Money: Leader

Since I first wrote six months ago about the new stockpicking formula devised by Jim Slater, his record has continued to impress. His methodology, readers may recall, is based on analysing so-called "Peg factors", which represent the ratio between the prospective price/earnings ratio of a share and its forecast earnings growth in the future.

Although Mr Slater has since added some important filters to refine his method (of which more anon), the basic principle is that a low Peg - ideally one below 0.75 - is the primary signal that a share may be worth buying. Essentially, the idea is to pick out fast growing companies whose growth potential is not yet fully valued in the market.

Come the new year and it is possible to take a fresh look at how his approach has performed. One advantage of his high profile methods is that it does at least allow others to judge how well he has marked his and their card.

The eight new year tips he selected in January 1995, for example, would have returned around 40 per cent to anyone who bought them all at the start of 1995 - some three times the return of the market as a whole. Meanwhile, Johnson Fry Slater Growth, the unit trust managed by his son Mark, which also broadly follows the Peg methodology, was the best performing fund in its sector last year, with the units rising in value by almost the same amount.

So these are unquestionably "hot hands" we are talking about. Not surprisingly, the book which outlines Mr Slater's methods, Beyond the Zulu Principle, is also selling well. Deservedly so, since it is a clear and well presented summary of a method which will appeal to those private investors who like to see strong action from their share portfolio. (I should declare an interest here: Mr Slater was helped in the editing of the book by my Independent colleague, Tom Stevenson.)

Equally unsurprisingly, the book has had mostly muted reviews from the papers and in academia - no doubt because the name still resonates with memories of the collapse of Slater Walker all those years ago. But what is interesting is how little attention has so far been paid to the methodology itself, which is genuinely innovative in UK terms. It is worth emphasising that the Peg system as Mr Slater has now refined it is much more sophisticated and securely based than the one he outlined in his first book about share selection, The Zulu Principle, a few years ago.

While Peg factors remain the primary screening factor, the other criteria he has now added represent a considerable tightening of the original selection process. By adding the requirements that cash flow should exceed earnings over one and five years, and insisting on relative strength against the market over the previous one, three and 12 months, the new methodology intentionally seeks to eliminate many of the spivvier stocks that have caught out unwary growth stock investors in the past.

Mr Slater himself emphasises that the system is not mechanical: investors have to use their own judgement in deciding when and where to override the criteria. One consequence of the more rigorous criteria he now adopts is that they tend to throw up only a limited number of shares at any one time - typically 20-30 or so, sometimes fewer, out of 2,400 or so listed companies.

Many of these are small companies. It is rare for the Peg screening system to produce large Footsie companies. They are usually too big to grow fast and too well researched to be seriously undervalued, though some such as Forte (before the takeover by Granada) and British Aerospace have crept through the net at times in the last 18 months.

So can one argue with these impressive results? Well, of course it is early days. The system has only been tested for 18 months. It has yet to be tested in a bear market. The kind of shares that Peg factors tend to throw up are relatively small companies in fast growing sectors such as media, computer services and leisure. Concept retail stocks have been regular features: Blacks Leisure, for example, was the best performing share Slater picked last year. JJB Sports is another classic Peg stock - a successful retailing formula which is now being rapidly expanded across the country. In computer systems, Parity - a firm which provides training and consultancy to industrial and other users - has been one of the best performers.

While it continues to grow, this kind of share often produces a sparkling performance. But what happens when the market or the economy turns down? One has to think that this kind of share could be particularly vulnerable. The earnings tend to evaporate and the company finds itself with tons of unwanted stock and scores of rapidly emptying retail premises. The market in shares of this size may become dangerously thin. Slater himself acknowledges all these possibilities, though he says that he is now learning to use his statistical screening service, REFS, to pick up warning signals about some of the impending problems before they occur.

Anyone who follows Mr Slater's methods should therefore expect to be taking on some additional risk (at least viewed from an ex-post standpoint), even with the added cash flow and relative strength filters. These are not shares to put away and forget about. But that is no reason for grown adults not to look at the system to see if it suits them. After all, the great charm of stock market investing is precisely that it allows you to take as much risk as you feel comfortable with. The only real sin is to take on more risk than you need without realising it.

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