Cutting losses

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The Independent Online
While I was away fishing for salmon, I had some time for reflective thought about investment.

First, let us look at the backcloth. In early March, I wrote about the case for a continuing bull market. Since then, the market has risen strongly and the outlook remains fair. I will only begin to worry when it looks too good and when unemployment begins to fall in earnest.

Stock selection remains the key, coupled with a rigid policy of running profits and cutting losses. Ingham, recommended in April, is up over 50 per cent. Earnings per share are forecast to grow by 66 per cent this year, so the shares are still on a current multiple of only 11 and remain an attractive core holding.

Amersham International, at 814p, is up 17 per cent and this year's growth in earnings is expected to be well above 40 per cent, putting the shares on a relatively modest prospective price/earnings ratio of about 19. Motor World and Shoprite are also doing well - both up over 17 per cent.

Now let us turn to the less palatable task of cutting losses. I wrote in April about deciding when to sell shares and said that this should be done immediately the story (the reasons for buying a share) changes for the worse.

It is particularly important to remember this rule with any shares that I recommend, because I am precluded from writing about any losses I want to cut for a six-week period both before and after dealing. This means that I cannot write about two shares in the portfolio, so I will dwell on Tepnel Diagnostics, which illustrates the principle.

I recommended Tepnel Diagnostics at 245p as a good share for 'a place in any British biotech portfolio'. Biotech is a high-risk area in which it is essential to have a widely spread portfolio as one big winner often has to make up for a large number of losses.

In July, the Independent reported that Terry Colley, a main founder and also the marketing director, was leaving the company. This announcement was an obvious change in the story. The shares, however, were little moved on the following Monday and Tuesday, and I hope that you noted my warning to sell immediately the story changed for the worse. Even a 15 per cent loss is unpleasant, but it is far better to cut than let it grow.

In my article on deciding when to sell I explained that the most difficult decision is when a share price is weak and there does not appear to be a change in the story. I suggested a 25 per cent automatic stop loss limit, but bearing in mind that I am not always free to mention every share in the portfolio, I think it would be more prudent to adjust this to a 25 per cent trailing stop loss. By this, I mean that you should sell when shares fall 25 per cent below the highest price the shares have been since you bought them.

The main thrust in this column has been to recommend investments in UK growth companies that share a well- above-average earnings growth rate; a low p/e ratio in relation to it; very little debt; strong cash generation and a high return on capital.

You should end up with a portfolio of super growth shares that are increasing earnings per share by 25 per cent to 40 per cent per annum. If the companies can keep on doing their thing for a few years, the share prices should rise at a well- above-average rate and also, in due course, enjoy a status change and consequent substantial increase in multiples.

The main problem is that no company can continue to grow at a high rate forever - 40 per cent per annum compound soon owns Britain. Inevitably, therefore, you will experience some losses as companies falter. However, strict initial investment criteria and a discipline of cutting losses should limit any damage. Meanwhile, the core of your portfolio should outperform the market by a substantial margin.

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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