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Cheap, fast growing stocks using Jim Slater's Zulu Principles

Created:

6 May 2008

Written by:

David Stevenson

Slater's investment philosophy

There's a natural US bias in any discussion about stock screening – it's biggest thinkers and supporters tend to be stateside. This month we're going to concentrate on a home grown hero – Jim Slater. He's been eloquently arguing a 'growth at reasonable cost' investment philosophy for many years now, with huge success. The clearest definition of his approach came in his book "Beyond the Zulu Principle : Extraordinary Profits from Growth Shares", which is pretty much the basic text book for British investors.

His obsession with screening also led him to set up the hugely valuable Company REFS information system – available on disc and in book form through HS Financial Publishing. Slater fits in a spectrum of GARP investing somewhere between the rampant growth style of Martin Zweig and the more conservative style of classic value investors. He's not as aggressive as Zweig and uses many more 'value' influenced measures but the kind of company he's fishing for is still (like Zweig) smaller, fast growing and reasonably priced. His key measure is the PEG factor or price to earnings growth factor – he thinks it's the best indicator of reasonably priced growth.

As Slater himself says in the guide to his REFs system, "The PEG is a much more sophisticated measure [than PER] because it relates the PER of a company to its future earnings growth rate and gives a better indication of value." It's a dynamic measure and it changes in time but Slater reckons that "over the long term, it has paid to buy the market on a PEG of one or below". Slater goes on to spell out in great detail his own take on the classic growth at a reasonable price screen. He uses the metaphor of 'a quiver full of arrows' to describe his approach of using a large number of measures. Slater's core concern is earnings consistency and momentum. That implies that the company must have four years of consecutive EPS growth and that each of the past 5 years must have been profitable, although a period of poor performance is allowed if the following four periods show a consistent upwards trend. To make this focus on earnings work Slater adds a number of important caveats:

• There must be a number of broker forecasts available, preferably more than one. The important point here is that Slater bases much of his analysis on 'expected' earnings growth and if only one broker covers the stock that figure may be deeply unreliable, especially if it is a 'house broker' with a relationship to the company's management.

• Slater thinks investors should be very careful with companies in the micro-cap Fledgling Index. They generally tend to only have one broker following the stock. Most fans of Slater approach tend to restrict their screens to firms with a market cap of at least £10m

• Cashflow per share should exceed EPS for the last reported year and for the average of the previous five years

• You must exclude the whole property sector and most companies in the building construction/materials sector

Slater also uses a great many measures borrowed from traditional value investing:

• The interest cover should be reasonable

• Current ratio of two or more

• Gearing should generally be no more than 50%

• ROCE should be above average for the sector and the trend should be upward

• Slater doesn't require a dividend but he says its 'preferred'

• Last but definitely not least Slater, wants some re-assurance that our cheap growth stock is actually capable of share price momentum. That means making use of the Relative strength or RS measure - look for positive figures for both the last month, and the last 12 months.

Our version of a Slater Screen

Our take on a Slater 'Zulu' screen essentially involves three stages or steps. The first step uses a series of quantitative measures to screen out unsuitable stocks - we're essentially narrowing down the universe of shares to fast growing, reasonably priced shares with a decent cashflow, reasonable operating margin and a generous return on the capital employed. The next step looks to exclude any companies where the directors have been aggressively selling large chunks of stock – Slater like many investment gurus regards this as a terribly bad sign for the future. This means excluding any shares where there’s either persistent selling (more than 2 big sales in the last few months) or very large scale (£100k or more) selling of stock.

Our last stage is the most detailed – we're looking at three key measures which will require you to conduct a bit of due diligence of the company's fundamentals. The main thing we're looking for is some evidence of increasing earnings growth. In this stage you should check that the current EPS growth rate is higher than it was three years ago i.e earnings growth is accelerating. If this is present award one point. If there's evidence of persistent buying of shares by the directors, award another point. Last but by no means least, if the share price (or relative strength) has been positive in the last 3 months add another – you could add another point if the RS measure if positive in the last 12 months as well. To make the grade companies should really score at least 2 points in this final screen

In summary here's the screen:

• The Price earnings ratio is no more than 20

• PEG below 1 or ideally below 0.75

• EPS growth rate in current year above 15%

• Cash flow per share greater than earnings per share

• Net gearing below 50%

• RS 1 year positive at least

• ROCE above 12%

• Profit margin above average or median for market

• Market cap either above £10m and below £1000m OR above £30m and below £250m

• PSR below 10

Second, more detailed screen:

• One point where current EPS growth rate above 3 year rate in EPS

• One point if directors buying shares

• One point if RS in last 12, 6 months and 3 months positive

• One extra point if RS in last 1 month positive

Past portfolios

Our first stab at a Jim Slater Zulu screen was back in November 2005 – we identified five shares which on average have increased by just under 30% (by comparison the FTSE 100 has only increased by 13.9%). That three times out-performance was bettered by our second attempt in November 2006 – that smaller portfolio of three shares is up 30% compared to a fall of 1% in the FTSE 100.

The Current Shares

We have to admit that when we ran this screen and then looked in greater detail at the shortlisted candidates we were more than a little concerned by the potential candidates – there was an overwhelming bias towards resources stocks. Looking at it dispassionately, you can understand why so many of these stocks would fit the Slater specification – they're not usually massively over-priced, they're growing fast off the back of rising commodity prices and the UK market has an unusually large number of quality outfits.

There's a huge risk here though – a consensus in the market is building that the resources sector is due a big pull back in the next few months and a portfolio that it's loaded up with resources stocks could be a disaster waiting to happen. That's why we've been very careful to limit the resources exposure in this portfolio to just two companies – we’ve chosen the two with the highest PEG factor based on Slater's methodology.

The two companies shortlisted will be familiar to readers of this newsletter – both Anglo and BHP Billiton are blue chip giants in this sector, and currently the hottest companies because of their key strategic mining interests and Chinese strategic interest. We'd very much agree with a metals & mining sector note from Lehman Brothers which said that BHP and Anglo American were its top sector picks. The broker recommended investors buy into miners on higher copper prices and said it has increased its copper price forecasts to $3.90/lb from $3.00 for 2008, to $4.50/lb from $2.75 for 2009, and to $4.00/lb from $2.00 for 2010. On the back of these changes, the broker hiked its price targets across the board, resulting in a new target for the BHP stock of 2,600 pence versus 2,100 previously.

Babcock International is already one of our top shares and we think this industrial services group is a class act. We'd very much concur with a brokers note from KBC Peel Hunt which recently initiated its coverage on Babcock International Group with an 'add' recommendation and target price of 650 pence (a 10% uplift on the current price). According to the analysts note, Babcock has rewarded shareholders well given its strong market positions and its huge potential particularly in Nuclear, Building Schools for the Future and Rail. In conclusion, the broker said "it expects some share price volatility due to wider political issues, particularly in defence and rail spending, however, in its view, the current valuation offers further upside not least given the highly secure earnings streams".

We think Weir Group is probably an even stronger buy than Babcock – we're increasingly big fans of this refocused global engineering group – it’s the world's biggest maker of pumps for the mining industry. We were particularly impressed by a recent post trading statement interview with Weir's boss Mark Selway where he reiterated his confidence in the outlook for its core markets, predicting further profit growth in 2008/09. Weir - which now focuses solely on the mining, power generation and oil and gas sectors - saw its 2007 pretax profit rise 56% to £120.2m compared to £77.1m last time while Selway predicted that he expects "profitability to rise by about a fifth in the next fiscal year. Our markets still look strong, with the vast majority of our profit stream coming from the aftermarket and services. The mining market looks very strong, while oil and gas is about the throughput and the number of barrels produced so we feel very comfortable with the outlook there. In power generation we're seeing upgrades right across the globe."

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