Last week, I outlined a – 30 per cent cash, 10 per cent gold, 10 per cent leading agricultural companies, 20 per cent convertible bonds and 15 per cent international stocks. The final 15 per cent was to be invested in carefully selected Aim stocks - which are the subject of this week's article.
In the present financial climate, it is vitally important that your protective criteria for these small companies are at their strongest. If you make a mistake and one of your selections falters, it will be difficult if not impossible to cut your losses effectively.
In the first edition of The Zulu Principle in 1992, I outlined a method of investment that worked particularly well with growth shares at that time. The essence of the approach was to find shares with a low price earnings growth factor (PEG) arising from above average forecast earnings per share (EPS) growth rate coupled with an anomalously low PE ratio. Nowadays this approach is often referred to as GARP (Growth At A Reasonable Price).
The idea behind GARP is that you buy into a growth share cheaply and if it continues, as hoped, to produce excellent EPS growth, the PE ratio should rise to a much higher level. This can then result in a status change, which coupled with EPS growth would produce a substantial capital gain. For example, if EPS growth was 25 per cent and the PE ratio rose from 8 to 12, the share price would increase by 87.5 per cent.
It has always been essential to incorporate a few protective criteria to avoid a potential Enron. Healthy cash flow and sound balance sheets are essential, and it's a good idea to check that directors aren't selling shares too. My final criterion is positive relative strength of the shares in the previous year. Nowadays, I also look for positive relative strength in the previous three months. Occasionally, this can give you an inkling that something might be seriously wrong that has not yet been announced and is lurking in the shadows waiting to destroy your capital.
