Zulu growth stocks passing Jim Slateramp;rsquo;s investing rules

Jim Slater, the businessman and one of Britain’s most popular share traders, once wrote that “investment is essentially the arbitrage of ignorance”. He insisted that individual DIY investors could get an edge against professional money managers by going where most of them feared to tread: into smaller, less well-known growth shares.

In his 1992 book The Zulu Principle, Slater said the successful investor “believes he knows something that other investors do not fully appreciate”. But he noted that this was next to impossible with large-caps because the market knows so much about them.

By contrast, given that most brokers can’t spare the time or money to cover small-caps, Slater said it was this relatively under-exploited area of the stockmarket that you’d be more likely to find a bargain (with some ignorance to arbitrage). 

Nearly 30 years after he first made that observation, small-cap investing still hinges on the idea that it’s an area of the market where individual investors can find an edge.

On the hunt for growth shares

Part of Slater’s considerable legacy is his strategy for finding the most promising, reasonably priced growth shares in the market. He described it in detail in The Zulu Principle, which remains a bible for growth company investors everywhere.

Central to his strategy is a focus on investing in companies that are potentially poised to deliver impressive earnings growth but can still be bought at a reasonable price. These are typically small, profitable stocks with robust cash flows, low debt and share prices that are already rising. 

Slater was keen to find firms with strong competitive advantages, offering new products or services that were steered by effective and enthusiastic management.

One of his most distinctive tools for picking these Zulu shares is something called the price-earnings growth factor, or PEG. He saw this as a crucial measure of whether a stock offered an attractive trade-off between price and growth. 

The PEG is worked out by dividing forecast price-to-earnings ratio (PE) by the expected rate of earnings-per-share growth (G). As Slater saw it, stocks with a PEG of less than 1.0 had higher growth rates than their PE ratios and were thus ‘cheap for their growth’. For instance, a stock on a forecast PE of 20 but expected to grow at 25% would have a PEG of 0.8.

Screening for Zulu stocks

At Stockopedia, our modelling of the kind of rules used by Slater shows how reliable this kind of approach can be over time. Over the past three years the model portfolio (pre costs and refreshed quarterly) has achieved a return of 52 percent, and over five years that rises to 103 percent. You can view the Jim Slater Zulu Principle Screen here. One of the drawbacks – which tends to afflict other growth strategies – is that it can suffer during market downturns. When markets drift or sentiment wavers, the stocks it holds can be hit hard and it struggles to find buying candidates. For that reason, the strategy has underperformed the market over the past 12 months. On the upside, it responds swiftly when confidence picks up again, which makes it an interesting barometer of the general market.

In detail, the Zulu screen looks for stocks with a PEG below 0.75, a price-to-earnings ratio below 20x, a return on capital employed greater than 12% and earnings that are expected to grow by at least 15%. Importantly, the shares also need to have positive relative strength against the market over the past year. Here are some of the shares currently passing those rules:

In what are cautions market conditions, the strategy still manages to find a number of potential Zulu shares, led by resource stocks Sylvania Platinum, the small-cap mining firm, and Serica Energy. Elsewhere, firms like Liontrust Asset Management, Ten Entertainment, Mortgage Advice Bureau and Telecom Plus are regulars contenders on this screen.

Right now, many investors are likely to be sitting on their hands ahead of what could be a volatile end to the year as Brexit negotiations come to a head. But in the hunt for growth stocks at reasonable prices, the Zulu strategy can be a useful gauge of the market and be the first place to find potential new buys during upturns. 

Part of the appeal of this strategy is its blend of growth and value to ensure a focus on buying the fastest moving stocks without overpaying for them. The strategy’s effectiveness, together with Slater’s enduring popularity are likely to keep it a favourite of many UK stock pickers.

Stockopedia