Jim Slater, the businessman and one of Britain’s most popular share traders, once wrote that “investment is essentially the arbitrage of ignorance”. He insisted that individual DIY investors could get an edge against professional money managers by going where most of them feared to tread: into smaller, less well-known growth shares.

In his 1992 book The Zulu Principle, Slater said the successful investor “believes he knows something that other investors do not fully appreciate”. But he noted that this was next to impossible with large-caps because the market knows so much about them.

By contrast, given that most brokers can’t spare the time or money to cover small-caps, Slater said it was this relatively under-exploited area of the stockmarket that you’d be more likely to find a bargain (with some ignorance to arbitrage).

Nearly 30 years after he first made that observation, small-cap investing still hinges on the idea that it’s an area of the market where individual investors can find an edge.

On the hunt for growth shares

Part of Slater’s considerable legacy is his strategy for finding the most promising, reasonably priced growth shares in the market. He described it in detail in The Zulu Principle, which remains a bible for growth company investors everywhere.

Central to his strategy is a focus on investing in companies that are potentially poised to deliver impressive earnings growth but can still be bought at a reasonable price. These are typically small, profitable stocks with robust cash flows, 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 1.0 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.

Screening for Zulu stocks

At Stockopedia, our modelling of the kind of…

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