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Low PEG Slater small caps

The five stocks highlighted by the Jim Slater-inspired small-cap screen I ran a year ago have delivered a total return of 20 per cent. Four new stocks meet the criteria for cheaply-rated growth plays this year
July 16, 2014

The price-to-earnings growth (PEG) ratio, and variants on it, crop up in many of the screens I run. Think John Neff, Peter Lynch and even my own "genuine value" screens. But for most UK investors, the person who is probably most closely associated with the use of this ratio is Jim Slater, who expounded its virtues in his book 'The Zulu Principle'. Mr Slater is an advocate of using the PEG ratio in its purest form - that's to say by dividing a stock's price-to-earnings (PE) ratio by the earnings growth rate for that company.

The screen I ran last year based on my interpretation of Mr Slater's stock-picking techniques has performed pretty well. The five shares the screen selected have produced a 19.9 per cent total return, which is ahead of both the FTSE All-Small index's 17.9 per cent and 9.5 per cent from the FTSE Aim All-Share (see graph).

While last year's screen produced a very limited number of stocks, their performance has nevertheless varied widely from a 41.3 per cent total return from Avon Rubber to negative 6.6 per cent from Netplay (see table). The range of individual stock performances highlights the high-risk nature of the approach, which is compounded by its focus on smaller companies - Mr Slater's chosen hunting ground.

NameTIDMTotal Return (19 Jun 2013 -11 Jul 2014)
NWF GROUP NWF 32.9%
NETPLAY TV NPT -6.6%
AVON RUBBER AVON 41.3%
URBAN CIVIC UANC 18.3%
RECORD REC 13.4%
Average-19.9%
FTSE SMALL CAP -17.9%
FTSE AIM ALL-SHARE -9.5%

Source: Thomson Datastream

The rule of thumb when it comes to PEG ratios is that anything below one can be considered interesting and potentially cheap. That said, PEGs can vary a lot depending on what kind of EPS figures are used in the PE ratio (i.e. using forecast EPS normally gives a far lower PE number than using historic EPS) and what growth rates are looked at (these can be forecast or historic over varying time frames). The formula I use for PEG in this screen uses a PE based on historic underlying EPS divided by the forecast average growth rate over the next two financial years. This varies from Mr Slater's focus on historic growth rates.

While a low PEG is central to Mr Slater's stock-picking strategy, there are a lot of other factors that he suggests using in order to find winning shares. While a number of the ideas are worked into this screen, some are tougher to deal with in a quantitative way. For example, Mr Slater thinks investors should always look at recent outlook statements to get a feel for how strong trading currently is. He also puts emphasis on factors like management ownership of shares.

The factors I have screened for are:

■ Value: A PEG ratio of 0.75 or less, based on either long-term consensus forecast EPS growth where available or the average forecast growth for the next two financial years.

■ Growth: Average forecast growth for the next two financial years of more than 15 per cent, but less than 50 per cent and positive EPS growth in each period.

■ Size: Mr Slater's view of larger companies is that "elephants can't gallop." I've therefore have set a market cap limit which this year is £500m, an increase from £250m last year in order to boost the number of results from the screen. I have also scrapped last year's £20m lower level in order to juice another result out of this year's screen.

■ Competitive advantage: A return on equity of more than 12.5 per cent or operating margins in excess of 15 per cent.

■ Sentiment: Three-month price movement greater than the median average.

■ Cash conversion: Operating cash flow equivalent to 90 per cent or more of operating profit.

■ Finances: Net Debt of less than 1.5 times cash profits.

Only five stocks have passed all of the screen's tests, even after relaxing the market cap criteria. It would have been five if a dud set of first-half results from emerging market fund manager Charlemagne Capital had not caused a massive 45 per cent downgrade to EPS forecasts. The stocks to make the grade are written up below in order of lowest to highest PEG.