Investment: Pointers to robust growth

LAST WEEK, I promised to give you my views on the criteria you should adopt for selecting great growth shares.

The first and most obvious requirement is that the companies in question should be growing at an above-average and sustainable rate. Although growth companies frequently make acquisitions, it is organic growth that is the essential ingredient, and this will invariably be reflected in the growth of earnings per share.

In normal times, you would look for EPS growth of a minimum of 15 per cent per annum, totalling at least 100 per cent over the last five years.

You should expect at least four years of increased earnings and, in particular, make sure that in the last recessionary year earnings were up by at least 10 per cent.

Two notable exceptions are a change of management (like Bill Castell joining Amersham International) or a radical change in the direction of a company, when a shorter period of past earnings growth would suffice, perhaps as little as two to three years.

Past earnings are one thing, but what about the future, which is so much more difficult to predict? You have to make your own assessment by using these valuable pointers:

The chairman's statement at the time of the annual report and at the interim stage must obviously be optimistic in both content and tone.

The dividend policy must be positive. If a company has been gradually increasing dividends and suddenly only maintains them, this could be a warning signal.

The Estimate Directory is an excellent monthly publication that your broker should have at his fingertips. It gives details of most brokers' forecasts. Well-known companies such as GEC or Wellcome might have as many as 20 circulars written about them giving a valuable fix on the consensus forecast.

Common sense is vital for an overview. For example, since the Clintons took charge of American healthcare, the outlook for drug stocks is not so favourable. Similarly, one should be on guard against a11 the optimistic supermarket forecasts, most of which seem to be based on expanding their share of an eventually limited market.

The third important criterion is to ensure that your selected company has a competitive advantage. Its edge over competitors will usually be due to one of several attributes. The first to look at is an excellent brand name such as Coca-Cola and Marks and Spencer. Reputations of this stature and quality take years to build and are immensely valuable. Then there are patents, like Wellcome's Retrovir for the treatment of Aids, or copyrights of popular records, film libraries or important publications. Next is a franchise created and granted by the Government such as television broadcasting rights and the supply of water and electricity. It is important to remember that the beneficiaries usually suffer from some kind of government regulation.

Other attributes to look at are an established position in a niche industry - for example Druck, a leader in pressure measuring devices; and dominance in an industry such as Rentokil in pest control and Pilkington in glass.

The essential question to ask yourself is whether or not the industry would be difficult to enter. The first three attributes are near-guarantees of invulnerability to competition, at least before franchises, patents and copyrights expire.

An established niche business can be more suspect if the profit opportunity attracts a big new competitor into the industry.

Size in itself and apparent dominance can also be dangerous to rely upon, as IBM would be the first to testify.

The acid test of whether or not a company's competitive advantage is being worked to advantage is the return the company makes on its capital employed. I insist upon 20 per cent per annum or more from industrial companies, and like to see a constant or upward trend.

Brokers can easily obtain for you the five-year figures from Datastream.

Next, you must ensure that a company does not have excessive debt. My limit is under 50 per cent of net assets and preferably much less. Last week's Amersham International had none. Often, really great growth companies generate so much cash that they have no debt at all.

Supermarkets, like Sainsbury and Tesco, buy bread on credit, sell it the next day for cash and pay their supplier a few weeks later. They spit out cash, which they use to expand and pay dividends. In contrast, car and truck manufacturers have to spend a large proportion of their profits on capital expenditure such as new machinery, which is necessary just to stay in business. Not much of their cash is left over afterwards for expansion and dividends.

It is vital to make sure that a company has strong cash flow and to double-check that there has not been excessive use of creative accounting. This is easy to do by simply reconciling the net operating cash flow of a company with its net operating profits. The former should be at least the same as and preferably more than the latter. Nowadays, in the Notes to the Accounts, the two figures are usually highlighted.

I may be old-fashioned but I always prefer companies that pay dividends which are steadily increasing. I make this one of my criteria because some institutions do not invest in dividend-less companies and I do not want to prejudice their future involvement. In addition, the dividend policy of a company can often give a valuable guide to the future outlook.

The price of a dynamic growth share with strong fundamentals should perform better than the average of the stock market as a whole. Charts are an essential tool in the investor's kit, if only because they present you with an easily understood picture of the price action of a share relative to the market. A Datastream chart of relative strength should be easily obtainable from your broker.

As a rule of thumb, I recommend investing in a growth share only when the price is within 15 per cent of its high. This may sound paradoxical, as obviously you would prefer to buy a share at a lower price, but the poor relative strength may be giving you a warning that there is something wrong with your judgement of the fundamentals.

As an important and added bonus, I like to find that growth shares are benefiting from 'something new', such as new management, new products or technology, new events in the industry as a whole or a new large acquisition. New management is by far the most important of these, as the impact of a new management team can be far-reaching and on-going. Archie Norman joining Asda and Gerry Robinson joining Granada are recent examples.

The importance of new products needs no elaboration. New events in the industry as a whole include the failure of main competitors and government legislation. A new sizeable acquisition could radically change the market perspective and direction of a company - for example, the RHM acquisition might have significant future consequences for Tomkins shareholders.

Small market capitalisation companies are more likely to double quicker than their elephantine brethren in the FT-SE 100 Index, but they have a greater operational risk and are less marketable.

Although small companies have done well during the last few months, they have under-performed the index over the last four years. They also tend to be under-researched by brokers and institutions. My preferred size is under pounds 100m, but I am prepared to stretch upwards into the mid-250 Index for a company like Amersham International, or right into the FT-SE 100 Index for an exceptional profit opportunity.

I like a reasonable asset position as a secondary support for a share price but I recognise that the assets per share of companies like Rentokil and Marks and Spencer are almost irrelevant. With smaller companies and those with some debt, it is more necessary to have the comfort of some assets to fall back on, in case a company hits troubled times.

It is reassuring to see the management sharing both the risks and the rewards of share ownership. There is no better way of ensuring that they have the 'owners' eye'. I am not worried about the size of their shareholdings provided that they are not merely nominal. Future dealings by management can also provide valuable clues to the trading outlook.

You now have all the criteria except the key one - the importance of buying a share at a very attractive price in relation to its growth rate. I will explain this next week.

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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