJuly and September stock-screens, and track their performance to dat e .We tell you which ones we plan to hold, which ones it’s time to sell – andwhich new shares we think should be bought. In this way, our stock-screening newsletter aims to provide you with mini portfolios ofm e t h o d i c a l l y -selected shares, and indications of their level of risk. As eve r,we ’ ve done the n u m b e r-crunching for you – but this time we ’re also givingyou the chance to try out your own stock screens, on our website.

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November 2005 | STOCK-SCREENING NEWSLETTER | 1

2 | STOCK-SCREENING NEWSLETTER | November 2005

This issue of the Investors ChronicleStock-Screening newsletter is all aboutGARP and STAR. But don’t worry if youthink they sound like Nasa rocket-scienceprogrammes – you’ll soon realise thatthey’re eminently more straightforwardstock-screening techniques, which caneven be tested on the newly-enhancedInvestors Chronicle website (which isnow nearly, if not quite, capable of Nasa-style calculations – see page 12!).

The world (of investing)according to GARPWe’re taking as our main theme the styleof investing known as ‘growth at areasonable price’ – or ‘GARP’, asanalysts tend to call it. In many ways, it’sthe holy grail for equity bulls, as itcaptures everything that investing inshares is supposed to be about: lookingfor smaller companies that are growingboth sales and profits at a sustainablerate – but which have share prices thatseem reasonable, in terms ofconventional fundamental measures.

In our September issue (issue number02), we examined the methods of arenowned exponent of the moreaggressive style of GARP investing:American guru Martin Zweig.

In this issue, though, we switch ourattention to a homegrown stock-pickingguru: Jim Slater. We examine how hisstyle of investing – a rather moreconservative, value-driven approach toGARP, which he termed ‘The ZuluPrinciple’ – can be translated intoinvesting practice, through stock-screening. Our back-testing of a stock-screen based on his methods has foundthat the shares it identified returned 32.6 per cent over the past two years.

Another less-well known, but equallysuccessful, stock-picking guru is theanalyst John Mulligan. He has pioneeredan interesting system of his own that’sknown as STAR. It’s a method ofselecting shares that focuses on analysts’estimates of future earnings growth – inparticular, when they are upgraded.

Devotees of his approach include asmall army of financial analysts and theinvestment editor of the Financial Times,Philip Coggan, who has spent the pastfew years assessing the STAR approach –and who is now convinced that it candeliver consistently above-averagereturns. It certainly did when JohnMulligan ran his own back-testing on it –he went back as far as 1986 and foundthat STAR shares outperformed the FTSEAll-Share index in 13 of the past 17 yearsand, in aggregate, produced averagereturns seven times greater than the All-Share index.

That’s why, for this issue, we’veinvited John Mulligan to become a guestwriter. He agreed to take us through asimple screen and select some shares (seepage 7).

A review of our stock-screening performanceAs this is the third issue of ournewsletter, we thought it important thatwe review our performance to date, andupdate you on some of our stock tips.

It’s important, too, that we remindyou that all our stock-screens, and theportfolios they suggest, are built on thepremise of buy-and-hold investing – forat least a year or so and, in some cases,for a term of five or more years.However, we realise that companies andtheir fundamentals do change – and we

sometimes have to alter our view of ashare.

So, later in this issue, we’ll tell youwhy we now think we should sell oneholding – shares in the footwear retailerStylo – from our top list of Piotroskishares. We’ll also explain why we’readding another holding, in the shares ofthe building company Bellway.

An apology... two, in factBut we have a couple of apologies tomake first.

Our first apology is for a promisewe’ve failed to deliver. In our last issue,we said we’d give you the inside track onusing software package ShareScope toscreen for shares. Unfortunately, ourcoverage of the two main screens in thisissue – plus that very necessary re v i e wof perf o rmance to date, and thosedetails of the enhanced InvestorsC h ronicle Stock-Screening tool – meanswe’ve run out of space. So we’ve had todelay the ShareScope article until ournext issue in January.

Also, you might notice that this issuehas come out to you slightly later thannormal. This is simply to make sure thatwe run the most up-to-date and in-depthstock-screens possible, using the monthlyCD-REFS data – rather than runningscreens that are a little out of date, usingold price information. So, from now on,we’ll publish nearer the middle of eachalternate month, and include the latestcompany data.

This iss u e s’ stock-s c re e n s :

GARP gurus ands c reen STA R s

Highlights inthis issue:T H E J I MS LATER ‘G A R P’S C R E E NTHE ‘STA R ’S C R E E NH OW O U RS H A R ES AREP E R FO R M I N GWEBSITE SCREENING TO O L


S h a re St o c k-s c re e n Price Ma r ke t R i s k- Comment IC VIEW A n a l ys t s ’

used to identify ( p) cap (£m) g ra d e o p i n i o n

VP (V P. ) S l ater GARP 1 9 7 9 1 1 4 9 Hire sales and profits are up in Good value, 206p 3most of the group’s businesses, 17 June 2005a p a rt from its tool-hire division.

Tikit (T I K ) S l ater GARP 1 9 2 24 . 5 9 0 Results in September showed Good va l u e , 1p r e-tax profits up 37 per cent 2 1 7.5p, thanks to the successful 9 Sept 2005i n t e g ration of two acquisitions.

P l u s Net (PNT) S l ater GARP 2 6 3 74 1 3 8 With 68 per cent growth in Good value, 228p, N / Abroadband subscribers - to 29 July 20051 1 3 ,000 over the year - first-half results easily beat ex p e c tat i o n s .

MTL (MTI) S l ater GARP 3 7 8 72 1 4 8 Orders for components carried Good value, 382p, 2f o rward into the second half 14 Oct 2005reached £6.8m, which is £2.2m higher than the previous ye a r.

Charles Stanley S l ater GARP 2 6 7 1 1 2 9 2 To reduce its reliance on vo l atile Good value, 281p, 1(C AY) t rading commissions, there’s 17 June 2005

been a shift to fee-based work –such as investment management.

Ashtead STA R 1 5 1 5 0 2 1 5 9 Fi r s t-q u a rter profits were up Good value, 145p, 1( A H T) 150 per cent due to invo l vement 23 Sept 2005

in the Hurricane Katrina clean-up.

Scapa (SCPA ) STA R 2 0 3 0 1 1 7 Scapa has been suffering due to High enough, N / Arises in raw material costs and 21.5p, dollar we a k n e ss . 10 June 2005

Ro yal & Sun Alliance STA R 1 0 1 3 ,0 0 0 8 9 R SA has plenty left to do in the Fairly priced, 92p, 3( R SA ) U S, and it faces a possible claim 19 Aug 2005

from General Motors, too.

C h a rter (CHTR) STA R 4 0 0 6 6 0 1 8 0 After years of restructuring, Good value, 377p, 2C h a rter is benefiting from a lowe r 7 Oct 2005cost base and an uplift in wo r k.

Rio Tinto (RIO) STA R 2 , 1 9 2 24 , 2 0 0 1 4 6 The mining group has turned in a Fairly priced, 2record result, with a strong 1,975p, p e rformance from iron ore. 12 Aug 2005

RHM (RHM) STA R 2 6 3 9 2 0 1 5 4 There has been a sharp drop in B u y, 259p, 3c a ke sales, but sales of branded 4 Nov 2005products were up 4 per cent.

Xs t rata (XTA) STA R 1 , 2 8 0 8 , 5 0 0 1 6 1 Xs t rata is acquiring 20 per cent of Fairly priced, 2Falconbridge for £940m, and its 1,256p, cash generation is prodigious. 19 Aug 2005

Prudential STA R 4 8 8 1 0, 8 0 0 8 8 Prudential is considering buying Good value, 482p 2( P R U ) the 21 per cent in online bank 28 Oct 2005

Egg that it does not already ow n .

L e gal & General STA R 1 0 9 7, 1 6 1 95 L&G shares trade at a near-2 0 Fairly priced, 127p 2( LG E N ) per cent discount to rivals, which 4 Nov 2005

reflects uncertainty over sales.

XP Power (X P P) STA R 3 4 5 6 4 7 8 XP managed to improve underlying Good value, 412p, 2profits by boosting sales of higher- 5 Aug 2005m a rgin ow n - b randed products.

B e l l way (BW Y) Price to Sa l e s 8 4 4 95 6 9 4 B e l l way recorded a 14th success i ve Good value, 870p 2year of growth despite 21 Oct 2005challenging conditions.

No t e sMa r ket cap and price: as at 31 October 2005

Ri s k G rade™: a Ri s k G ra d e ™measure is an open and tra n s-parent benchmark to measurethe risk of the world's finan-cial assets. The Ri s k G ra d emeasure can va ry from 0, forcash, to values well in exc e ssof 1,000 for highly speculat i vei n ve s t m e n t s .

IC VIEW: Investors Chronicle'smost recent recommendat i o non the share – 'buy', 'goodvalue', 'fairly priced', 'highenough', or 'sell'

A n a l ysts' opinion: Co n s e n s u sof all analysts' opinions on theshare, where 1 is strong buyand 5 strong sell (source:D i g i ta l L o o k)

W h at’s new :

The shares identified by this month's stock-s c reens


So far in this newsletter, we’ve tended totalk an awful lot about influential USinvestment gurus, such as JosephPiotroski and Martin Zweig (see issues01 and 02). But in this edition, we’regoing to concentrate on a home-grownhero: Jim Slater. He’s been eloquentlyarguing a ‘growth at reasonable cost’(GARP) investment philosophy for manyyears now, with huge success.

Principles behind the stock-screenThe clearest definition of his approachcame in his book, Beyond the ZuluPrinciple: Extraordinary Profits fromGrowth Shares, which is pretty much thestandard text book for British investors.His obsession with stock-screening, as atechnique, also led him to set up thehugely valuable CompanyREFSinformation system – available oncompact disc and in book form throughHS Financial Publishing.

Slater fits into a spectrum of GARPinvesting somewhere between therampant growth style of Martin Zweigand the more conservative style of classicvalue investors. He’s not as aggressive asZweig and uses many more value-influenced measures. Even so, the kind ofcompany he’s looking for is still verysimilar to the kind identified by MartinZweig: small, fast growing andreasonably priced.

For Slater, the key measure is theprice-to earnings-growth ratio – or PEGratio (see page 6). He argues that it’s thebest indicator of reasonably pricedgrowth. In fact, as he himself says in theintroduction to his Company REFssystem: “The PEG is a much moresophisticated measure [than the price-

earnings, or PE, ratio] because it relatesthe PE ratio of a company to its futureearnings growth rate, and gives a betterindication of value.” It’s a dynamicmeasure and it changes in time, butSlater reckons that “over the long term,it has paid to buy the market on a PEGof one or below”.

Slater goes on tospell out in great detailhis own take on theclassic GARP screen.He uses the metaphorof ‘a quiver full ofarrows’ to describe hisapproach of using alarge number ofmeasures. Slater’s twomain core concerns are earningsconsistency and momentum.

The stock-screening criteriaTo that end, he insists that a companymust have four years of consecutivegrowth in earnings per share (EPS) andthat each of the past five years must havebeen profitable – although a period ofpoor performance is allowed if thefollowing four periods show a consistentupwards trend. To make this focus onearnings work, Slater adds a number of

important caveats: n There must be a number of brokerforecasts available, preferably more thanone. The important point here is thatSlater bases much of his analysis on‘expected’ earnings growth, and if onlyone broker covers a company, that figuremay be deeply unreliable – especially if itis a ‘house broker’ with a relationshipwith the company’s managementn Would-be investors should be verycareful with companies in the micro-capFledgling Index. They tend to only haveone broker following them. So most fansof Slater approach tend to restrict theirstock-screens to companies with a marketcapitalisation of at least £10m

n Cashflow per shareshould exceed EPS forthe last reported yearand for the average ofthe previous five yearsn Companies in theproperty sector andmost companies in theconstruction andbuildings materialssector should be

excluded altogether.Slater also uses a great many measures

borrowed from traditional valueinvesting. These are:n Interest cover should be reasonablen Current ratio (the ratio of currentassets to current liabilities) should be twoor moren Gearing should generally be no morethan 50 per centn Return on capital employed (ROCE)should be above average for the sector,and the trend should be upward.

STYLE:

DIFFICULTY:

STOCKS TO BE SCREENED:

RISK LEVEL:

SUITABLE FOR:Investors who want the best of both worlds: a value-based approach to picking fast-growing stocks

H I S C O R E

CONCERNS ARE

E A R N I N G S

C O N S I ST E N CY

AND MOMENTUM

St o c k-s c reen of the month:

A Jim Slat e rs c re e n


n Dividends are not required but theyare “preferred” n Relative strength (RS) of the shareprice should be positive for both the pastmonth, and the past 12 months. This useof a technical (ie share-price movementbased), as opposed to a fundamental,measure is because Slater wants some reassurance that our cheap growth stockis actually capable of share-pricemomentum. This can be assessed usingthe relative strength measure – which canbe sourced from most websites that offerinteractive share-price charting.

Our version of a Jim Slater screenWe have adapted these principles todevise screening criteria that can be inputto a stock-screening tool. There are threesteps. The first step is to use a series ofquantitative measures to screen outunsuitable stocks – we’re essentiallynarrowing down the universe of shares tofast-growing, reasonably-priced shareswith a decent cash flow, reasonableoperating margin and a generous returnon the capital employed. Step one – the screening criteria:n PE ratio no more than 20n PEG ratio below 1 (ideally below 0.75)n EPS growth rate in current year above15 per centn Cash flow per share greater thanearnings per sharen Net gearing below 50 per centn RS positive at least for one yearn ROCE above 12 per centn Profit margin above average or medianfor marketn Market capitalisation either above£10m and below £1,000m OR above

S h a re Price (p) P EG Ma r ket cap (£m) EPS growth EPS grow t h EPS Grow t hin next ye a r over last over last( % ) 3 years (%) 5 years (%)

P l u s Ne t 2 6 3 0. 2 1 74 6 7 5 8 5 8M T L 3 7 8 0.74 72 1 5 . 3 1 2 . 1 2 1 . 6Vp 1 9 7 0. 6 1 9 1 1 8 . 2 2 7. 9 47. 4Tikit Group 1 9 2 0. 4 3 24 . 5 3 1 . 5 1 7 2 3 . 2Charles Sta n l e y 2 6 7 0. 6 6 1 1 2 1 9. 6 1 9.7 N A

As at 31 October 2005. See below for a full analysis of all these shares

Shares identified bythe Jim Slater

screen

To be honest, only two shares really tick all the boxes of our Jim Slater screen:MTL Instruments and P l u s Ne t. Both of them score ve ry highly in step three ofthe screen (with a score of at least 3 points out of a possible 4), and both areclearly experiencing ve ry strong earnings acceleration. Our only problem is thatt h e y’re already on our buy list! MTL Instruments was first identified by ourMaster Growth screen back in July – since when it’s bobbed up by more than 4 per cent in value – while broadband provider PlusNet appeared in our Ma rt i nZweig screen in the September issue. But we still rate both shares a strong buy.

MTL Instruments is clearly beginning to ramp up both sales and profit grow t h .When announcing the most recent interim results, the management of thesafety equipment company revealed that profits had shot up from £2.4m to£3.15m, despite some evidence of tighter profit margins, and declared that“order activity” remained strong in the second half of the ye a r.

P l u s Net also announced that sales momentum for its broadband internet sev i c eis strong, and the outlook for 2006 is “ve ry positive”.

Charles St a n l ey is regarded as a strong buy by analysts – and our stock-s c r e e nconcurs. Profits at the broking firm have struggled to get back to the recordl evels set in 2001 but, on eve ry other measure, Stanley looks to be growing ve ryq u i c k l y. Its EPS growth is unlikely to dip below 17.5 per cent a year over the nex tfew years. So the prospective PE ratio of just 12.5 looks horribly cheap for asector likely to undergo ex t e n s i ve merger and acquisition (M&A) activity. Wealso think that net cash of 103p per share is the icing on the cake.

Tikit Group has similar characteristics. The software outfit has only recentlyseen its profit levels climb back to 2001 levels, but EPS g r owth over the nex tthree years is forecast to be near 30 per cent. Again, a large pile of net cashand a reasonable prospective PE ratio of just over 13 makes its shares highlyappealing. Be warned, though: it is a tiny company with a market capita l i s at i o nof just over £20m, and that forecast is based on just one house broke r.

VP is arguably a better bet than Ti k i t, because of its size – five brokers cove rthe £90m equipment specialist, all of whom rate it either a buy or an add. ItsE P S g r owth is less spectacular and, in the past few years, it has struggled tokeep its profits moving ahead – last year they rose by just 6.55 per cent. Butc a s h f l ow per share has clearly been moving in the right direction and thedividend yield – at 3.5 per cent next year – is beginning to look ve ry appealing.

Jim Slater: the shares


One drawback to the price-earnings (PE) ratio as ayardstick for valuing shares is that you may not be able toset much store on the earnings per share (EPS) figure. Andeven supposing that you can, the PE ratio is one-dimensional. It tells you nothing about the company'sg r owth prospects. So the price-e a r n i n g s-t o- g r owth (PEG )f a c t o r, devised by investment guru Jim Slat e r, attempts tofind a simple way around this.

The PEG ratio is calculated by dividing a company’s price-earnings (PE) ratio by its expected rate of future EPSg r owth. This is easy to work out. For example, if we ass u m eCompany X is trading on a current PE ratio of 20, and itsprojected EPS g r owth for next year is 40 per cent, its PEGratio is as follow s :

= current PE ratio / future EPS growth rate = 20/40 = 0. 5

G r owth stock investors tend to like companies with a PEGratio no higher than 1 – and preferably below 1, or ideallyb e l ow 0.5. In my experience, though, anything much below0.1 should be treated with some caution. There has to be astrong possibility that it’s a false value generated by faultye s t i m ates.

I t’s also wo rth pointing out some other cave ats with theP EG measure. The big one is that it relies on estimates offuture growth – usually based on an ave rage of analys t s’e s t i m ates called a ‘c o n s e n s u s’ – and these are hugelys p e c u l at i ve. And many – if not most – of these estimat e sare usually wrong by at least 10 or 20 per cent. In genera l ,

the smaller the number of analysts covering the company,the greater the chance a big mista ke .

Another problem with the PEG is that it can changesharply from one day to the nex t, when a company report sits results. One solution to this is to use some form ofmoving ave rage for both the PE ratio and EPS g r ow t hnumbers, to smooth out the va r i ations between historic andp r o s p e c t i ve figures. In this way, you give more weight top r o s p e c t i ve figures the closer a company gets to itsfinancial ye a r-end. This also makes it possible compare theP EG ratios of companies that have different ye a r-e n d s .Statistical services, like Jim Slat e r’s Company REFs, do thissmoothing for you. You can also screen for stocks using theP EG ratio using the Investors Chronicle St o c k-Sc r e e n i n gtool, at w w w . i n v e s t o r s c h r o n i c l e . c o . u k / s c r e e n e r.

The PEG ratio tends to work best with growth companies –those that are steadily growing over the long term. PEG stend to break down in the highly vo l atile world of thec yclical stock (there’s not much consistency there), and arenot of much use to analyse recove ry situations or ass e t- r i c hcompanies with poor trading prospects.

Still, even with all these cave ats, the PEG is still a greatmeasure of value for fast- g r owing companies. Put simply,the PEG ratio lets you do a simple check on whether a shareis wo rth further inve s t i gation. It simply looks at thep r o s p e c t i ve PE ratio and compares it with the expected EPSg r owth – questioning whether a company’s growth is beingreasonably priced. For example, the PEG ratio willi m m e d i ately alert you if yo u ’re being asked to pay 20 timesearnings for a company that analysts expect will only growat 5 per cent a year during the next two years.

n Exclude any companies with directorsselling shares in big clusters, or largesingle sales by a director.

Our last step is the most detailed. We’relooking at three key measures that willrequire you to conduct a bit of duediligence of the company’s fundamentals.The main thing we’re looking for is someevidence of increasing earnings growth.So, in this step, we check that the currentEPS growth rate is higher than it wasthree years ago – ie, earnings growth isaccelerating. If this is the case, award onepoint. If there’s evidence of persistentbuying of shares by the directors, award

another point. Last, but by no meansleast, if the share price relative strengthhas been positive in the past threemonths ,add another – and one morepoint if the RS measure if positive in thepast 12 months, as well. To make thegrade, companies should really score atleast two points in this final screen.Step three – the screening criteria: Look for at least two of the followingn Current EPS growth rate above three-year EPS growth rate n Directors buying sharesn RS positive in the past six months andthree monthsn RS positive in the past month.

£30m and below £250mn Price-to-sales ratio (PSR) below 10n Dividend yield at very least positive (iecompany pays out a dividend).

The next step is to exclude anycompanies where the directors have beenaggressively selling large chunks of stock.Slater, like many investment gurus,regards this as a terribly bad sign for thefuture. This means excluding any shareswhere there’s either persistent selling(more than two big sales in the past fewmonths) or very large-scale selling ofstock (£100k or more). Step two – the screening criteria:

Measure of the month: the PEG ratio


I bet very few of you have heard of JohnMulligan and his STAR system. But whathe has quietly developedis a hugely eff e c t i v esystem of stockselection. It concentrateson finding re a s o n a b l ypriced stocks whereanalysts’ estimates off u t u re earnings gro w t hby analysts has beenconsistently rising.

Principles behind the stock screenIn other words, he’s simply looking for“consensus acceleration”, on the basisthat the share prices of big companiesrespond in a predictable way to steadyincreases in analysts’ consensus estimatesfor earnings growth. His strategy is tofocus on FTSE 350 companies, buy theshares of all the companies that meetthese estimate-based criteria, and then sitback and watch the share prices increase.

It’s certainly an attractive system, as ittargets large, fast-growing, reliable, well-researched companies with a reasonableshare price. But because it is based onmarket sentiment towards future earnings

growth, it can be volatile. You are tryingto capture something that is, by its

nature, quite short-term and fleeting, so itmakes little sense touse this strategy tobuild a buy-and-holdportfolio. Perhaps abetter way of applyingit, then, is to run itevery quarter, buy allthe shortlisted stockswithout exception,

and then sell them one year later.Even so, when John Mulligan back-

tested his original STAR system all theway to 1986, he found that it out-performed the FTSE All-Share index 13

S c re e n St y l e Total re t u r n Annual re t u r n How many times it Risk fa c t o r

( % ) ( % ) b e at the FTSE 100P i o t r o s k i Value / Small-c a p 1 4 1 2 1 .7 7. 8 L owG raham Defensive Va l u e 1 1 2 1 7. 3 6 . 1 9 L ow to mediumPr i c e-t o-s a l e s Value / Larg e-c a p 9 4 1 4 . 5 5 . 1 9 L ow to mediumTweedy Brow n e Va l u e 8 9. 5 1 3 . 8 4 . 93 L owG raham Enterprising Value / SmallcCap 8 9 1 3 .7 4 . 9 L ow to mediumROCE Best of both wo r l d s 7 8 1 2 4 . 3 L owPr i c e-t o-ta n g i b l e- Deep va l u e 6 7. 1 1 0. 3 3 .7 Me d i u mb o o k-value (PTBV)

Notes: To tal return is with all dividends reinvested. Pe rformance measured from 1 Fe b r u a ry 1998 to 31 August 2004

A screen for fa s t- g rowing FTSE 350 stocks:

The STA Rs ys t e m

times in the past 17 years – turning£1,000 invested at the end of 1985 into£17,620 (before costs) by the end of2003. That’s compared with an increasefrom £1,000 to just £2,660 if the moneyhad simply tracked the FTSE All-Share.So, in aggregate, his STAR sharesproduced average returns seven timesgreater than the market. That’s why wethink his system is hugely interesting –and why, for this issue, we’ve asked himto explain his methods and identify themost promising shares. Over to John...

The stock-screening crieria “I decided, in the late 1980s, that Ineeded to develop a structured approachto share selection and portfoliomanagement. The aim was to see if therewas any correlation between the expectedgrowth in a company's earnings and itssubsequent share price.

“The estimated earnings data forseveral hundred larger-cap companies, asproduced by a number of leadinganalysts, was then tabulated on amonthly basis, over a 10-year period. Allthe shares covered were then ranked

Our stock-screeningstudy: the results

STYLE:

DIFFICULTY:

STOCKS TO BE SCREENED:

RISK LEVEL:

SUITABLE FOR:Growth investors who prefer to hold shares in larger, well-researched companies in the medium term

JOHN MULLIGAN

H AS DEVELOPED

A HUGELY

E F F EC T I V E

SYST E M


S e c t o r Co m p a n y Price (p) Yield % G e a r i n g R a n k i n gS u p p o rt serv i c e s Ashtead 1 5 1 0.0 3 8 0 2Chemicals Scapa 2 0 0. 5 3 8 7I n s u rance Ro yal & Sun Alliance 1 0 1 4 . 6 n / a 9E n g i n e e r i n g C h a rter 4 0 0 0.0 8 8 1 0M i n i n g Rio Tinto 2 1 9 2 1 . 9 3 0 1 1Food producers R H M 2 6 3 6 .0 n i l 1 3M i n i n g Xs t rata 1 2 8 0 1 .0 1 8 1 7Life ass u rance Prudential 4 8 8 3 . 2 n / a 3 0Life ass u rance L e gal & General 1 0 9 4 . 6 n / a 3 3E l e c t r o n i c s XP Powe r 3 4 5 4 . 1 4 3 3 4

As at 31 October 2005. See below for a full analysis of all these shares

Shares identified bythe STAR

screen

Ashtead and Royal & Sun Alliance are of particular notein this list. As you’d expect, this STAR system tends tofocus on recovery stocks and on sectors that are out offavour with investors. And both of these companies lookto be recovery stocks that have benefited from recentincreases in forecast earnings in the coming two years.

XP Power and the recently-listed RHM are somewhatmore doubtful selections, as their consensus earningsestimates have been lowered marginally over the pastcouple of months. At the moment, XP Power remains abuy as the estimate changes have been too small totrigger any negative action. RHM, though, as a newly-listed company, creates a problem: it is still a little early todetect the trend in earnings estimates, and it can alsotake a little time for the impact of negative tradingannouncements to filter through to the consensusestimates from which the earnings forecasts are derived.

Charter, the engineering group, has been a past STARwinner as it was first selected as a growth share inSeptember 2003 at 75p.

Prudential and Legal & General from the out-of-favourlife assurance sector are also interesting selections. Thisdemonstrates the ability of the STAR approach tohighlight sectors, as well as shares that are currentlyunpopular.

Scapa Group is in some ways too small to be within theSTAR universe. It was originally included when it was amuch larger company, but it has been retained as it nowappears to be on a recovery tack.

John Mulligan 01452 770144 e-mail: [email protected]

http://www.companynews.co.uk/star/index.htm

The STAR system: the shares

together with the latest mid-market shareprices. The 300 constituent shares thata re regularly covered are then rankeda c c o rding to their expected earn i n g sg rowth rates, and further selection is fro mthose shares within the lowest quart i l ebased on their future price-earnings ratio.

“A number of other screens and filtersare also applied to eliminate companieswhose future earnings have been reducedsignificantly over the past few months,and to ensure there is not undue over-weighting in specific industry sectors.

“More specifically, the monthly STARrating list is generated by entering on aspreadsheet the latest per share datacovering price, as well as actual and

forecast earnings and dividends for eachof the shares covered by the methods.

“Once the data is entered and fullytested, share screening and selection isachieved by first sorting the whole fieldaccording to price-earnings values, andthen sorting according to expectedearnings growth over the next twofinancial periods.

“The final ranking list is comprised ofthose companies that have the highestexpected earnings growth rates and arealso within the cheapest quartile in termsof valuation. In terms of portfoliomanagement, additional sector filters areapplied to ensure that there is not toomuch over-weighting in any one sector.”

using 9 different equations. Thesecovered key variables such as expectedfuture earnings growth rates, currentshare valuations, dividend yields, sectorweightings, and step changes to expectedprofits and earnings growth. The bestresults were achieved from a broadly-based selection of shares that combined: n above average projected earnings, with n below average current valuations.”

John Mulligan’s version of aSTAR stock screen“Essentially, the STAR procedureinvolves the monthly collation of theconsensus earnings estimates from mostof the leading UK equity analysts,


A question that readers of this newsletter,and of Investors Chronicle, commonlyask is: how long should we hold theshares you recommend? In the case of thenewsletter, our answer is that, generally,we make therecommendations on thepremise of buy-and-holdinvesting – for at least ayear or so and, in somecases, for a term of fiveor more years (the STARsystem can be shorterterm, though). However,companies and theirfundamentals do change,so we re-run our stock-screens every twomonths to see if weshould reconsider any of our holdings.Here are the findings of our latest review.

Shares from our July 2005stock-screens Our core portfolio of five value stocksbased on the Piotroski stock-screen that

we ran in July 2005 has slightlyunderperformed its benchmark index, theFTSE All-Share. It has had one hugeshort term success to date: businesscentre developer Basepoint has accepted

a takeover offer, givingus an immediate 29 percent profit. But ourbiggest failure to datehas been nightclub andrestaurants operatorLuminar: down 16 percent so far – although,in our defence, wewould point out thatwhen we recommendedit, we did say it was themost ‘marginal’ share inour screen, and the

share with the highest risk. Still, we’llstick with it as a core buy especially asLuminar tends to top most analysts’probable takeover candidates for 2006.

Then, when we ran the Piotroskiscreen again in September 2005, weadded footwear retailer Stylo to our list

P i o t roski, Pr i c e-t o-Sales & Zweig screens:

U p d ates on our-s t o c k-s c re e n s

O U R

C O M B I N ATION OF

FOUR CLASS I C

G R OWT H

SCREENS HAS

P E R FO R M E D

A D M I R A B LY

of holdings. Again, though, it hasn’t beena great performer of late: it has sincefallen by more than 10 per cent afterrecent, poorly received results. In fact,those results were nothing short ofhorrible, and we note with particularconcern that in recent months Stylo hassuddenly started bleeding cash at theoperating level. This massive turnaroundin fortunes – far worse than we expected– is hugely worrying, so we recommendcutting your losses and selling Stylostraight away before the company’sfinancial position worsens.

Our Price-to-Sales-Ratio (PSR) stock-screen, also first run in July 2005,identified only the integrated utilitycompany Centrica as a share to buy. Butthis single holding has performedrespectably to date, moving up just under5 per cent. And we’re still enthusiasticabout Centrica in the long term, rating ita strong buy. There were no more sharesidentified by the PSR screen inSeptember, but this month it hassuggested a new holding: Bellway, thebuilding firm. It’s our top stock for thisissue – see page 11 for more details.

Our final stock-screen from July 2005– the ‘Master-Growth’ screen, combiningfour classic growth screens – hasperformed admirably, too. The six sharesit identified then are now up 1.35 percent on average.

Our favourite of these, and our topstock of the July 2005 issue, is the

S h a re St o c k-s c re e n Price recommended Price at Change (%)13 July 2005 (p) 31 October 2005 (p)

Vo d a f o n e P i o t r o s k i 1 4 3 1 4 3 . 5 0. 3L u m i n a r P i o t r o s k i 5 6 1 47 0 - 1 6 . 2B a s e p o i n t P i o t r o s k i 1 4 2 1 8 2 . 5 2 8 . 5St y l o P i o t r o s k i 6 9 6 1 . 5 - 1 0. 9JS Real Es tat e P i o t r o s k i 4 5 0 4 47. 5 -0. 6Ce n t r i c a Price to sales 2 24 2 3 5 4 . 9MP Eva n s Master Grow t h 2 0 1 . 5 2 1 0. 5 4 . 5C a rter & Cart e r Master Grow t h 3 4 9 3 8 0 8 . 9M T L Master Grow t h 3 6 2 3 77. 5 4 . 3AV E VA Master Grow t h 8 0 7. 5 8 2 8 . 5 2 . 6E n t e rtainment Ri g h t s Master Grow t h 3 2 2 6 .7 5 - 1 6 . 4P i p ex Master Grow t h 8 . 8 7 9. 2 5 4 . 3F TSE All Share index 0. 5 0

Update on our July 2005

stock-screens

the stock-screen and re-examined thefundamentals, we don’t think theinvestment case has changed enough towarrant a sell. If anything, we thinkshares in Home Entertainment lookstupidly cheap at these levels – making iteven more likely that its management willtake it private, as the take-out price looksto be falling all the time.

For safety only, we suggest operating a35 per cent stop-loss on both ourdisappointing Master-Income screenstocks. So sell Home Entertainment if theshares go below 90p, and sell Sirdar ifthe shares fall below 40p.

As for our Ben Graham Defensives c reen, it seems to have been anything but– registering the worst perf o rmance todate. It identified two housebuildingcompanies – We s t b u ry and Georg eWimpey – both of which have beena ffected by negative sentiment. Buttakeover activity is now lifting the sector –and, as we go to press, We s t b u ry hasreceived an approach from Persimmon(see right). It’s ru m o u red to be a cash off e rof 560p a share, so we’ll sit tight.

Stock-screen performance summary:n Martin Zweig -1.3%n Graham Defensive -6.6%n Master Income -4.8%n FTSE All-Share index -1.9%.

identified in this issue by our Jim SlaterGARP screen (see page 4). Our twocommodity stocks, Vedanta and BHPBilliton, also look very cheap to us –especially Verdanta – so we continue torate both a buy, as well.

Our Master-Income stock-screen hasfared less well. On average, the 11 sharesit identified have fallen by 4.8 per cent –but this is slightly annoying because mostof that is due to the recent travails of justtwo of the companies: Sirdar and HomeEntertainment Group, which are bothdown by more than 20 per cent.

But, looking at their fundamentals,nothing has changed in either case thatwould make us a seller of these shares. Infact, recent results from Sirdar wereactually hugely impressive. We realisethat’s little consolation to investors whohave already had to put up with biglosses, but Sirdar now looks impossiblycheap, with a huge dividend yield ofmore than 6.5 per cent.

It was also from the Master-Incomescreen that we selected our top stock forthe September issue: HomeEntertainment Corporation. And wecan’t possibly deny that its performanceis the intervening months has beenanything other than terrible: down by 24 per cent. Again, though, having re-run


broadband internet service providerPipex, which has risen 4.3 per cent – andin recent days has seen its share priceshoot up above 9p, fuelled by talk of awave of merger and acquisitions activityin the broadband sector. We still ratePipex a very strong buy.

Even media company EntertainmentRights – the only one of the six sharesidentified to have substantially under-performed to date – is still worthholding. In fact, we still rate all the othershares from the Master-Growth screen asa strong buy.

Stock-screen performance summary:n Piotroski + 0.2%n Price-to-Sales Ratio + 4.9%n Master Growth + 1.35%n FTSE All-Share index + 0.50%

Shares from our September2005 stock-screens Of the stock-screens we first ran inSeptember 2005, we’re most pleased withthe Martin Zweig results. Overall, thethree shares that this screen identified aredown 1.3 per cent to date, but that’s overa period when the FTSE All-Share indexhas fallen by 1.9 per cent. Of those three,broadband play PlusNet remains a verystrong buy – a recommendationreinforced by the fact that it’s also

S h a re St o c k-s c re e n Price recommended Price at Change (%)1 September 2005 (p) 31 October 2005 (p)

Ve d a n ta Re s o u r c e s Ma rtin Zwe i g 5 6 6 5 5 0 -2 . 8P l u s Ne t Ma rtin Zwe i g 2 6 8 2 6 3 - 1 . 9BHP Billiton Ma rtin Zwe i g 8 0 7 8 1 3 . 5 0. 8Wimpey (G e o rg e ) G raham Defensive 4 2 6 3 95 . 5 -7. 2We s t b u ry G raham Defensive 4 5 1 4 24 -6 .0

Master income screensWa g o n Higher Risk Smaller Cap 1 7 8 1 7 0. 5 -4 . 2S i r d a r Higher Risk Smaller Cap 4 1 . 5 2 9. 5 -2 8 . 9ScS Upholstery Higher Risk Smaller Cap 3 2 8 3 6 1 . 5 1 0. 2Home Entertainment Higher Risk Smaller Cap 1 2 9 9 7. 5 -24 . 4Flying Bra n d s Higher Risk Smaller Cap 1 79 1 8 2 . 5 2 .0Games Workshop Income Larger Cap 3 83 3 8 8 . 5 1 . 4Go Ahead Income Larger Cap 1 3 0 0 1 3 72 5 . 5Ho l i d ay b r e a k Income Larger Cap 5 93 6 2 8 5 . 9Pe r s i m m o n We i ss Income screen 8 0 0 83 0 3 . 8Bovis Ho m e s We i ss Income screen 6 5 7 5 9 8 -9.0F TSE All Share index - 1.9

Update on our September 2005

stock-screens


Bellway isn’t one of the stocks identified by this issue’sfeatured screens. But it found its way into this newsletter,and announced itself as our top stock, when we re-ran ourhugely-successful Price-to-Sales-Ratio (PSR) screen. Thisscreen aims to find companies with copious quantities ofturnover, decent dividend yields and sound financials –trading at bargain prices. When we first ran it, in July2005, only one share passed the test: utilities playCentrica. Now, though, housebuilder Bellway hasconstructed a strong case for inclusion.

Of course, given how poorly our existing housebuildershave performed, having been identified by the Ben GrahamDefensive screen, you might think we’d want to avoid thewhole sector. But far from it – we think we’re no more thana year away from the bottom of the current house-pricecycle, and strongly believe that now is the right time to buycheap, well-run builders.

Our reasoning is simple. The housing market has hadplenty of opportunity to crash, yet it hasn’t. House pricesare slowly falling by a very small margin – but it’sincreasingly clear that, in the core Southern propertymarkets, prices are NOT going to collapse. There willcertainly be pressure on builder’s profit margins, but wethink this will actually spark another wave of consolidation– and Bellway’s shares look cheap.

Investors Chronicle’s companies editor, SimonThompson, reached a similar conclusion just a few weeksago. He pointed out that the best housebuilders are stillchurning out stellar and sustainable profits. And, despitethe boom in share prices since 2000 (which has mirroredthe earnings growth), most companies in the sector arestill only rated on half the earnings multiple of the FTSEAll-Share index.

He also noted the positive impact of the changes inpension rules that come into effect in April 2006 when, forthe first time, residential property will be allowed to be heldin self-invested personal pensions (Sipps). So for the750,000 or so higher-rate taxpayers in the UK, theattractions of recycling the 40 per cent tax relief onpension contributions into investment property should becompelling. A similar boost will come from the bonuseslikely to be paid to City workers at the end of the year – asresidential property tends to be the main beneficiary of thisCity wealth.

Bellway may even be helped by one of its rivals. It is nowlikely that the country’s largest housebuilder, Persimmon,will join the FTSE 100 index at the next quarterly review inDecember. If it does, tracker funds will be forced to buy theshares, pushing the price up. This could lead to a re-ratingof other housebuilders’ shares – and, even if a re-rating

doesn’t happen, Persimmon’s rumoured bid for smaller rivalWestbury is likely to spark further activity in the sector.

But even without all these factors, Bellway looks in goodshape. It has just reported its 14th successive year ofgrowth despite the challenging conditions. Margins weremaintained at a record 19.5 per cent and turnover wasboosted by strong forward selling. Units sold rose from6,601 to 7,001 during the period, at an average selling priceof £163,800 (from £161,400 last year), and the land bankof plots with planning permission rose from 20,700 to22,500. Reservations in the first two months of the currentfinancial year were up by 4 per cent. This helped to offsetcost inflation arising from labour costs and the increaseduse of sales incentives.

Admittedly, forward sales at the year-end were downfrom a year earlier, and margins may now slip a little, too.In fact, sales for this year are likely to increase onlymarginally – further outlets are being opened, but most willnot come on stream until the year-end. So analysts nowexpect 2006 earnings to be flattish at £218m.

That said, pressure on costs is likely to ease, though, asmore skilled labour comes in from Eastern Europe, andBellway’s 25 per cent usage rate for timber constructionhelps to hold down materials costs. So, for 2007, analystsexpect earnings to move up to £228m. Of course, thisgrowth rate looks fairly pedestrian compared with the past,but it’s far from a disaster.

Turning to the company’s fundamentals, Bellway’sshares are expected to yield close to 4.12 per cent nextyear (more than you’ll get from most savings accounts onthe high street), and they trade on a forward PE ratio ofjust 6.2 times. They’re also backed by book assets of justunder £800m, against a market capitalisation of just under£1bn. Cash flow is strong, too. Last year, Bellway churnedout cash at the operating level of just under £230m, all ofwhich it spent on building up its huge land bank. So aprivate-equity predator could buy the company for £1bn,and repay everything within just five years based on thiskind of cash flow.

We think it’s interesting that of the 12 brokers’ notes thatfollowed the October results, at least eight rated Bellway abuy or an overweight. It suggests that, amongst buildinganalysts, Bellway is regarded as the cheapest share in asector which is also cheap by every historic standard. Andit’s getting cheaper by the month as the supposed housingcrash recedes.n Forward dividend yield: 4.12 per centn Risk level: Low to mediumn Suitable for: Cautious investors who want decentgrowth prospects with a cheap share price.

Our top stock: Bellway

The Investors Chronicle Stock-Screening Newsletter is published bi-monthly, at thebeginning of January, March, May, July, September and November. To subscribe,you simply need to telephone 0870 240 6663 or visit w w w. i n v e s t o r s c h ro n i c l e . c o . u kand give your details. You can then choose to receive the newsletter as a PDF fileor a text file sent via e-mail, or as a 12-page printed document sent by post.

I n vestors Chronicle magazine and this newsletterare published by FT Business Ltd, Ta b e r n a c l eCo u rt, 16-24 Tabernacle St r e e t, London EC 2 A4 D D. © Financial Times Business 2005 .I n vestors Chronicle is a trademark of Fi n a n c i a lTimes Business Limited 2005 “Financial Ti m e s”and “FT” are registered trademarks and serv i c emarks of the Financial Times Ltd. All rightsr e s e rved. No part of this publication may be repro-duced or used in any form of adve rtising withoutprior permission in writing from the editor.Registered office: Number One, So u t h wark Bridge,London SE1 9HL. ISSN 0261-3115 Material (includ-ing tips) contained in this magazine is for genera li n f o r m ation only and is not intended to be reliedupon by individual readers in making (or refra i n i n gfrom making) any specific investment decision.A p p r o p r i ate independent advice should beo b tained before making any such decisions.Financial Times Business Limited does not acceptany liability for any loss suffered by any reader asa result of any such decision.


In previous issues of this newsletter,we’ve mentioned some of the computersoftware and data that can you canbuy to automate your stock-screening.

But, as of this month, InvestorsChronicle readers don’t have to. That’sbecause we’ve just enhanced the stock-screening tool on our website, to allowyou to carry out detailed screens – likethose described in this newsletter.

Using this new online tool, you cannow screen UK shares based on all thekey financial ratios (including P&L,balance sheet and cash flow ratios), aswell as on price performance, and onbrokers’ forecasts.

So, for example, if you wanted toscreen out shares in companies that

have weak balance sheets, poorearnings, and below-average share-price performance, you can now do it inone go. You simply type in yourminimum requirement for each of thesemeasures, in the relevant boxes on theweb page, and click on ‘Find stocks’ toget a list of the shares that match up.

You can repeat this process as manytimes as you like, until you have ashortlist of interesting shares. Then, allyou have to do is a bit of research intothe companies listed – which you cando on the website, just by clicking ontheir names – and make a finalselection. To start using the stock-screening tool, go to:www.investorschronicle.co.uk/screener.

You can select the index or sector fromwhich you want to screen stocks usingthe drop-down menus (or leave themenus displaying ‘Any’ to screen all UKstocks). You can then type in price-performance criteria over a range oftime periods. And you can type in thegrowth rates, ratios and forecasts thatare acceptable to you (growth is nowmeasured as the annual growth in eachyear of the period you specify, not thetotal over the period – so you can carryout screens from this newsletter!).Select how you want the stocks listed,and that’s it: you’re stock-screening!

I n vestors Chro n i c l e ’s tips and tricks:

S c reening on our we b s i t e

IN THE NEXT ISSUE… Goldman Sachs spills thebeans on picking shares

Motley Fool goes in searchof sexy small-caps

We give you the inside tra c kon using Io n i c’s ShareSc o p es o f t ware to do your s t o c k-s c r e e n i n g

P LUS updates on all ours t o c k-screens to date –including Piotroski, Pr i c e-t o-Sales Ratio, Ben Gra h a m ,Ma rtin Zweig and Ma s t e rG r owth & Income

How to subscribe

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