The volatility that hit the market in February is still making its presence felt. For many shares, this wave of uncertainty has caused their momentum to falter. But one area of the market that is proving to be much more resilient is smaller-cap growth stocks.
While the blue-chip FTSE 100 (UKX) is continuing to drift back towards 7,000 points, small cap indices like the FTSE Small Cap (SMX) and AIM All-Share (AXX) are showing solid signs of a rebound. If you dig deeper into those trends you find that the companies that have fought their way back are the ones that fit very neatly with one of British investing’s best loved strategies – Jim Slater’s Zulu Principle.
Well priced growth shares recover
Slater forged his reputation as a City dealmaker before going on to become hugely popular figure among individual investors. He passed away in 2015 but his legacy includes his highly respected 1992 book, The Zulu Principle. This is seen by many as a rulebook for finding great growth shares at reasonable prices. In it, Slater offered a compelling case for growth investing but also clearly understood the challenges faced by many private investors.
The book was inspired and partly researched by Slater’s son, Mark, who still uses his father’s Zulu principles at his fund management firm, Slater Investments. He is now one of the UK’s best performing fund managers.
Central to Slater’s growth strategy is a focus on investing in companies that are poised to deliver impressive earnings growth but can still be bought at a reasonable price. These are typically small, profitable stocks with robust cashflows, 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 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.
A strategy tracked by Stockopedia that models Slater’s rules has generated a 13.4 percent return over the past year, and 46.4 percent over two years, easily outpacing the market.
With those rules in mind, we’ve created a list of stocks that currently fit with Slater’s strategy. Among the rules, companies need to have a PEG below 1.0, 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.
Name Mkt Cap £m Forecast PE Ratio PEG Slater Forecast EPS Growth % ROCE % Relative Strength 1 Year Victoria 855.6 15.8 0.3 56.6 10.9 73.5 Huntsworth 320.3 14.7 0.3 44.4 11.9 145.1 Impax Asset Management 206.1 13.1 0.4 34.3 16.7 114.7 Gocompare.Com 485.3 14.1 0.5 29.9 161.8 33.1 VP 335.3 8.95 0.5 18.9 12.8 3.23 Macfarlane 134.7 12.2 0.5 25 14 31.4 S&U 277.6 9.92 0.6 16.4 13.3 13.4 Elecosoft 38.7 17.9 0.6 28.6 15.6 41.9 Miton 72.5 10.7 0.6 16.9 10.4 3.58 Premier Technical Services 185 16.3 0.7 24.9 10.2 88.3
Source: Stockopedia Past performance is not a guide to future performance
These strategy rules produce a list of stocks that have predominantly shaken off the effects of market volatility. Among the names here with the lowest PEGs are the carpet and flooring manufacturer Victoria (VCP), followed by firms including PR consultancy Huntsworth (HNT), financial comparison service, GoCompare (GOCO), packaging firm Macfarlane (MACF) and fund manager Miton (MGR).
A powerful growth strategy
Evidence from the early months of 2018 suggests that Slater’s focus on earnings growth in smaller stocks with reasonable prices, has been a strong combination for withstanding volatility. Part of the appeal of the strategy is its relentless focus on rules-based investing. It blends growth and value to ensure a focus on buying the fastest moving stocks but 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.
Interactive Investor’s Stock Screening series is written by Ben Hobson of Stockopedia.com, the rules-based stockmarket investing website. You can click here to read Richard Beddard’s review of Stockopedia.com and learn more about the site.
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It’s worth remembering that these and other investment articles on Interactive Investor are simply for generating ideas and if you are thinking of investing they should only ever be a starting point for your own in-depth research before making a decision.
*No fee for publication is involved between Interactive Investor and Stockopedia for this column.
About the Author
Ben Hobson is Investment Strategies Editor at Stockopedia.com. His background is in business analysis and journalism. Ben researches and writes regularly on investment strategy performance and screening ideas for Stockopedia.com. He is the author of several ebooks including “How to Make Money in Value Stocks” and “The Smart Money Playbook”
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