Shares: Riding back into favour: Form suggests blue-chip selection should do well

AN INVESTMENT strategy that can generate substantial long-term rewards is to buy shares in leading growth stocks when they are out of favour. The basic logic is simple - they always come back into favour at some point in the future.

Now seems a favourable time to buy. The UK stock market has suffered a significant reaction since its peak in February, because of the dramatic collapse in bond prices triggered by rising US short- term interest rates.

But shares and bonds both climbed after the latest rise in US short-term rates, suggesting that the weakness in capital markets may have run its course. When share prices stop falling they rarely stand still - more often they climb.

This seems particularly likely in the UK, given the healthy state of the economy. There are signs that we are enjoying a low- inflation, relatively low-key boom, with company profits leading the advance. Any strategy that involves buying out-of-favour shares should concentrate on leading blue- chip stocks and build in further protection by buying into a spread of companies. Such companies are almost impregnable from assets accumulated over decades and strategic market positions.

Usually the worst that can happen is that they stay out of favour for longer than expected. A decent spread (say 10 shares) makes it likely that enough will recover from their real or perceived difficulties to make the portfolio profitable. If most, or all, rebound and start moving to new all-time peaks, the portfolio can deliver dramatic capital gains and growing income.

Supermarket shares have been hit by price wars and the absence of food-price inflation; pharmaceuticals have suffered from government efforts to control healthcare costs and competition from cheap generic drugs.

A key point about the 10 shares I have selected for my portfolio is that they are all growth stocks - or, at least, have delivered remarkable growth in the past. The 10 are BAT Industries at 447p, Bowater at 484p, GEC at 312p, Inchcape at 480p, Kwiksave at 643p, Legal & General at 473p, Lloyds Bank at 559p, SmithKline Beecham at 459p, Unilever at 1,169p and Guinness at 503p.

Kwiksave, for example, the ubiquitous discount grocery chain now expanding in south- east England and Scotland, has been a top performer of the past 20 years, in terms of both profits and share price.

One technique I find helpful is to look at the share price against a 525-day moving average. The simple rule is that the shares are a buy whenever the price drops below this long- term moving average. Since the company was floated in 1970, Kwiksave shares have dropped below this average on six occasions, including the present decline.

Purchases on each of the previous five occasions would all have been profitable - although recovery took a few months and the position deteriorated before improving on some occasions. My hunch is that recovery could be quick this time, with the whole sector showing signs of coming back into favour.

On a very long-term view, all the companies I chosen have been sensational performers with shares and profits going up many-fold - despite being giant concerns by the standards of the day 20 years ago.

Further evidence of current investor disenchantment comes from looking at latest share ratings. Based on consensus forecasts for 1995 earnings, the p/e on the 10 stocks ranges from under nine in the case of Lloyds to just over 14 for Guinness and Legal & General. Prospective dividend yields for 1995 range from an expected 3.2 per cent for Unilever to 6.8 per cent for BAT, which tends to be under a permanent cloud because of investor distaste for a group that makes most of its money selling cigarettes.

In every case, reasons can be produced for the weakness of the shares. Inchcape, for instance, has a huge exposure to Toyota sales worldwide, which are being hit by the strong yen.

The logic for buying is that these worries will not last for ever and are largely discounted by the share price weakness that has driven the shares below their 525-day average.

If the overall stock market is heading for a strong rally, buyers may not even have to be patient.

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