The diamonds and the dogs

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The Independent Online

There are thousands of share clubs in Britain which meet regularly to pool and invest cash. For more than two years we have followed the fortunes of the Reservoir Dogs, a group of London friends.

There are thousands of share clubs in Britain which meet regularly to pool and invest cash. For more than two years we have followed the fortunes of the Reservoir Dogs, a group of London friends.

Here's a tip worth remembering: stock markets get it wrong - regularly. They overdo price corrections while ignoring perfectly good companies because such firms don't show up on the analysts' "radar".

Spending time sifting out the genuine dogs from the fallen angels with long-term potential, has served the Reservoir Dogs well already, having generated substantial profits on companies such as Brookes Service Group and Lloyds TSB.

But how can you tell if the market has over-reacted to bad news or troubling rumours? Most share clubs need to do plenty of hard work and detailed analysis. We look for companies whose share price has slumped to a 52-week low, before identifying sectors we either like or hate. We're not desperately keen on building stocks, for example, because the whole sector has bombed. We also steer clear of engineers because too many companies are being hit by the heinous exchange rate.

We then look for other warning signals:

* Very recent profits warnings spook stock markets, especially if the company is in a fast-growing sector. Be honest - if an IT or electronics company can't boost profits in this climate, what chance will it have in a recession?

* A price/earnings ratio that is still above average for the sector is troubling. Marks & Spencer's share price is at a historic low of 200p, for example, but it is still valued at a higher rate than more efficient peers such as Next, French Connection and Kingfisher.

* If the company's directors are selling the shares, this should sound warning bells. Just as troubling is a 52-week low accompanied by absolutely no director buying, if only because directors should display real faith in their company.

Other factors are also worth considering. If the company is producing a strong dividend yield, look at how well the dividend is covered by the profits. Find out what the earnings (profit) per share are, and then divide by the dividends per share. Any ratio below 2, implying a dividend cover of 2, should alert you to the possibility that a sharp downturn in profits could lead toa dividend cut, which could be disastrous for a stock whose share price is supported by investors looking for a yield.

Using this analysis, several companies are worth considering. A highly exceptional stock is ARC International, a small but rapidly growing chipset developer in the mould of the heavyweight ARM.

ARC has only been on the stock market for five weeks. Interesting companies with first-rate technology can get their timing badly wrong. ARC came to the market just as investors started to turn against reliable technology stocks, prompted by continuing fears of a downturn in sales for equipment suppliers to the telephone companies. The timing may be wrong but, like Parthus - a similar stock - a short-term downturn can provide a brilliant buying opportunity.

The other stocks we can subdivide into three categories: interesting but avoid; interesting but watch; interesting and buy now.

Marks & Spencer, at around 200p, sports club group Cannons at 115p and ITNet at 352p, fall into the "interesting but avoid" category. M&S does not represent fair value until it falls below 180p, while Cannons looks good value on the surface but one wonders what's gone wrong with the sports club business. Plenty of chic new centres costing a fortune have appeared across London, which leads us to suspect that there is too much capacity in the short term.

ITNet may be worth a closer look as it appears to hold a lucrative franchise in supplying IT support to local government, but recent bad news from a north London contract spells short-term instability.

On a more optimistic note, British Vita heads our "interesting but watch" category. This specialist chemicals company has been caught in a sector-wide downdraught but scrutinising its reports and accounts reveals a company with solid profits growth. Any price below 160p could be a golden buying opportunity.

We're a little less sure about Vita's two other companions. Kingston Communications was once Hull's great white telecoms hope, the David to BT's Goliath. Except, of course, BT has been felled and the entire sector has dived. The shares debuted at 225p a short while ago, climbing as high as 1,600p, but they're back down to 400p. Kingston is an excellent outfit with some interesting projects; any price below 390p could be an irresistible opportunity.

Spring, an IT recruitment and consulting firm, is in a similar situation. Its share price has tanked from a high of 390p to 90p today, owing to a slowdown in the IT services industry. The firm has been radical in recent months, setting up a generous share options programme for its IT consultants. In the medium term, Spring is in the right sector and probably worth buying into below 75p.

According to our analysis, three heroes represent outstanding value. St Ives, one of Britain's biggest printers, has nearly a decade of solid earnings and sales growth, and a dividend of about 3.92 per cent. It's laughably cheap and is notoriously aggressive when it comes to maintaining market share. Printing is increasingly hi-tech and large-scale; St Ives is the biggest and best.

Nord Anglia isn't quite as obvious a buy but is still an excellent play on government outsourcing. The educational services group has been moving steadily into running educational contracts for local government, an area of business bound to expand. It also boasts a solid pedigree in private-sector learning and education and a growing nursery schools business. Shares have languished around 105p, prompting pretty heavy director buying - a healthy sign.

We also like Asian Technology. No prizes for guessing this investment trust's specialism, and with a share price stuck in the low 30p region you would guess that worries about Asian instability have killed this stock for good.

Far from it: Asia represents the next great frontier for technology. The next two years may be a bit hairy but the five-year to 10-year outlook is staggering. The truth is, very few easily accessible unit or investment trusts specifically invest in this sector. One to tuck away for the long term.

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