Anthony Bolton's five keys to success

In his 25 years at the helm of Fidelity's Special Situations fund, Anthony Bolton turned £1,000 invested with him in 1979 into around £140,000. How did he do it? This week, he told the FT his favourite five ratios for picking non-financial stocks. So what are they, and what do they tell you?

1. Price/earnings ratio

The price/earnings, or p/e, ratio measures how cheap or expensive the current share price is in relation to one year's earnings, either current or predicted future. As well as looking for a low current p/e ideally measured against a firm's average for the last 20 years and against its peers Bolton also looks for a low forward p/e for up to the next two years. So if a firm has a current and forward p/e of, say, five and six times respectively, whereas its average historic p/e is 12, and competitors trade on, say, ten, Bolton might see a bargain. But watch out: p/e ratios aren't suited to some asset-intensive sectors, such as house building. The price/book ratio (the share price as a multiple of balance-sheet assets) is often a better bet.

2. Enterprise value/Ebitda ratio

The p/e ratio is popular, but also flawed. For one, it only focuses on whether a firm's equity is over- or undervalued. But if a firm also relies on a lot of debt funding, that won't give you the full valuation picture. Then there's the problem with the 'e' earnings. The ratio uses net earnings, stated after deducting several items that have little to do with operating profitability. These include the tax charge, financing costs such as interest paid, and the arbitrary deductions against earnings made by accountants to write down the cost of fixed assets. Bolton's second ratio is therefore what analysts call 'EV/Ebitda'. This compares 'enterprise value' the market value of both debt and equity, less any hidden nasties such as a pension-fund deficit to earnings before interest, tax, depreciation and amortisation. Bolton likes to size up the latest number against similar figures for at least one full business cycle and the firm's peer group. Once again, a low ratio might indicate a bargain. But only if the reason for such a low valuation isn't a looming cash-flow crisis.

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3. Free cash flow per share ratio

That's where the next ratio comes in. This requires a forecast of free cash flow. That's the firm's cash flow from its day-to-day operations less 'non-discretionary' payments, such as tax, interest on bank loans and usually an estimate of the amount needed to fund the replacement of existing fixed assets. You then divide that figure by the number of 'ordinary' voting shares to give free cash flow per share. A very low number is a warning that a firm may have little scope to expand, or even meet dividend payments, without new funding.

4. Price (or enterprise value)/sales ratio

This fourth ratio is particularly useful for companies making losses or low profits where a p/e or even EV/Ebitda may be impossible to calculate due to a lack of any 'e' or even 'ebitda'. But that's not the only reason to use it. Sales are the lifeblood of any business without them, few businesses can generate profits or, by extension, cash flows. So this time the firm's value, in either equity or equity and debt terms, is compared to one year's turnover. Again, the lower the ratio the better when set against other similar firms and a historic average.

5. Cash flow return oninvestment ratio

There are several versions of this ratio. One of the most popular starts with one year's cash flow as a percentage of the market value of the firm's debt and equity capital. So, for example, if cash flow is ten and capital employed 100, that gives 10%. The next step in Bolton's process is to compare this 10% to the 'risk-free rate' the minimum return an investor should expect to earn. If 10% is higher than the risk-free rate then, by extension, the share price should be somewhere above the value of capital invested in the firm (another fiddly calculation). If it isn't, there's either trouble ahead or, says Bolton, the market may have undervalued the firm's shares.

What to buy

Bolton is no longer an active fund manager at Fidelity, but his hand-picked successor, Sanjeev Shah, also seeks out the "unloved and undervalued". Normally this approach would focus on mid-to small-cap companies, but, as Bolton notes, the turbulence of the past two years has thrown up opportunities among the largest companies in the UK too. Shah tips broadcaster British Sky Broadcasting (LSE:BSY), which has suffered a share price drop of nearly 20% in the last 12 months, despite a "robust business model". He also likes publisher Pearson (LSE:PSON), which should benefit from long-term educational spending. Finally, there's IT consultancy and outsourcing firm Logica (LSE:LCMG) a turnaround stock with new management and untapped potential growth in both the West and India.