11 Steps to Stock Market Success

Statistics show that the best way to grow your money in the long term is through careful investing in small cap value stocks; but finding them can take a LOT of digging – even if you know what to look for. That’s why legendary investor Jim Slater devised a clear 11 step plan to make the process of stock selection much easier.

Jim Slater started out as a chartered accountant and became well-known for penning an investment column in the Sunday Telegraph under the nom-de-plume ‘Capitalist’. Unbelievably, his column tips achieved a gain of 68.9% over a period of 2 years compared to a market average of just 3.6%.

Best-selling investment tomes The Zulu Principle, Beyond the Zulu Principle and How to Become a Millionaire followed and in 1994, Slater devised Company REFS, a stock selection tool based on his unique model.

Since 1994, the stock market and indeed the global economy has seen turbulent times, but the principles of Slater’s formula remain valid. In fact, his son Mark Slater was named as the UK’s number 1 Fund Manager by The Telegraph. To this day, his fund, the MFM Slater Growth Fund, successfully deploys the stock selection strategy devised by Jim described herein.

How Falling ill in Spain ‘Accidentally’ Turned £3,000 into £40,000

In 1958 on a business trip to Spain, Slater caught a nasty virus – which in a roundabout way changed his life completely. For the two years that followed, he was weak, exhausted and unable to get out of bed much of the time. Down to his last £3,000, he realised he needed to find a way to make money, that didn’t involve ‘working’ in the traditional sense.

Slater knew that if he could just pick the right stocks, he could make money without working; convalescing in Bournemouth, he did just that.

Convinced that there must be a pattern displayed by big stock market winners that would allow him to predict the future, Jim scoured two years’ back issues of the Investors’ Chronicle and the Stock Exchange Gazette.

As he did so certain, very particular, patterns cropped up again and again; investing his very limited cash on the basis of this new theory was a leap of faith – but that basic formula enabled him to buy his first shares, and turn £3,000 into £40,000.

Jim Slater wasn’t interested in quick wins, and as any serious investor will tell you, this isn’t the secret to long term success; he hadn’t unlocked a fail-safe trick to the perfect investment and in the 1970s seriously overstretched himself, ending up a ‘minus millionaire’

However, he paid back all his debts with interest within just a few years by investing shrewdly in the stock market – using the same strategy he’d discovered during his illness.

Jim Slater’s Market-beating Formula

Slater coined a now-famous phrase in his best-selling book The Zulu Principle, ‘Elephants don’t gallop, but fleas can jump over two hundred times their own height’.

In other words, it usually takes many years for shares in large companies – such as you would find in the FTSE 100 – to show the same growth potential as smaller listed companies.

Behemoths like HSBC or GlaxoSmithKline are just not going to double in price quickly; on the other hand, it is quite possible for a small company to double, triple or quadruple its share price in a short space of time.

‘Elephants don’t gallop, but fleas can jump over two hundred times their own height’

A recent example is online fashion retailer ASOS; at one point in early 2014, its share price had increased by an unbelievable 35,000%+ since it launched at 20p per share in 2001.

Even if you’d come late to the party, ASOS’s peak of over £70 per share at the start of January 2014 would have represented a five-year gain of over 1,700%.

That is just not the kind of gain you will ever see from a big company because they are already well established in the market and can’t multiply their profits quickly; not so for small companies, which can – and do – multiply profits at a rapid pace all the time.

Also, most leading brokers cannot spare the time and money to research smaller stocks so there are more likely to be bargains in this relatively unexploited area of the stock market – as an AIM listed stock, ASOS also gains from considerable IHT benefits too.

This doesn’t mean the Slater principles won’t work with large cap stocks either. Back at the Telegraph in 2014, Jim recommended ITV which at the time was quoted at 203p. By August 2015, it was up to 280p. That’s a 38% gain in less than 10 months.

Income or growth, whatever investors’ approach to investment they usually begin the search for attractive shares with their preferred key criteria, and then look for other supporting factors. So what are the principles of Jim Slater’s market-beating stock selection formula?

• A positive growth rate in earnings per share in at least four of the last five years

Slater looked for steady growth of at least 15% per annum; a shorter record can be acceptable if there has been a recent sharp acceleration in earnings growth.

• A low price to earnings ratio relative to the growth rate

He warns investors not to pay excessively for future earnings; he liked companies with a PEG ratio below 1 and describes the PEG ratio – which divides the PE ratio by the earnings growth rate – as a useful metric for ‘measuring the value you get for your money’.

• The Chairman’s statement must be optimistic

Slater warned that ‘if the chairman is pessimistic, earnings growth could be at an end’.

• Strong liquidity, low borrowings and high cash flow

For Jim Slater, strong cash flow was an essential indicator of a promising stock. He wanted to see EPS converted into cash year after year and to see it translating into strong cash balances or, at the very least, rapidly reducing gearing. Cash flow per share for the last reported year should exceed EPS. Sometimes a compromise can be made if there is a good reason (e.g. very rapidly increasing sales with a consequent increase in working capital). However, if the last reported one-year figure is adverse, the average cash flow per share for the previous five years must substantially exceed EPS for that period.

• Competitive advantage

He found the shares he believed he should invest in by starting out with the whole universe of quoted shares and applying a series of sieves like low PEGs, strong cash flow and high relative strength. He would then examine the shares that found their way through the sieves and try to identify the competitive advantage that they must be enjoying to possess such outstanding financial characteristics; he identified the many different types of competitive advantage that can be the source of a company’s winning formula. High ROCE and good operating margins are usually strong supportive evidence of a company’s competitive advantage.

• Something new – such as a new product or move into a new market

A change of CEO, new products or a major acquisition can have a significant effect on future EPS and can often be the trigger for a reappraisal of a company’s PER.

• A small capitalisation

Slater wrote that investors should target companies smaller than £100 million, which was increased to £250 million when he wrote Beyond the Zulu Principle in 1996 – equivalent to £430m today.

• High relative strength of the shares compared with the market

Relative share price strength in the previous month must be positive and relative strength in the previous twelve months must be both positive and greater than the one-month figure. The only compromise Slater recommended was on the relative strength of the previous month, which may sometimes be mildly negative while a great growth share pauses for breath. In this event he would check the relative strength for the previous three months. If that too is negative, it is recommended to skip that share and look elsewhere.

• A dividend yield

Preference should be given to companies that are paying dividends. Most of them do, and those that do not should be treated with caution.

• A reasonable asset position

This is a low priority for growth shares and is only of any real significance if the company’s gearing is high. When gearing exceeds 50%, caution is needed. In practice, Jim Slater would increase this to about 75%, provided cash flow was strong.

• Management should have a significant shareholding

Slater recommends keeping an eye on Director Dealings –  if the directors are ditching large shareholdings in their own company, this is likely to be a significant indicator of troubled times ahead.