Slater said investors should specialise in a certain aspect of investing and concentrate their efforts so that they are able to exploit trading opportunities that elude the average investor.
He also said that investors should prefer smaller companies that have been undervalued by the market.
“Most leading brokers cannot spare the time and money to research smaller stocks. You are therefore more likely to find a bargain in this relatively under-exploited area of the stock market,” he wrote in his book “The Zulu Principle”.
Jim Slater was a popular figure in the investment world and was nicknamed “The Master” by the financial media due to his immense success during the 1960s financial bubble.
In the 1960s and 1970s, Jim Slater was one of the top players, and he remained active in business and investing until his death in 2015.
Slater rose to prominence as head of Slater Walker, a property, banking and investment group founded with Peter Walker.
Slater had an immense passion for share dealing, which began as a hobby when he was young. He lost his father when he was quite young, leading him to leave school at 16 and train to be an accountant and later qualify as a chartered accountant.
He was famous for spotting and analysing shares that were undervalued. Making some solid profits from early dealings, he began advising friends and colleagues, and eventually started writing a share-tipping column for the Sunday Telegraph.
His column in the Sunday Telegraph, under the pen name ‘Capitalist’, brought him to public attention.
Slater bought and sold companies the same way he bought and sold shares. He was not interested in the operations of the companies and was interested only in the profit to be made from buying and selling the businesses and their assets.
This was the period when the term “asset stripping” was coined to describe his knack of buying an undervalued company and selling its properties or other assets at a huge profit.
He always insisted there was nothing wrong with asset stripping, because it resulted in assets being used more efficiently.
He also authored a famous book The Zulu Principle (1992), which explained his strategies to small-scale investors. His book popularised the idea of investing in small cap stocks, and the use of the PEG ratio to help identify stock targets.
He also continued to invest in a variety of business ventures, as well as being an active stock market investor.
The PEG ratio
Slater used the price-earnings-growth ratio as a stock picking tool which attempts to combine the elements of growth and value into one convenient measure.
To use the PEG ratio the price/earnings ratio needs to be divided by the expected growth rate to arrive at the PEG.
Slater usually focused on small cap stocks and believed that big companies rarely double in size, but small ones can. He termed this as “elephants don’t gallop”.
He focused on niche areas of knowledge and wanted to know everything about a few things.
“Investment is essentially the arbitrage of ignorance. The successful investor believes he knows something that other investors do not fully appreciate. There is very little that is unknown about leading stocks. In contrast… most leading brokers cannot spare the time and money to research smaller stocks. You are therefore more likely to find a bargain (with some ignorance to arbitrage) in this relatively under-exploited area of the stock market,“ he said.
Slater said it was important for investors to own really good quality businesses as their quality meant investors rarely had to worry about their financial results.
“You know the results are going to be good – the management are good and they focus on the right things. The problem is they are rare and they are quite difficult to identify,” he said.
What are the Zulu Investing Principles?
Slater’s investing style came to be known as Zulu Investing in which he looked for a combination of growth and value and looked for shares which were currently valued at a price that was low relative to their forecasted earnings.
“I have always been attracted to growth shares, particularly those that can be purchased at what I perceive to be a discount to their proper value,” he said.
Let’s look at some of the principles that Slater introduced in his book:
1. A positive growth rate in earnings per share in at least four of the last five years
Slater said investors should look for stocks that can provide steady growth of at least 15 per cent per annum and they should avoid cyclical stocks.
“A shorter record can be acceptable if there has been a recent sharp acceleration in earnings growth which might be due to new factors, which would make the historic earnings less relevant,” he said.
2. A low price earnings ratio relative to the growth rate
Slater said investors shouldn’t pay an excessive price for the future earnings they are buying. and should look for a modest P/E ratio in relation to the earnings growth.
3. The chairman’s statement must be optimistic
Slater said if the chairman is pessimistic, earnings growth could be at an end.
“Watch with bated breath for his statement and for the interim results,” he said.
4. Strong liquidity, low borrowings and high cash flow
Slater said investors should look for self-financing companies that generate cash and they should avoid companies that are capital intensive and are always requiring more money for new machinery or for the replacement of old machinery at a vastly higher cost.
He said although capital expenditure is essential, some companies simply eat cash, whereas others spit it out.
Slater said there are two ways of checking liquidity. The first is to see if the company has a positive cash balance.
“Watch out for overdrafts and short term loans on the other side of the balance sheet. You are looking for net cash,” he said.
The second method is to determine the cash flow by analysing the accounts.
5. Competitive advantage
Slater said the ideal business is one investors can rely upon to produce increased earnings per share year after year.
He said this reliability is usually based on the competitive advantage of well known brand names, patents, copyrights, market dominance or a strong position in a niche business.
“You are trying to identify businesses which are not operating in an over-crowded market where intense competition will erode margins. The key points are that the product or service the company is supplying should not be easy to substitute; and new entries into the industry should be hard to envisage. A quick way of obtaining an idea of a company’s relative strength in its industry is to examine pre-tax profit margins and the return on capital employed,” he said.
6. Something new
Slater said investors want shares to have a story that is new and interesting.
“It can be something that has happened relatively recently: a new factor in the industry, a new Chief Executive from a very successful firm. All of these new factors are potential reasons for a substantial increase in future earnings and form the basis of the story upon which the shares will be bought,” he said.
7. A small capitalisation
Slater said as “elephants don’t gallop”, investors should give preference to companies with small market capitalisation.
8. High relative strength of the shares compared with the market
Slater said sometimes shares perform poorly in the market in spite of very appealing fundamentals.
” If the shares are not keeping up with the market, you should be on red alert. At the time of purchase, as a quick rule-of-thumb cross-check, make sure that the growth shares you select are within 15% of their maximum prices during the previous two years,” he said.
9. A dividend yield
Slater said the dividend yield can be well below 4%, provided that dividends paid are growing in line with earnings.
“Some institutions or funds will not invest in the shares of companies which do not pay dividends. We are anxious not to preclude any of them from participating in our selections,” he said.
10. A reasonable asset position
Slater said although investors should welcome the comfort of a strong asset position, they should remember that book values are often unreliable.
11. Management should have a significant shareholding
Slater said investors should want the directors to have a significant shareholding in relation to their personal finances.
“You are looking for shareholder-oriented management that will look after your interests with the ‘owner’s eye’. Avoid companies which still have two classes of shares, one of which gives extra votes to management. The ideal scenario is for management to have about 20 per cent of the company so they are highly motivated but cannot block a bid,” he said.
Slater suggested ten very broad and basic guidelines which could help investors to improve their investment performance:
1. Select a system of investment that suits your temperament and concentrate upon it.
Slater said whichever system investors choose, the essential ingredient must be that the shares they select should provide them with a margin of safety.
2. Set aside at least three hours a week to apply The Zulu Principle to your chosen system so that you become an expert in that relatively narrow area of the market.
Slater said investors should use most of the time for analysis and always read the accounts of selected companies from beginning to end.
He said investors should refine and improve their system as they learn from both their successes and mistakes.
3. Allocate from your available resources a sum to invest – patient money that you can spare and afford.
Slater said investors’ aim should be to avoid being pressured into having to make a premature sale.
“Invest between 50 per cent and 100 per cent of your patient money at all times. When you believe the outlook to be exceptionally bearish you can reduce your investments to 50 per cent of your portfolio if you feel more comfortable doing so,” he said.
4. Choose a broker who understands your objectives and is out to help you.
Slater said investors should carefully choose a good broker as it can be an invaluable ally.
5. Invest in a maximum of twelve shares which meet your criteria.
6. With any system based on small to medium-sized growth stocks, you are seeking to identify a few super-growth shares and hold on to them through thick and thin.
Slater said selection is far more important than timing and investors should buy shares which have low P/E ratios in relation to their growth rates and consequently low PEG factors– not more than 0.75 and preferably below 0.66.
“You are searching for companies with strong business franchises that enjoy an excellent return on capital employed and generate plenty of cash. Always reconcile a selected company’s trading profits with its net operating cash flow. Remember that cash is the only indisputable asset and that when making an investment you should look down first,” he said.
7. After you have purchased a share, maintain a really hands-on approach.
Slater said investors should be very active in monitoring their portfolio.
8. Growth shares should be sold if the market goes mad and in the process awards any of your investments an absurd multiple.
Slater said with smaller companies, investors should plan to exit when the PEG is around 1.2, but subsequently keep an eye on excellent growth stocks in the hope of finding a better opportunity to repurchase them.
9. The converse of running profits is to cut losses.
Slater said shares should be sold the moment the story changes to such an extent that the shares no longer satisfy their buying criteria.
“There are also other signals for selling, such as major sales of stock by Directors. Be disciplined about this,” he said.
10. With turnarounds, cyclicals and asset situations you have more limited investment objectives.
Slater said once the crowd recognises that a company has been turned around, the cycle is well on the way up again or that a share price better reflects the underlying asset value, investors will usually find that the share has appreciated sufficiently to provide them with a graceful and profitable exit.
When it comes to picking good quality growth stocks, Slater delivered several years of impressive results at his fund.
Slater is a legend among many famed investors due to his ability to find the most promising growth stocks in the market. Indeed his book, The Zulu Principle is a bible for growth company investors all over the world.
(Disclaimer: This article is based on Jim Slater’s book “The Zulu Principle”.)