Six big reliable shares

Our 'big reliable' stock screen, while not based on Mr Train's own specific investment criteria, takes a similar approach to the fundamental question of how to select shares. It looks for signs of quality companies without worrying about the valuation of their shares. And it, too, has outperformed the market over recent years. Since we first ran the screen on 17 May 2011 and again on 6 June 2012, the cumulative total returns from the two portfolios is 34.5 per cent (see table) compared with 26.9 per cent from the FTSE 350 from which the shares were selected.

Still, valuation should always be a consideration when making any investment. Mr Train, for instance, is wary of shares valued at 30 times earnings. So while our screen does not have any valuation-based criteria in it, we would regard this as a matter for consideration later rather than something to be ignored altogether. The key measures of business quality we look for in 'big reliable' companies is consistent earnings growth and consistently high return on equity (RoE), along with good cash conversion and a sound balance sheet. For the purposes of our screening criteria this breaks down into:

■ EPS growth in each of the past five years.

■ RoE of 12 per cent or more in each of the past five years.

■ Forecast earnings growth in the current financial year and the year after.

■ Gearing of less than 50 per cent, or net debt of less than two times cash profits.

■ Cash conversion (cash from operations as a proportion of operating profits) of 90 per cent or more.

Only six FTSE 350 stocks match our criteria fully, and we have given them a write-up below and provided some key valuation metrics, too. The shares are ordered from lowest to highest forecast PE ratio. The other list of nine stocks are those that failed either the EPS growth test or the RoE test in one of the 10 periods we looked at.

Micro Focus (MCRO)

Micro Focus is the lowest rated big reliable share based on the forecast earnings multiple. The company's business is to drive efficiency improvements out of its clients' IT systems and its strategic aims are very much focused on producing the best returns on investment that it can. But while this approach has won the group a place at the top of our 'big-reliable' stock table, it has yet to win its place as a 'stock market darling'.

Concerns about the company's European clients are weighing on sentiment, but analysts also believe management needs to set out a clearer narrative for investors. There are hopes that a clearer vision of strategy may be set out at the end of the financial year. The company also has a strong record for using its impressive cash generation to return cash to shareholders. The low valuation and strong cash generation has given rise to speculation that Micro Focus could be a target for private equity groups (Last IC view: Buy, 571p, 7 Dec2012).

Source: S&P Capital IQ

Serco (SRP)

International outsourcing giant Serco recently underlined its confidence in prospects by announcing that it would be reducing its targeted dividend cover from four times to 3-to-2.5 times in the coming years. In fact the outsourcing industry does appear to have got on to a more stable footing following some testing post credit-crunch years.

Despite its status as a 'big reliable' company, Serco's shares trade at a discount to peers such as Babcock and Capita. While this suggests there may be some rerating potential, it also reflects the fact that the group does more blue-collar work, which generates lower margins. The mix of work is improving, though, and management expects the group's organic revenue growth rate, which is routinely pepped up with bolt-on acquisitions, to pick up in 2013 from the 3.3 per cent achieved in the previous financial year (Last IC view: Buy, 620p, 5 Mar 2013).

Halma (HLMA)

Safety equipment specialist Halma has made it into the 'big reliable' portfolio for the third year on the trot. The group has a deserved reputation as a quality play, which has recently been in vogue with the market. There is a strong structural growth story that underpins Halma's growth based on ever-increasing regulation driving demand for its products.

The group itself has a strategic focus on targeting long-term growth markets based on a 15 to 20- year view. Management also has a record of using Halma's strong cash generation to pep up underlying growth with acquisitions. While the weak economies of Europe have provided something of a headwind, recent trading has been reassuring and defensively positioned end markets also serve to keep any serious worries at bay (Last IC view: Hold, 421p, 20 Nove 2012).

James Fisher (FSJ)

Marine services company James Fisher has built its solid record focusing on specialist market niches, such as ship-to-ship transfers and offshore oil. The company is expected to have a weak first half due to tough markets for its defence business and the absence of the Olympic-related business that buoyed demand in early 2012.

However, other parts of the business look strong. An increased focus on offshore oil safety is helping demand and the company should benefit from activity in the North Sea. Exposure to Asia and developing markets also underpins Fisher's growth prospects. The recent acquisitions of a diving equipment supply business should aid this year’s results and builds on Fisher's record of finding business-enhancing bolt-on acquisitions (Last IC view: Buy, 897p, 6 Mar 2013).

Dunelm (DNLM)

Homeware retailer Dunelm is the growth darling of the general retail sector. Its stores are tremendously popular with shoppers and its relatively limited geographic penetration means there is an ongoing rollout story with a current target of increasing store numbers from 126 to 200. Many analysts think there is scope for an even larger store portfolio.

As the business grows, scale-related savings should boost returns on investment, which are already dividend-yield industry leading. Numis forecasts a whopping return on invested capital from new store openings of 36 per cent. The company is also very cash generative and had £32.7m net cash when it last updated the market in April, which underpins the expansion plans. Numis Securities also points out that, while the shares are expensively rated compared with those of other retailers, a sector-wide rerating has substantially reduced Dunelm's premium rating from 60 per cent to about 30 per cent. That said, investors need to have confidence in the compelling growth story to pay the current price (Last IC view: Hold, 832p, 10 Apr 2013).

Telecity (TCY)

Telecity shares are a play on two major trends: the growth of internet traffic in Europe and the move to cloud computing – where computer data and programmes are stored on remote computers and accessed through many different types of device. The company is at the 'picks-and-shovels' end of things, building and operating data centres. A trading update last week confirmed that everything is going to plan and announced a £25m Turkish acquisition.

Turkey is expected to have the fastest internet growth in Europe in the coming years, so represents an exciting new market. The rating is lofty, but so are growth expectations. Broker Killik & Co is predicting a 27 per cent compound annual earnings growth rate over the next three years (Last IC view: Hold, 863p, 13 Feb 2013).