Therefore, my first set of criteria is of a general, as opposed to an arithmetical, nature.
Above all, look for incoming management with a good provenance. You want to see a heavyweight board joining a lightweight company.
Full details of the incoming entrepreneur (and management team, if any) should be contained in the prospectus and there will usually be plenty of press and newsletter comment to help you make a judgement. You should be looking for evidence of previous positive achievement.
Classic examples in recent years have been Christopher Miller and Philip Turner setting up Wassall, after having been key executives of Hanson; and Alan Bowkett joining Berisford International after building up and selling RHP for a significant profit.
I like to see the incoming management acquiring a sizeable stake in a shell; not just taking options, but buying shares using their own or, if necessary, borrowed money.
The calibre of the sponsoring broker and merchant banker is crucial for future share placings, to finance the acquisitions that you hope will be coming thick and fast.
If a business is being reversed into a shell (for example, Pizza Express into Star Computer), the record of that business and the provenance of its key management is the only way to judge past achievements.
Forget about any shell unless it has a full listing or is on the USM. Inititutions avoid shares without a full quote like the plague and it is almost impossible to deal in any size, especially on bad news.
Now for the arithmetical measures:
Within reason, the smaller the shell the better. It does not matter too much, then, if the priceearnings ratio or premium to asset value is very high.
For example, a shell company quoted at, say, 30 times earnings with a market capitalisation of pounds 6m would have a 'hot-air gap' of only pounds 3m (assuming that a price-earnings ratio of 15 was more appropriate for the business in question).
The hot-air gap might be 100 per cent over real value, but in absolute terms pounds 3m is a small premium to justify for an able, well-backed entrepreneur. One sizeable deal of quality and the gap would be filled.
In contrast, a hot-air gap of pounds 50m in a shell capitalised at pounds 100m is a much more difficult problem. The percentage premium is still 100 per cent, but pounds 50m is a big hole to fill in absolute terms.
All things being equal, I prefer shells with low share prices. As soon as the share price rises over pounds l, the company might begin to lose its shell-like quality.
Investors could then begin to question what the company had achieved so far and how the soaring share price compared with the fundamentals.
This could give rise to substantial profit-taking; to maintain a premium rating, a shell needs to keep travelling and postpone arrival as long as possible.
My preferred range for the initial price of a shell is from 5p to 30p.
These kinds of prices attract those members of the investing public who like penny shares; a little buying in the early stages can work wonders for the share price of a shell.
As shells are riskier than most established companies, I like to make sure that the company's liquidity is reasonable. A shell with heavy borrowings can very easily run into trouble. I look for a strong cash balance or, at the very least, containable borrowings.
Now for my final piece of advice. if you like the idea of investing in shells, you should spread your investments over at least five shares and preferably more.
The risk / reward ratio is high; gains can be mouth-watering, but there are also plenty of failures.
As you know, with all the shares I recommend, I strongly advise running profits. I also advise cutting losses if the story changes for the worse or the shares fall more than 25 per cent from their high since you purchased them.
With shells this is even more important: you do not want to be the kind of unhappy investor who took no action while Clarke Foods fell from 168p to nothing or sold Hanson, just because the shares had doubled, when the company was capitalised at only pounds 5m.
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.Reuse content