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Large-cap, low-correlation update

Created:
25 March 2008
Written by:
David Stevenson

Back in February, I made it very clear that this screen will pick shares that won't be exciting growth stocks, poised to shoot up ten-fold. I also cautioned that buying virtually any share – large or small cap – in the current market is to risk some short-term downside or volatility. But the shortlisted shares using this screen will be:

• Large caps with decent fundamentals that make them relatively cheap (but not the very cheapest)

• Relatively speaking, lower risk and more secure

• Should do well if bear market starts to slow down and some confidence returns to equity investing

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My initial screen identified four shares - so far they're down an average of 5.2 per cent, as the table below shows. I'd be the first to admit that this isn't a great performance but I'm sticking to my guns because I think these blue-chips will survive and prosper over the medium to long term.

This month our screen identified only one new candidate:

• Buy BP at 511p. Here's a company we've been keen to hold for a long time. You can't get bigger or better than this oil behemoth and we think that at its current share price level it's an ideal purchase for cautious investors, even if oil prices do start to fall back. Its management have had a sticky year or so but there's a new sense of direction in the company and EPS is expected to increase by 7.3% next year putting the shares on a forward rating of just above 9 times earnings, which is bargain compared to most other extravagantly priced resources stocks. The generous yield is well covered by the cash flow and unlike many other companies that crop up on this screen, net borrowings are low as well.

Name TIDM Return %
Hays  HAS 2.9
Marks & Spencer Group MKS -7.9
Persimmon PSN -6.3
William Hill WMH -9.8
Average   -5.2

LARGE CAP BASICS:

In troubled times investors eventually have to dump the risky investments and start investing in what are perceived as less risky bets. That means big companies paying chunky dividends, with strong prospects and capable management. Such shares are unlikely to be bargains, but they will weather stormy stock markets better than most.

I've tried to evolve a slightly more sophisticated way of spotting blue chips with solid prospects, which I term the "large-cap, low correlation" screen. The original criteria were:

• Relatively large - that means a minimum of £500m in market value.

• Above-average dividend yield – in this case above 3% if not above 3.5%

• Decent cashflow. That means the PCF measure – share price relative to cashflow – must be positive and be below 10

• The beta should be low. Beta is simply the measure of a shares volatility relative to the market (in this case the FTSE 100). A beta of greater than 1.0 indicates that the share is more volatile than the market, and less than 1.0 is less volatile than the market.

• The correlation with the stockmarket should also be low. Correlation is simply a way of measuring how two sets of numbers – in this case a share price and a wider index - move together. A correlation coefficient of +1 means that two variables (share price and index) will always move up and down together. A correlation coefficient of -1 means that one variable moves down when another moves up. A correlation coefficient of zero means that the movement of the two variables shows no pattern. We’re looking for a correlation as close as possible to 0, but preferably below 0.8

• Progressive dividend policy - preferably with rising dividends over five years.

• Adequate dividend cover - that means EPS is at least twice the dividend payout.

• Some growth prospects. These aren't growth stocks, but we don't want stagnation either. Look to avoid buying shares where analysts estimate a fall of more than 10% in EPS in the coming year.

These are explained in more detail in the original article, High yield shares for bears

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