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Jim's three gems

Created:

20 March 2009

Written by:

Jim Slater

Investors have many different approaches for determining the PEG of a stock. Put simply, the PEG is the growth rate divided into the prospective PE ratio. For example, a growth rate of 20 per cent with a prospective PE ratio of 10 would produce a PEG of 0.5. However, first you have to determine the growth rate and whether or not it is sustainable. To be consistent and to enable meaningful comparisons to be made, I recommend using a rolling 12 months ahead prospective PE ratio with the growth rate calculated over exactly the same period. This usually means taking a portion of the current year’s forecast and adding it to a portion of the following year's.

For example, looking on 31 March 2009 at a company with a financial year ending on 31st December, you should take nine months (75 per cent) of the 2009 forecast and add it to three months (25 per cent) of the 2010 forecast. This will give you a rolling 12 months ahead forecast of EPS from which to calculate the rolling twelve months ahead prospective PE ratio and growth rate.

I do not regard the growth rate as genuine growth unless it is further growth added to past growth, as opposed to recovery from a recent setback in EPS. The minimum period I need to see is two years past growth and two years forecast growth or three years past growth and one year’s forecast growth. In general, you should be looking for a PEG of well under one avoiding shares on high multiples with very high forecast growth which is obviously unsustainable. For example, a company with a PE ratio of 30, a future estimated growth rate of 60 per cent and a PEG of 0.5 would not attract me, as a growth rate of 60 per cent cannot be maintained. In today’s difficult markets, the best way of dealing with this problem is to restrict the prospective PE ratio to 15 (reduced from 20 in a bull market).

With such poor general outlook for earnings growth, you would be right in thinking that in the year ahead very few companies can look forward with any confidence to increasing EPS substantially. However, we are searching for the exceptions not the rule. Fortunately I have been able to find three companies with measure up to my demanding criteria. They should serve you well.

Advanced Medical Solutions (AMS)

The first selection is Advanced Medical Solutions which is engaged in the design, development and manufacture of novel high performance polymers for use in advanced would-care dressings and medical adhesives for sealing tissue. The niche in this market, in which AMS operates mainly is moist healing worth £400m a year and growing at 13 per cent per annum. The products of AMS are particularly effective for healing foot ulcers.

The technologies used by AMS embrace foam, film, hydrogel, hydrocolloid, alginate and silver alginate, all of which promote better healing by protecting wounds during the healing process.

AMS has become a substantial supplier to the NHS and has excellent relationships with international partners such as Johnson and Johnson and Kimberley-Clarke. A particularly exciting aspect of AMS is that it has recently announced that it has received its first F.D.A.510 (k) clearance for its LiquiBand product. This is the key to opening a major new market in the US. LiquiBand is a way of sealing the skin and tissue without stitching. The market for it has great growth potential. The good news for AMS is that this will provide further valuable dollar income for a product that is already selling very successfully in Europe.

The 2008 AMS results announced on Tuesday were at the top end of market expectations. Brokers forecasts for 2009 are about 2.5p a share, giving a prospective PE ratio at 34p of 13.6. Relatively high in today’s markets but the prospective growth rate is a heady 33 per cent resulting in a PEG of only 0.4. Also AMS has a strong cash balance and is cash-generative. A further bonus is that in the healthcare sector takeovers are always a possibility. I have recently announced that together with my family I own 6.98 per cent of the company.

Education Development (EDD)

Education Development (EDD) is my second choice. It is a leading educational quality assurance company, government approved and regulated with UK and international reach and expertise in IT-based product delivery and administration.

In the UK, EDD has over 300 accredited vocational qualifications, 279 specialist awards and approved programmes, 1,873 registered centres, 200,000 candidate registrations a year and over 650 school customers for on-line assessments.

In case this is not enough to impress you, EDD also has a strong and growing position in the larger international market with over 4,500 registered centres across 103 countries and 275,000 candidate registrations a year.

As a result of a recent very bullish announcement by EDD, Brewin Dolphin, the company’s brokers, have increased its forecast for 2009 by over 50 per cent to £5.6m pre-tax with EPS of 9.4p. Based on a low tax charge as in past years, 9.4p of EPS at 56.5p would result in a prospective PE ratio of only 6. With forecast EPS growth of 65 per cent the resultant PEG is absurdly low at 0.1.

Further pleasing facets of EDD are that the company is very cash-generative with a net cash balance of over £3m at the end of 2008. My own buying, resulting in a current holding of 3.7 per cent, has contributed to the share price having a great run during the last couple of months. Also after the announcement of increased profit expectations, there was further buying by directors, who added to their already significant shareholdings.

The tax charge has to be considered because there is only £4.3m of tax losses to be used in 2009 and in 2010 they will run out. Another factor is that the rate of growth will obviously slow from the astonishing 65 per cent but nevertheless it looks as if it should still be very substantial, especially in relation to the very low PE ratio. I find it hard to understand why a company like EDD in a business so well-suited to today’s difficult conditions, growing very fast and generating plenty of cash, should be on such a low prospective multiple.

London Capital Group (LCG)

My third selection is London Capital Group (LCG) in which I have a comparatively small holding. This company operates in the riskier area of spread-betting with a client base of over 30,000. LCG attracts me for three reasons:-

1.The figures which were announced on 18th February were up to expectations and showed a growth rate of 35 per cent.

2.LCG has no debt. Brokers estimate that LCG has substantial free cash of about £8m and its estimated future cash flow is very strong.

3.Unlike many of its competitors, LCG has negligible bad debts (only £87,000 in 2008) as it does not give its customers credit.

The consensus brokers’ future forecast is for EPS growth of 30 per cent to give EPS for 2009 of 26.8p. At the present price of 260p this puts LCG on a prospective PE ratio of about 10 with a very low PEG of only 0.33. The dividend yield of over 4 per cent is also attractive.

To summarise, as an important part of my suggested two-way portfolio, I recommend 5 per cent in each of these three AIM gems. Potential investors in these stocks should bear in mind that the markets in all of them can be narrow at times. After a recommendation prices are usually marked up for a day or two, so wait until the excitement dies down before setting a close limit with your broker.

Remember too that in my suggested portfolio, the 30 per cent in cash is not to be kept in cash ad infinitum. It is there as a strategic reserve to be invested if the market falls substantially or when the future outlook becomes more certain.