Thornton uses formula to put some momentum into shares

A new fund will tap the FT-SE Small Capital Index, reports Clifford German

There is nothing like a formula for deciding an investment strategy, especially if it works and outperforms the average. So Thornton Investment Management, the Dresdner Bank's London investment arm, is launching Momentum Investment Trust, which will buy the shares of the smaller UK companies which City analysts predict are about to increase their earnings fastest in the next 12 months.

It is a simple theory, based on two assumptions. One, that analysts are generally right about the companies they study and pick up improving profit trends ahead of the market. And two, that among small companies there will be a time-lag before forecasts get into wider circulation and are priced fully into the shares.

Using data collected by IBES, which records the quarterly profit forecasts of all analysts covering companies in the FT-SE Small Capital index, the investment managers exclude all loss-making companies before classifying the remaining shares according to whether analysts on average have upgraded or downgraded their forecasts or left them unchanged. The upgrades are then split into upper and lower divisions, the top upgrades being eligible for investment. About 100 companies are selected each quarter.

The managers buy the shares and hold them for at least 12 months, although a quarter of the portfolio is reviewed every three months. Those shares which still meet the criteria are kept, the rest are sold. Turnover is inevitably high, with 80 per cent of the stock churned each year.

The technique has been tested back to 1988, however, and forecasts have successfully identified the shares which have performed best in the following 12 months.

If the fund had been operating throughout, it would have produced an annual compound growth of 12.9 per cent net of expenses, compared with 4.2 per cent from the FT-SE Small Cap index as a whole. Outperformance has been greatest since 1992 when the cycle began to favour small companies. Even at the low point of the market, 26 companies were eligible for investment and the portfolio would now contain almost 400 stocks.

Thornton is now raising up to pounds 30 million through an institutional placing, now closed, and a public offer which closes on 19 August. The sponsors are Greig Middleton. The trust is expected to have a life of 10 years, the launch costs are capped at 4 per cent and the management fee will be 1 per cent a year. The portfolio cannot be guaranteed to rise, but if the future is any guide to the past it should outperform index tracker funds over a complete business cycle.