Smaller Companies: Saracen looks for winners under the blanket

THE signs are looking good for continued growth in smaller company shares, which last year out-performed large companies for the first time since 1988.

But two big problems face investors: they will find it increasingly difficult to identify this year's winners, and they will face a growing danger of picking hefty losers whose profit performances will not live up to expectations.

A large hope, faith and charity factor is built into many of the rises. Beneath the blanket re-rating are shares that will not deliver the earnings growth that will a main key for sustaining out-performance this year.

Earnings growth is going to be a prime selection criteria for Saracen Value Trust, the investment trust that will soon launch its prospectus to raise pounds 50m to invest in smaller companies.

Jim Fisher, a director of Saracen who used to handle pounds 1bn of funds at Scottish Amicable, said: 'The only thing that happened in 1993 was that the price/earnings base was re- rated - nothing has come from earnings.

'I don't think that small housebuilders and property companies offer good value. They have got to deliver (profits). There will be better buying opportunities later on.'

Saracen's portfolio will exclude investment trusts, and the top 350 companies in the UK. The pounds 50m will probably be spread over no more than 80 companies, with market values ranging between pounds 25m and pounds 275m.

About pounds 15m of the offer will be open to the public, enabling investors to erase many of the risks they face going it alone.

Saracen's model for its selections of its dummy portfolio, which yielded a gross 3.2 per cent and saw a capital gain in excess of 40 per cent, included 42 financial ratios.

'The model initially points to areas for growth stocks. One key ratio is cash flow, and the weighting will remain high.

'Two-thirds of the portfolio will be in growth and asset-backed stocks,' Mr Fisher said.

Saracen is convinced that it is an appropriate time in the economic cycle to invest in the lower reaches of the stock market, because low and relatively stable interest rates should facilitate growth in smaller companies that are more exposed to the domestic economy.

Those beliefs are also held by Hoare Govett, the stockbroker. John Houlihan, a director, has predicted a 20 per cent increase in 1994 for the Hoare Govett Smaller Companies Index, which measures the companies in the bottom tenth of the stock market by value.

Hoare's index stormed ahead by 44 per cent last year, largely relecting the return of investor enthusiasm as prospects for the economy brightened.

And while the Budget tax increases will dent the pace of recovery, they are unlikely to derail it - which looks good for smaller companies.

A pathfinder propsectus for Saracen's offer can be obtained from Charterhouse Tilney. Worth reading.