Star quality

I described these methods in some detail in last year’s piece (20 October 2006, The System That Really Works) so I won’t repeat that detail now. However, a brief note on the background will probably be helpful for those who didn’t see last year’s piece and who are interested in the various methods by which shares may be selected.

My basic thesis was that by using available data sources to compile lists of those quoted companies with the highest expected rates of profits and earnings growth over the following couple of years, it should be possible to obtain above average share price gains by selecting those shares at the bottom end of the price earnings range. This approach is now often referred to as GARP or Growth at a Reasonable Price.

I undertook the basic testing work back in the late 1980s, prompted by the dramatic stock market falls of autumn 1987, and discovered that there was a definite correlation between future share price movements and the various GARP permutations that I tested.

The Main Features of the STAR Share Selection Methods

After the initial testing work was completed in the late 1980s the STAR method was developed to select growth and income portfolios of 10 and 20 shares that possessed the highest expected growth rate in earnings over the coming two years while also being within the cheapest 25 per cent in terms of current valuation.

The initial selections are now made from a basic pool of the largest 300 plus companies whose shares are quoted on the main market of the London Stock Exchange, although recently a few of the companies covered are traded on the Alternative Investment Market (AIM).

The method for selecting income shares is the same as that for growth ones with the addition of an extra filtering process that weeds out any shares with a current dividend yield below the median for the whole field of 300 plus companies.

The record of the basic 10 share growth selections over the past two decades is summarised in the attached table (Star tests 1985 to 2007). This record shows that the STAR selections have out-performed the All Share Index in 17 of the past 22 years. It should be noted that this comparative table merely tracks the record of selections on a mid-market basis and does not include any allowance for dealing costs as the STAR selections are tracked within an active fund.

The Risk Factor

However, there is no perfect method for share selection that is always profitable. If there was, there is no doubt that everyone would be using it. As with all other methods for selecting and managing investment portfolios STAR is fallible. Its advantage is that it has been proven to be remarkably reliable over the long haul. The main criticism is that the resultant portfolios tend to be risky with substantial share price variations between the high flying selections and the losers. In order to decide how best I could mitigate the risk factor attaching to individual shares I discovered that no selection list should have less than ten individual shares and should contain no fewer than 10 individual holdings and that no more than two shares should be in any single sector for a 10 share list and no more than three in a 20 share portfolio. I have found that this basic guideline has prevented the portfolio being severely hit by poor performance by a single investment, as has recently happened with Northern Rock.

The 2006 STAR Share Selections as at October 2007

The attached tables update the two selection lists made in early October last year. The first table is that of 10 shares selected for growth on the basis of prices and earnings estimates ruling as at 4 October 2007. The other smaller list, based on data on the same date, is of five shares that had recently received a substantial upgrade in estimated earnings per share two years ahead. While the former list is intended to be the basis for a long term portfolio with only occasional changes made each year, the latter was developed to highlight shares that might out-perform over the following months.

So how have these selections done over the past 12 months?

The Ten Share Growth Selections

The immediate answer is that the basic ten share growth selections have been hit by the inclusion of Northern Rock whose value has fallen by a massive 85 per cent in the year. Despite this huge loss the overall selection of ten shares is still recording an total gain, before costs, in the year of just over 10 per cent which is closely in line with the All Share Index advance of just under 11per cent. The fact that the overall portfolio performance is as good as it is justifies, I believe, the need to maintain a reasonably wide spread of shares in all serious long term portfolios. Apart from the unfortunate inclusion of Northern Rock and the less disastrous Persimmon none of the other selections have made a loss and several, such as mining group Kazakhmys and oil explorer Tullow Oil, have risen in value by over 50 per cent.

However, the collapse of the Northern Rock share price following the disclosure of the group’s financing problems in the wake of the US sub-prime financing turmoil illustrates that this was a problem unforeseen by many, if not most, of the City’s banking analysts. As recently as early September the consensus estimates for Northern Rock were pointing to higher earnings for the year to end December 2008. It seems that the fundamental and structural weaknesses of this highly aggressive mortgage lender were not fully understood by the analysts. If they had full knowledge of the situation they would, or at least should, have appreciated that the bank’s need for massive short term funding could cause serious problems as soon as the London Interbank lending system seized up. The Northern Rock saga clearly demonstrates the weak linkages between companies and their investors and the lack of understanding of many business models by many of the City experts.

Of course, the other side of the coin is that such predictive failures are relatively rare and the supply side analysts’ estimates remain the only effective source of estimates available to private investors. Over the past 20 years, during which I have run the monthly STAR analyses, there have been no more than a small handful of Northern Rock type basket cases. In recent years PartyGaming was one and some years ago British & Commonwealth was another. Against these few disasters there have been a pleasing number of true stars with shares such as Charter and Next rising by over 1000 per cent while many years ago an investment in Midland Bank was outstandingly profitable.

The 10 October 2006 Growth Selections

The Five Speculative Selections

For varying reasons four of the five speculative selections (Sainsbury, Kazakhmys, Invensys and Cable & Wireless) have risen very strongly over the past year as may be seen from the attached table. The average price gain returned by these shares is approximately 36 per cent thus exceeding the ASI gain over the same period by a factor of three.

In terms of individual gains Sainsbury has benefited from the corporate re-structuring put in place earlier but in particular from the on-going take-over approaches that now appear to be reaching fruition. Kazakhmys, the fast growing Kazakstan-based copper mining and refining group has risen in line with the whole metals sector and Invensys has gained from a general recovery and re-rating.

The October 2006 Speculative selections

Lessons from The Past Year

Although STAR is a structured method of selecting shares that has proven itself over many years it is always possible to learn from results and, in the case of Northern Rock, to see if it would be possible to avoid such an extreme loss in the future. One way to do this is to incorporate a technical filter that triggers an automatic sale when on a pre-determined percentage decline in the share price occurs. In fact I did introduce such an embellishment some years ago and found that although it saved a few losses it actually resulted in many more transactions and in some cases removed shares that subsequently rallied strongly. It is also often a mistake to mix fundamental analysis with technical indicators and thus end up with a method that is neither fundamental nor technical but an unsatisfactory mix of both.

Current Selections for Growth and Income

So much for the past year which has been good in places, like the curate’s egg, but marred in the past few weeks by the Northern Rock downfall.

Turning to the current selections for both growth and income (click here to read the article in full and to see the new selections [you'll have to be an IC Advantage subscriber to read this]) it will be interesting to see how the stock market in general performs over the coming year as many commentators are predicting a difficult time ahead for both the UK and US economies.

The new portfolios contain ten selections for both growth and income as well as five speculative suggestions. All selections are based on analysis of prices and other data as at 3 October 2007. Both the growth and income selection lists contain no more than two shares in any single sector in order to avoid undue sector over-weighting for such a small portfolio. However, there are no sector limits or dividend hurdles for the speculative list.