10 small-cap growth shares Jim Slater would approve of

One of the interesting aspects of the recent wave of volatility in UK equity markets is the remarkable resilience shown by smaller companies. The macro-economic worries that shook confidence in larger companies just didn't have the same impact on small-caps.

Evidence of this resilience can be seen in the performance of some of the main UK indices during the third quarter of 2015. The value of the FTSE All Share and the blue chip FTSE 100 slumped by around 7.0% and 7.6% respectively over the past three months. Yet the FTSE SmallCap index (excluding investment trusts) proved to be much more robust, falling by just 2.0%.

In terms of index performance, the strength of small companies is plain to see. But what the trend doesn't tell you is the precise nature of the shares that rebounded so well from the market turmoil. Which companies resisted the slump and fought their way back? At least part of the answer to that can be seen in the performance of one of the best known and most popular strategies followed by UK investors - Jim Slater's Zulu Principle.

Well-priced growth shares bounce back

One of the long-term experiments at Stockopedia is to model and track the strategies of the world's greatest investors. One of the most interesting aspects of that is to witness how these models fare in periods of market weakness.

Once infamous as a City corporate raider, Jim Slater made his name in the investment community in the early 1990s with his book, The Zulu Principle. Over the past three months a portfolio of shares that meet many of his main investing criteria, has risen in value by 9.7%. Over the past year, that portfolio, rebalanced quarterly (excluding costs), has grown in value by 18.2%.

Clearly the Slater model has been able to position itself in stocks that have managed to withstand the market dip. The rules aim to pick up growth shares at a reasonable price by focusing on earnings growth in generally small, profitable companies with strong cashflow, low debt and signs of strength in their shares.

Among the most important features of the strategy is the PEG, or the "price/earnings growth" factor. The PEG measures whether the promise of growth comes at a reasonable price. It's calculated by dividing the forward price/earnings (PE) ratio of a share by the estimated future growth rate in EPS (earnings per share). Any share with a PEG over 1 gets short shrift from Slater. A score of 1 receives consideration and anything under 1 is worthy of a much closer look.

One of the biggest advocates of this approach is Jim Slater's son Mark, who has used it to great effect at his MFM Slater Growth Fund. The formula has helped his fund produce consistently strong returns in the UK All Companies sector. In the year to the end of August the fund was up by 11.4%, despite sliding market valuations.

With Slater's rules in mind, Stockopedia created a list of stocks that have met the Slater rules over the past three months - and continue to do so. Among the rules, companies need to have a PEG below 0.75, a PE ratio below 20x, a return-on-capital-employed (ROCE) greater than 12% and earnings that are expected to grow by at least 15%. Importantly, the shares also need to have positive relative strength against the market over the past year.

These strategy rules produce a list of stocks that have predominantly shaken off the effects of market volatility. Among the names here with the lowest PEGs are online gaming and casino operator 32Red, telematics equipment business Trakm8 Holdings and jet aircraft operator Gama Aviation. Unsurprisingly, there is a trend towards small, innovative, technology-led firms, such as Adept Telecom, Telit Communications, Solid State, iomart and Maintel. The list also includes car dealership chain Cambria Automobiles and mortgage broking network, Mortgage Advice Bureau.

An enduring growth strategy

Evidence from the past three months suggests that Slater's focus on earnings growth in smaller stocks with reasonable prices, has been a strong combination for withstanding volatility. Part of the appeal of the strategy is its unremitting focus on rules-based investing. Indeed, in The Zulu Principle, Slater noted:

"In a very sharp bear market almost all shares go down, but shares bought in a systematic way will fare better than most. In fact one of the most reliable tests of an impending bear market is that you will find it extremely difficult to identify shares that fit your highly selective criteria."

The strategy's recent effectiveness, together with Slater's huge popularity and compelling personality are likely to keep it a favourite of many UK stock pickers.

About Stockopedia

Interactive Investor's Stock Screening series is written by Ben Hobson ofStockopedia.com, the rules-based stockmarket investing website. You canclick here to read Richard Beddard's review of Stockopedia.comand learn more about the site.

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About the author

Ben Hobson is Investment Strategies Editor at Stockopedia.com. His background is in business analysis and journalism. Ben researches and writes regularly on investment strategy performance and screening ideas for Stockopedia.com. He is the author of several ebooks including "How to Make Money in Value Stocks" and "The Smart Money Playbook".

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.