My secret to selecting winning shares

Here is the issue of Penny Sleuth you've been waiting for. The time has finally arrived to answer that burning question: how do I spot a winning share?

Let's start with this simple observation. A successful company will make a successful share. If the company is unsuccessful then its shareholders won't make any money. I am not talking about short-term trading here - that's a mug's game as far as I'm concerned. I have never met anyone who has played the short-term game with sustained success, and I certainly would not recommend it to a novice.

I'm talking about the very few companies - out of the thousands quoted on the London stock market and overseas - that have everything it takes to deliver serious returns. What does it take? Well after 20 years of investing, I've boiled it down to five key factors.

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Let's take each in turn...

A good product

A good company will sell something that its customers really want to buy. This could be anything - a mobile phone, a software program, or a life-saving drug. Just ask yourself whether the company that you are looking at has a product that could change the life of its customers in some small way.

A lack of competitors

Very few businesses have no competition, but occasionally one comes up with a completely innovative idea. By constantly staying ahead of any competitors, through good marketing or perhaps some patent protection, a company can have the field to itself, and that enables it to command a price that will not be beaten down by rivals. Most mature businesses - banking, clothes retailing, or cars for instance - are locked in intense competition, and that makes it very difficult for them to make big profits.

Growth prospects

You have found a company with a good product that is ahead of the game. Now ask yourself whether it can really grow its sales. If the company is making pin cushions, for example, its market is going to be rather limited. But if it is making tablet computers, these could sell in millions all over the world.

Repeat sales can be an important foundation for sales growth. Some companies have recurrent income' in the form, for instance, of customers who regularly buy cola. Others - a house builder for example - need to continually make new sales tojust stand still, let alone make progress.

Profitability

The acid test of a good business is whether it makes any money. You need to start looking at financial reports. The best businesses make good profits. Their revenues exceed their costs by a comfortable margin. It is as simple as that! It doesn't take long to uncover what is really going on in a company. Head to a company website and you'll be able to view annual reports, quickly giving you the vital figures you are looking for. And you can follow the news on some of the most exciting shares here in Penny Sleuth.

A reinvestment opportunity

This is important and often overlooked. A good business will have a level of sales upon which it can make a good profit margin. But what will it do with these profits? What we want is a business that has ample opportunity to re-invest these profits today so as to make even more in the future. A good example would be a successful restaurant chain. If one outlet is thriving, a reinvestment opportunity would be to open more outlets with the money generated.

Those are my five key factors. If a company I'm researching for Red Hot Penny Shares or the Red Hot Biotech Alert doesn't meet these criteria, I drop it.

But that's not the end of the process. I think you should also take into consideration these three important criteria...

Is the management any good?

Should you go for youthful enthusiasm or grey-haired wisdom? Successful business people come in all shapes and sizes, so frankly I think this is a difficult one to judge. But a little background research can give you a good idea into the management style and where the company sees itself heading.

Bank debt

This is where your eyes might start to glaze over, but you should be wary of any company that has borrowed large sums of money. If the business is steady enough - Tesco, for instance - the company can be confident of servicing these loans. But if its sales are less predictable it could get into real trouble. Most businesses that crash do so because they are overloaded with debt that they simply cannot repay. In order to spot high debt you need to learn how to read a balance sheet, although the annual and interim reports of companies will usually include a reference to these financials.

Company size

A huge amount of rubbish is talked about this. Financial regulators like to characterise small companies as high risk' and big companies as low risk'. But risk is not necessarily a function of size. Big companies such asRoyal Bank of Scotland(RBS) can turn out to be very risky, while a small company such as patent expertMurgitroyd (MUR) is, in my opinion, pretty low risk.

What makes shares risky is the nature of the company's business and its debt-load. It is, however, true that many small companies, especially if they are in the early phase of business development, do have an uncertain business and high debts - think, for example, of a small company working to develop a gold mine. So, while it is true that small companies are more likely to be high risk, it is not true that they necessarily are so.

In any case, the statistical evidence of history is that the overall average returns from small companies exceed those from big companies. While many small companies undoubtedly fail, those that succeed can grow and prosper for many years. In contrast, big companies are almost all struggling to achieve sales growth, have relatively low profit margins and are locked in fierce competition over a finite market.

Finally, and perhaps the most important lesson of all for investment success, is this: be patient.

Be highly selective. Apply your criteria strictly. Don't waste your ammunition on inferior shares. Wait for the really good ones to come along, back them over time - and see how they will grow your money while you just sit and admire.

This article is taken from Tom Bulford's free twice-weekly small-cap investment email The Penny Sleuth. Sign up to The Penny Sleuth here.

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