Stockwatch: five guiding principles for stock selection in an ISA

As the deadline for using this tax year’s ISA allowance nears, and with a new tax-free allowance just a couple of months away, analyst Edmond Jackson has some tips for investors. 

ISAs are essentially a tax-free wrapper for investments - unless government meddles with this original promise that aimed to help people take responsibility for their financial future. 

They might. Covid spending has left the Tories with a big fiscal headache, on top of which Labour talks of public investment as a bid to win the next general election. Both parties seem to agree on “those with the broadest shoulders” giving support.

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Taxation of SIPPs relates to drawdown whereas nothing applies to ISAs beyond the annual limit to contributions. A worse-case scenario is chancellors meddling with this, perhaps to cap the total tax-free amount that can be contributed.  

Despite political uncertainties, it makes sense to accumulate savings in such vehicles whenever possible - investment taxes are rising and liable to continue doing so. 

But without guiding principles for portfolio building, you may not make the most of this tax-free element to savings and investments.

Rule One: focus on investments with a sound risk-reward profile  

Eliminate loss-making situations buoyed on hope value. 

A key virtue of being tax-free is an enhanced ability at compounding returns to accumulate a lump sum for use possibly decades into the future. You don’t want even a few big losers affecting the outcome, so best search for equities with an established financial record, hence intrinsic value. 

A relatively younger investor might naturally prioritise capital growth, although be aware of anything promoted as having high-gains potential as it is very likely to involve high risks. 

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An older investor might prefer stocks with a strong yield profile. This is where an ISA can hit a sweet spot for retirement living, as a tax-free cash cow.  

Yet the apparent gift horse of attractive yields needs examining. In the early noughties, banks were typically held by income portfolios with few aware that the 2008 US mortgage debt bomb would explode across a global industry that was variously over-stretched. 

Portfolio strategy could “age” with the investor, from capital growth towards income; ideally, with investee companies maturing from growth years into cash generators.  

You are going to experience setbacks, but personally I would avoid high-risk speculation in a tax-free wrapper, especially if it is something you hope to depend on in later life. The likelihood of portfolio volatility and duds increased from 2013 when ISA rules relaxed to include AIM-listed stocks. 

Rule Two: take special care with growth ratings

“Growth at a fair price” is a proven strategy for capital accumulation, yet there is a risk of overpaying for stocks now the financial world has moved on from ultra-low interest rates. 

From 2008, and especially after the onset of Covid three years ago, there was a unique golden era in support of growth ratings. It began tailing off around September 2021 when inflation prompted speculation that interest rates would need to rise fast. 

Much now depends on how successful central banks are at controlling inflation, and whether rates stay higher for longer. Investors can benefit – but ultimately lose out – when this macro influence on growth ratings holds greater sway than what companies are actually doing. 

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An acceptable rating – if possibly quite full in the near term – is shown by BAE Systems (LSE:BA.) on a forward price-to-earnings (PE) around 15 times and yielding just over 3%. As war in Ukraine intensifies, NATO expands and there is tension over Chinese spying, Britain’s leading defence contractor has appeared a safe haven for growth versus economic troubles. 

The share price registered an all-time high as Russia invaded Ukraine and, at 888p, has risen 50% since. Should markets destabilise, some profit-taking is likely, as is the case if Russia is defeated in Ukraine and its threat reduced. 

Rule Three: contrarian out-of-favour stocks have their uses 

Growth investors typically sneer at “dogs”, but the risk-reward profile is what counts. 

After housebuilders were hit hard last year, their stock prices have rebounded as investors realise balance sheets are stronger than the 2009 downturn, and that Britain faces a long-term shortage of housing. 

Mind that housebuilders do historically show signs of performing well in the run-up to annual results, which may have conflated with a particularly strong “January effect” in equities this year. 

Further upside may hinge on the extent that companies follow the example of Persimmon (LSE:PSN), which has scrapped its dividend policy and special dividends, hence its stock having hit an eight-year low.  

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It is a useful example of how an ISA might allocate a portion of capital towards industrial cyclical stocks when sentiment is against them, although the challenge being exactly when will the market start to price in recovery? 

The example of Devro (LSE:DVO), a sausage skin manufacturer, also illustrates a touchstone of investment value – when a private buyer takes a radically better view of an apparently dull company than the market. 

Devro listed in 1993 and after the 2008 crisis its stock rose four-fold to 2013. Then, as growth players bailed out, it drifted to a high-single-figure PE and yield near 6%. In recent years, it’s been a classic dog stock. 

Yet it became a hot dog last November following a takeover approach, and yesterday Germany’s Saria group raised its offer equating to a 94% premium to where Devro traded in October. 

Finding such targets is speculative but does show virtue in contrarian “value” stocks as tuck-away’s – especially businesses with relatively consistent demand than outright cyclicals. 

Rule Four: care is needed with income approach

Attractive yields exist as risk-compensation, where earnings are typically hard to predict, especially in mature or cyclical industries. 

Fund managers such as Terry Smith have railed against income investing given a likelihood of exposure to firms facing high risks and/or long-term decline. Yet I recall Fundsmith did in past years hold Imperial Brands (LSE:IMB) in tobacco, and this fund was hit last year with a growth stock bias.  

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In Stockwatch, I have quite similarly endorsed British American Tobacco (LSE:BATS) for its 8% yield based on very strong free cash flows. It is also a market leader in vaping despite this yet to turn profitable. The stock re-rated a year ago, amid a general shift from growth to value, though I have lately adjusted to “hold” given the risk of a menthol cigarette ban in the US. 

Moneysupermarket.com (LSE:MONY) also used to be quite a favourite among income funds, especially after its 2008 crisis run from 50p to 350p. But it had matured by 2016 into sideways consolidation on a 3-4% yield. Competition in price comparison sites meant its stock more than halved between 2019 and 2022. Yesterday’s annual results affirmed an underlying turnaround, making it a candidate to re-assess – yielding over 5%, albeit with modest earnings cover of around 1.3 times. 

Rule Five: total shareholder return is your guiding principle

Along with the adage “a share does not care who owns it” you should heed another dispassionate maxim about how intrinsic value can be widely based. 

It may include a company’s growth in earning power, a series of dividend, and even asset disposals. Such different means add up to total shareholder return or “worth to a private owner” as Devro has affirmed. 

While investment funds tend to follow specific styles - often for marketing purposes - intelligent use of an ISA or SIPP would involve a balance of approaches described here. 

It is up to you to decide priorities.

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.