The Investment column: Alternative routes to the investor's holy grail

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The Independent Online
In recent years there has been a flurry of attempts to systematise stock selection by using a series of purely financial sieves to reduce a large universe of shares to a manageable, and hopefully outperforming, portfolio. It is the investment equivalent of the search for the holy grail - stock market success with a minimum of knowledge or effort.

The criteria used have varied considerably but all have been made possible by the enormously improved power of computers which has allowed the sort of wide-ranging probing of company databases that investors could only dream of until recently.

An important assumption these systems tend to share is the belief that finding stocks that will outperform their wider markets can be done using essentially mechanical means and rigid statistical criteria. Not surprisingly this approach to investment has been greeted with scepticism by the professional investment community, the livelihood of which depends on the opposite assumption - that investment is an art, not a science, and as such dependent on the experts found in just that professional investment community.

Jim Slater, one of the greatest systematisers, says he is constantly amazed by the unwillingness of fund managers to accept his basic investment premise that the biggest potential gains are likely to be found in shares trading on low price/earnings ratios relative to their forecast growth rates (low PEGs to use the jargon), which also enjoy strong cash flow and have already started to outperform the rest of the market.

He finds those shares using computerised trawls through a massive database of corporate data, a technique that many subscribers to Hemmington Scott's Really Essential Financial Statistics (devised by Mr Slater) are also adopting.

He says he asks sceptical investors the reverse question - why should these sort of shares not outperform - and rarely gets an answer. He is the first to admit that the number-crunching is only the first step and no replacement for experience and an element of subjective appraisal, and it does seem curious that his attempts to be rigorously analytical should be treated with such wariness by supposedly rigorous analysts.

A research note issued this week by UBS, the Swiss investment bank, underlined the divide, dismissing many of Mr Slater's claims on its way to coming up with a portfolio of six long-term investment tips. It concludes with four investment "rules": there is no easy system for valuing growth stocks; the PEG ratio is no better or worse than other valuation methods; past earnings growth is no sure indication of future growth and choosing stocks on the basis of highest forecast growth does not generate above average returns. Finally it advises investors to pick growth stocks on the basis of their "qualitative" characteristics and their impact on earnings momentum.

As such of course, the note is little more than an apology for expensive stockbrokers' research departments. But what is really interesting is that the 12 "qualitative" criteria UBS proposes are remarkably similar to the subjective criteria Mr Slater uses in conjunction with his financial sieves in his latest book, Beyond the Zulu Principle. The only difference is that he uses the numbers to find companies that satisfy the criteria while UBS suggests using the criteria to find companies that cut the mustard financially. The two approaches look increasingly like flip-sides of the same coin.

The criteria are really only common sense, but no less valuable for that. Invest in companies, they suggest, operating in growing markets such as information technology, the media or pharmaceuticals, with growing market share, protected by high barriers to entry and with little pricing pressure thanks to positions in fragmented industries, producing branded goods or crucial services.

Other sensible criteria include a management with a clear business strategy, an ability to market a good product effectively, a new product pipeline and the potential to replicate success at home in overseas markets. This is especially important in the Mid-250 index from which the companies in the table were chosen by UBS because companies of this size (between about pounds 400m and pounds 2bn) are often approaching saturation in the UK and need to move overseas to continue growing.

Only after these criteria have been satisfied does UBS look at financial criteria - low earnings volatility, a defensiveness in economic downturns, growing or stable margins and transparent accounting.

There is no space to discuss each of the six in detail here, but all of the companies merit further attention. Although they are very different, ranging from Bowthorpe's steady electronics and electrical businesses to CMG's high-tech systems integration, from Compass's low-tech outsourced catering operations to LIG's growing condom and medical gloves business, they all share many of the growth criteria highlighted in the table.

A word of caution, however. Unlike Mr Slater's PEG approach which seeks out overlooked or misunderstood stocks, UBS makes no claim that any of its choices are excessively undervalued. It is looking for long-term investments and for many investors, the price of quality stocks such as these may seem rather rich.

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