Profile
Jim Slater has had a colourful career. Starting out as an accountant, he worked in managerial positions in various manufacturing companies before founding Slater Walker Securities, an investment bank which unfortunately collapsed during the financial crisis of 1974. The collapse left Slater technically insolvent, however he managed to recoup his losses within a few years.
Slater originally rose to prominence with a share tipping column, “The Capitalist” in the Sunday Telegraph newspaper. His tips focused on small, fast growing and reasonably priced companies - a bias that saw “The Capitalist” portfolio increase by 68.9% over 3 years, at a time when the UK market rose by just 3.6%.
In 1990 he published “The Zulu Principle” in which he revealed the strategies and investment criteria that underpinned “The Capitalist’s” success.
Growth At Reasonable Price (GARP)
So what is Jim Slater’s formula for choosing winning shares? He essentially uses a combination of growth and value investment strategies, looking for shares where brokers are forecasting high earnings growth, but which are currently valued at a price that is low relative to their forecast earnings. As he puts it “I have always been attracted to growth shares, particularly those that can be purchased at what I perceive to be a discount to their proper value”. He believes growth shares to be the most rewarding investments, with unlimited upside if the right companies are picked.
Smaller Companies
He prefers smaller companies that have been undervalued by the market on the basis that “Most leading brokers cannot spare the time and money to research smaller stocks. You are therefore more likely to find a bargain in this relatively under-exploited area of the stock market.” Smaller companies tend to grow more rapidly than larger ones, however, the company shouldn’t be too small, ideally in the £30m - £250m range.
Broker Forecasts
Companies in the micro-cap or Fledgling index tend to have only one broker covering the stock. One of Slater’s basic conditions is that there there must be a number of broker forecasts available. This is because, as we shall see, the screens that Slater applies when selecting stocks are very much dependent on ‘expected’ earnings growth. If only one broker covers the stock, that figure could be very unreliable - especially so if the if the forecast has been provided by an in house broker.
Prospective P/E Ratio Less than 20
P/E ratio = current share price divided by forecast earnings per share (EPS).
A company with a share price of 100p and earnings per share of 10p has a P/E ratio of 100/5 = 20
As a rule Slater will look to buy companies ideally on a P/E of less than 10, and certainly no greater than 20. Any shares with a P/E ratio of more than 20 are immediately eliminated.
The PE ratio is useful because it shows how many times the current earnings the shares cost, however the P/E ratio on its own is rather one dimensional.
Slater realised that a high P/E ratio doesn’t mean a stock is expensive, so long as the company is anticipating a large growth in earnings. ie a company with a very high P/E ratio must have a very high growth rate to justify the price.
Which brings us to his next criteria:
Low PEG
Out of all of Slater’s criteria, the Price Earnings Growth (PEG) ratio is the most famous.
The PEG is a means of identifying shares where brokers are forecasting high earnings growth, but which are currently valued at a price that is low relative to their forecast earnings.
The PEG tells us the price of the stock relative to its earnings growth rate. It is calculated by dividing its prospective P/E ratio by the estimated future growth rate in the Earnings Per Share (EPS) of the company.
Using our previous example, a company with a share price of 100p and earnings per share of 10p has a P/E ratio of 100/5 = 20
Now, for example, say the brokers’ forecast earnings growth rate for this company is 20%, its PEG is calculated as
PEG = P/E ratio divided by estimated future growth rate
So in this example, the PEG would be calculated as P/E 20 divided by growth rate of 20, gives
PEG = 1
According to Slater, a PEG of 1 means that this company is fairly valued. A PEG greater than one means that the market is paying too much for future earnings growth, whilst a PEG of below one suggests the company’s share price is undervalued.
Slater looks to invest in companies that are undervalued, ie those with a PEG less than 1, and ideally below 0.75.
You need to bear in mind that a company with a prospective growth rate of 20% and a prospective P/E ratio of 20 has the same PEG as one projected to grow 40% on a PE ratio of 40. A growth rate of 40% is unlikely to be sustainable, so as you can see the PEG ratio should not be considered in isolation but relative to other factors.
Consistent Profits & Growing Profits
Slater looks for companies achieving consistent profits. Each of the past 5 years results must have been profitable - none may show a loss.
He also wants to see that the company’s earnings are growing consistently. Companies must boast four successive years of earnings growth, this can include forecast periods. So companies with only two years of past EPS growth and two year’s future forecast growth could be considered.
The company’s earnings growth needs to be sustainable, so he looks for forecast growth rates of between 15 - 25%. He is wary where growth exceeds 25%, as that sort of growth rate is usually unsustainable.
Outperformance & Strong Cash Flow
Most good growth companies tend to have strong cash flow, with net cash on their balance sheets. Cash flow is of utmost importance when looking at smaller companies as it can make or break them. You should look for companies where the cash flow exceeds the Earnings Per Share for the last reported year and for the average of the previous five years, ie look for companies where cash flow per share / EPS is greater than 1. If the company has debt, then its gearing (ie the debt expressed as percentage of the company’s total assets) should be no more than 50%.
Competitive Advantage
This is usually evidenced by a high Return on Capital Employed (ROCE) and good operating margins. ROCE is a ratio that indicates the efficiency and profitablity of a company. It tells us the earnings as a percentage of the funds that shareholders have invested in the company. The higher the ROCE, the more effectively and profitably the company is employing shareholder capital. You should look for ROCE to be above 12%.
High Relative Strength
Positive Relative Strength indicates the shares have recently been performing better than the market.
Look for companies with Relative Strength greater than 1 over the previous 12 months and previous month - a sign that investors are beginning to appreciate the company’s potential.
Low Price to Sales Ratio
Price to sales ratio (PSR) is used for valuing a stock relative to its own past performance. It is calculated by dividing the company’s market capitalisation by its sales revenue over the previous 12 months (which is the same as dividing the stock’s share price by the revenue per share).
A company with a low PSR is considered a better investment since the investor is paying less for each unit of sales.
Director Dealings
Slater recommends keeping an eye on Director Dealings. If the directors are ditching large shareholdings in their own company “I start to worry”, he says.
Each of the past 5 years results must have been profitable - none may show a loss.
Industry Bias
Slater avoids property companies and investment trusts, whilst companies in cyclical sectors (eg building & construction) are subject to very stringent requirements: they should never have incurred a loss or suffered an EPS reversal in any of the last five years of reported results. This eliminates most of the companies in those sectors, but leaves the few that are arguably genuine growth companies.
Zulu Principle
Applying these investment criteria has proven to be very profitable and the strategy has attracted a great many devotees. The Zulu Principle was the first book to present British Investors with a specific stock market strategy. It is a great book to use as a starting point to selecting growth shares, and you can hone Slater’s methods to suit your paritcular style and risk profile.
Company Refs
In 1993 Jim Slater teamed up with Hemscott to create Company REFS (Really Essential Financial Statistics) to help investors to apply his system by listing PEGs and other key ratios and company information. The software includes screening tools to enable you to filter and identify stocks based on various criteria, including Slater’s own.
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