Seeking alpha - and finding it

And this year has been no different. The surge in share prices in the past seven months, whether justified or not, has resulted in a 67 per cent average gain in this year's stocks, and turned that hypothetical £30,000 into around £50,000. That gives a compound annual growth rate on the bargain portfolios of around 17 per cent.

The process of picking the shares is simple in concept, but complex in execution. At the start of each year, I screen thousands of companies, then go through the accounts of hundreds of those, whittling down over 2,800 listed companies to a motley crew of bargain shares for the year ahead. The idea is to pick shares that will rerate over the following 12 month period as more and more investors cotton onto the valuation discrepancies on offer.

This year, that awakening has happened in double-quick time. By the end of May, the overall portfolio was up by 42 per cent in just 15 weeks and, given that I was wary of a stock market correction, I advised banking profits on half the holdings at the time (Taking Stock, 26 May 2009) with the intention of buying back in at a lower price.

Bargain portfolio 2009: inception to 22 May

The rationale behind "top slicing" the portfolio was that if the market falls then I can always buy back in at a later date and lower my average entry point. But if I am wrong, then at least I retain some equity market exposure to the upside. In the event, the stock market has continued to power on up, so if you had followed the original advice, invested £1000 in each of the six shares, and ignored the advice to sell in May, your portfolio is now worth £10,000.

By contrast, if you had top sliced the portfolio at the end of May, and adjusting for the bid proceeds for GNE (which succumbed to a takeover), that £6,000 initial investment is now worth £9,266. This consists of £4,900 of cash following the divestment at the end of May plus the £4,366 current value of the five remaining holdings. Taking some profits in May has reduced the overall return by 12 percentage points to 54 per cent, but has reduced the amount of capital exposed to the market to just £1,100, reducing market risk.

Bargain portfolio 2009: inception to present

** Taken over at 190p a share cash in April 2009 Share prices correct at 25 September 2009

And market risk is something I am concerned about at the moment, because although the portfolio has handsomely outperformed the FTSE All-Share - against which all the Bargain portfolios have been benchmarked for the past decade - if the market corrects, as I made the case for last week (Time for caution, 21 September 2009), then my portfolio is vulnerable. That's because it's stuffed full of small-cap shares that have been dramatically rerated and are thus more susceptible to a rise in investor risk aversion.

That said, I am not going to bail out completely, as shares in sat nav specialist Trafficmaster still only trade on 9.5 times 2009 earnings estimates; broadband and telecoms systems maker BATM Advanced Communications is rated on 11 times prospective earnings; Indian infrastructure investment company Trikona Trinity Capital is valued at less than half its last reported net asset value (NAV); and auction house Mallett is valued on a near 40 per cent discount to its latest NAV. The only company that has disappointed is French Connection which has yet to see a turnaround - although in the meantime the company's lowly valuation is being supported by a cash pile equivalent to half the current share price and net assets worth 75 per cent more than the share price.

So I'm going to top-slice the portfolio again and sell a third of the five holdings to recoup another £1455, meaning that I will have recovered £6,355 of the £6000 original investment, but retain holdings worth £2,900 in the five companies. And if the market does correct this time, I will have ample cash on hand to pick up shares in these decent companies at bargain basement prices once again.

■ Avalon Acquisitions, a fund formed by private equity group Permira, has come good with a 76p a share formal bid for Aim-traded Just Retirement, a financial services group specialising in the retirement sector. I advised buying shares in the company at 67.5p (An Investment to Retire On, 20 July 2009), a price they were readily tradable at for most of last month, to play the potential upside if a bid materialised. Net of transaction costs this gives us a 12 per cent return in two months, which equates to annualised return of almost 100 per cent. That's good enough for me, and I would advise accepting the cash offer rather than taking up Avalon's alternative offer of holding shares in the unlisted bid vehicle.