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Zulu Investing: Would Jim Slater buy these 5 growth stocks?

Cover of  by Jim Slater

?Investment is the art of the specific and selection is far more important than timing.?

Of the stalwarts of stock market investing, Jim Slater?s enduring appeal to UK private investors perhaps owes the most to his obvious affection for high quality but not overpriced growth companies. For the former City corporate raider, broadsheet columnist and children?s author, growth companies require careful and considered selection. After all, while buying into a growth story at the right moment and at the right price is paramount, these are companies that an investor could conceivably keep in a portfolio for very many years ? come bulls and bears.

Never short of a forthright view and always amenable to sharing his views on stocks, Slater?s 1992 book The Zulu Principle has gone on to become a modern classic amongst private investors. In it, he not only sets out a carefully calibrated technique for measuring a company?s growth potential but he also encourages investors to do their own digging, to read between the lines and interpret information in a way that will give them an edge.

Start sieving

His approach starts by sieving the market for potential growth stock candidates and identifying which of them are attractively priced. The first hurdle for any company is ownership of a proven record of earnings per share (EPS) growth together with broker forecasts that the growth will continue by at least 15% over the next couple of years. ?This gives you an arithmetical fix on the company,? Slater explains. Importantly, the stock must have four years of EPS growth ? historic of forecast, or a combination of the two.

While scrutiny of past and future growth form the backbone of his screening technique, Slater?s commitment to the story behind a stock is what makes his approach intriguing to adopt. Investors are urged to scrutinise companies and filter the basket using a common sense set of criteria.

For instance, small, profitable companies with strong cashflow and low debt and signs of strength in their shares are important, while sectors that are less susceptible to cyclical patterns are preferred. Meanwhile, a competitive advantage, strong management and signs of optimism in the chairman?s statement are all pluses. Finally, a critical moment, such as a new CEO, as well as directors buying shares are also on the checklist.

PEG formula

On passing these criteria, a stock will face Slater?s most famous metric ? the PEG, or the price-earnings growth factor, which measures how the price of a share relates to its earnings growth rate. He doesn?t much like the traditional use of the price-earnings (PE) ratio to value a share and prefers instead to study the relationship between the forward PE and the expected rate of EPS growth. His calculation is simple ? divide the forward PE of a share by the estimated future growth rate in EPS to arrive at the PEG. Any share with a PEG over 1 gets short shrift from Slater while a score of 1 receives consideration and anything under 1 is worthy of much closer inspection.

It is worth stressing that Slater?s analysis concerns itself with the future performance of a stock according to broker forecasts. Whereas conventional PEG valuations popularised by the likes of Fidelity fund manager Peter Lynch, divide the trailing PE with the forecast EPS growth, Slater?s PEG uses the forward PE in its place. Investors and analysts have argued about the double counting of earnings growth in this method. Nevertheless, using Stockopedia PRO we have scanned all Main Market, AIM and PLUS market companies to see which of them are currently qualifying for closer inspection based on Slater?s Zulu Principle technique.

The top contender is Globo (LON:GBO), a company that develops and sells mobile, telecom and software systems to business customers. Established in Greece but with offices in seven countries, AIM listed Globo has consistently grown its net profits, and last year?s figures were up by 54% to £3.8 million. With strong EPS growth over five years, brokers are now forecasting forward EPS growth of 51% and a forward PE of just 3.79 ? establishing a Slater PEG of 0.07. Slater would warm to news that chief executive Costis Papadimitrakopoulos has dipped into the market to buy shares on two occasions since the summer. Globo also matches the criteria set out by Slater for investing in smaller technology companies; the PEG has to be low, as does the multiple, and the company?s cashflow and liquidity are vital. Globo?s cashflow more than halved last year to £3.8 million, following an exceptional year in 2009, but nevertheless its liquidity ratio remained sound.

Moving on, Tim Dyson has spent nearly 20 years as CEO of public relations group Next Fifteen Communications (LON:NFC) but his embrace of digital innovation has proved decisive in protecting the company from harsh economic conditions. Next Fifteen produced record revenues and profits last year, together with five small acquisitions for a modest increase in debt. The shares had drifted from 84p to 73p since the end of the summer but bounced back in October and are now trading at closer to 85p ? that recent spike in investor interest is an important factor in Slater?s criteria. With a forward PE of 8.45 and forecast EPS growth of 19.7%, Next Fifteen qualifies for a Slater PEG of 0.43.

Further down the list is First Derivatives (LON:FDP), the Northern Ireland based software and consulting group that develops data and trading systems for financial institutions. The company has been investing heavily in building an asset base and last year recorded a 44.2% rise in sales to £36.7 million as its target client base began recovering from the economic crash. Net profits have grown every year for the last five years and EPS is predicted to grow at a rate of 25.3%. With a forward PE of 10.5, First Derivatives achieves a Slater PEG of 0.42. The company carries a hefty debt pile of around £20 million, much of which is secured against a substantial property portfolio that it owns. Cash on the balance sheet more than doubled to £3.5 million last year but operating cashflows were dented as the group absorbed a substantial increase in headcount of 139 to 524.

Next up is Immunodiagnostic Systems (LON:IDH), a darling of AIM investors for its phenomenal share performance ? rising over three years from 202p to a high of 1244p this summer. Despite recent falls in the price ? now at around 770p ? sales of the company?s diagnostic testing kits for the clinical and research markets continues to grow. Pre-tax profits were up last year by 51% at £16.6 million and the company made a point of slashing debt and focusing on cashflow. Last October, operations director Ian Cookson stepped up to take the helm as CEO and drive the company?s planned international expansion. As a healthcare stock, Slater would be a fan of IDS because of the perceived competitive advantages that companies can achieve through patented designs ? in this case its recently introduced automated testing system, the IDS-iSYS. With a forward PE of 12.4 and forecast EPS growth of 20.9%, IDS achieves a Slater PEG of 0.59, putting it squarely on the Zulu radar. Of note, the only other healthcare stock on the Slater screen is Surgical Innovations (LON:SUN).

Finally, we have a stock that departs from the Zulu list of favoured sectors but nevertheless plays to the heart of Slater?s more recent investment thinking ? gold mining. The first of two gold plays appearing on the screen is Pan African Resources (LON:PAF) but seeing as the South African miner recently triggered a price surge by indicating that some sort of significant deal could be in the pipeline, we have chosen the second stock, Highland Gold Mining (LON:HGM). Russia-focused Highland hit its target of producing 200,000 ounces of gold in 2010 and this year it wants to add a further 10-20,000 ounces. After paying off its debt early, the company is throwing off a great deal of cash ? £60.6 million last year ? while net profits grew by 52% to £78.4 million. With a forward PE of 6.26 and forecast EPS growth of 22.8%, the company boasts a Slater PEG of 0.27.

It won?t come as much surprise to hear that all of these stocks enjoy strong buy recommendations from brokers. With modest PE ratio forecasts and high EPS expectations, the numbers point to attractively priced companies that the brokers think will grow faster than the market. Slater does caveat the use of professional forecasts by encouraging investors to study in detail the story behind a stock. He also devised (and later sold) his own data service, Company REFS, to give investors access to the financial information they needed to identify growth companies. While arguments continue about Slater?s PEG formula, the technique ? and the man ? remain popular with investors.

How relevant is such a growth screen in the bleak times that Europe faces today? Good question - of course, no-one knows what the future holds. Still, we do see value in adhering to time-worn investing principles and strategies, be they growth or value, that look beyond the 24 hour newscycle, however grim. Now more than ever, investors need to apply careful and considered selection techniques to find those companies, if they are going to weather the vagaries of the market. We'll be tracking the performance of this screen closely to see how it fares...

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