Originally published on March 11, 2016
Mark Slater is one of the most successful and widely followed growth fund managers in the UK. Since setting up Slater Investments 22 years ago, he and his team have delivered an exceptionally strong performance record across their growth and income funds.
A great deal of that success is down to an unshakable focus on buying good quality growth shares at reasonable prices. But equally, it's about really understanding the nature and likely longevity of that growth. That means recognising the traits of different growth stocks and dealing with the psychological battles of buying, holding and selling these types of companies.
Back in 1992, Mark worked with his father, the late Jim Slater, on writing and publishing The Zulu Principle. It became, and remains, one of the most influential UK-focused investment guides around. The strategy rules in the book have a common sense, yet distinctly buccaneering feel to them. Arguably, that's precisely what's needed in the search for the great growth stocks of tomorrow. And it's the reason why Mark still applies them today. With that in mind, I went to meet him to discuss his approach and some of the lessons learnt from his career in investing.
A word of warning: The interview covered a lot of ground, and while we've pared it back to the key parts, it's still extensive! To help, we've broken the interview into sections to make it easier to navigate.
Mark, what is your assessment of how markets, and growth stocks in particular, have performed in recent years?
The period coming out of the crisis has been very, very strong. A lot of companies that we've done well with were really bombed out back in 2008 and 2009. We were starting from a very, very low base, so I think from 2009 onwards, one would have expected to do pretty well.
Since the crisis, our approach has been to assume that life would be tough, and I think for the average business life is very tough. Having said that, zero rates have helped and certainly it could have been an awful lot worse. But the key thing is that coming out of the crisis valuations were so low that it didn't surprise me that a lot of companies went up multiples.
On current market conditions...
Conditions have been a little more unsettled in 2016 so far. What's your perspective on these types of market movement?
We've had a sort of correction without a correction. I invested for the first time in 1985, when I was 16. But I got very actively involved in the early 1990s. If you go back to 1992, there had been a nasty recession which hit small companies and it was a very tough time to make money. But '93 to '96 were bonanza years, they were fantastic. In a way they were comparable to what has happened in the last few years because the starting point was so low. Then, '98 and '99 were very good for us. There was a wobble with the Asian crisis and the dotcom collapse, but again there were fantastic opportunities for several years afterwards. It is interesting, you tend to get big opportunities pretty much all the time. I think the backcloth just determines how quickly they pay off.
It doesn't surprise me that there is some sort of correction going on now. From summer onwards last year, it was very difficult to find good value without serious problems. It was very difficult to find normal good businesses at low prices, and that's still the case today mainly because there hasn't been any proper selling yet.
As a fund manager focused on growth and value, how do you handle these sorts of conditions?
In relation to market action, we find that things don't tend to happen in one day, it's a rolling process. You can be waiting and waiting, and then all of a sudden, a couple of companies you have been very keen to buy over a long period suddenly become attractive.
A good example of that was back in October 2014 when there was an 8% fall in the market. That's less than we have had recently but it happened in a short period. In the space of two or three weeks some companies fell 20-30%, and in one or two cases, they fell by that much in a day. Within a couple of days of each other, we bought a holding in Liontrust Asset Management, which is a very well-run business, very cheaply. We also bought a big holding in dotDigital. That was a company we'd always found just a little bit too expensive. It'd already drifted a bit and then fell 20-25% in a day, and we were able to buy a good slug of shares, 4% or 5% of the company, in a day - bang! We'd been looking at it for 18 months before that, but it had always been out of reach.
At the moment, we are nibbling occasionally on a number of companies.
It sounds like you resist the temptation to predict movement and time your investments?
We don't look to invest according to a market view, that's just too difficult. The number of people who are good at getting markets right you can count on the fingers of one hand. And I am not sure they are consistently good. The vast majority of people, and probably the vast majority of your readers, try to time the market even though they probably know they are not very good at it. They still try and do it even though it doesn't make any sense.
The only macro view we take is the obvious. We know Russia is a really difficult place to do business, so we are not going to be exposed to Russia. We know Turkey is pretty unstable at the moment, so we are not going to be exposed to Turkey. We'll look at what we own, and we might change our view on it or we might sell something as a result of obvious macro developments. But we are not going to try to take a view on the general market direction.
On growth investment strategy...
Do market conditions ever lead you into compromising on value and paying a bit more for quality?
I think in general your entry price is an important determinant of the investment outcome. But in the case of equities, and particularly in the case of quality, growing businesses, I think quality is more important than price. There are two reasons for that. The main reason is that a quality business can compound your money over a long period of time. Whereas a low-quality business simply can't do that. The second thing is that your risk is actually lower in many ways with quality businesses.
I think as a generality, it makes sense to pay up for quality. The hard thing of course is determining what is quality and what isn't - that is the hard bit. It's not a formulaic thing, I don't think one can say: "okay, I'll pay a PEG of 1.5 rather than 1 or I'll pay multiples of 25 rather than 20 going forward". It doesn't work that way because you can end up paying 25 times for rubbish and then you have a problem. There is something comforting about owning really good quality businesses because when they report, you are not worried about them. You know the results are going to be good, they are doing their thing, the management are good and they focus on the right things. The problem is they are rare and they are quite difficult to identify.
Has that process of finding growth stocks got easier over time, or harder?
Certainly, it's difficult to invest in growth businesses in an environment where growth is more rare than it used to be. The ability to grow reasonably consistently with some sort of track record is harder to find now than it was in the late 1990s.
Our universe was probably two-and-a-half times bigger in the late 1990s than it is now, which is quite a big change. In the late '90s, it was an extremely benign environment where even pretty mediocre businesses were able to grow quite quickly. Whereas now, we very much take the view that life is tough for the average business, and as a result, you don't really want to be in the average business.
It's pretty hard to find companies that can grow reliably where you can ask the sort of Warren Buffett question: "Is this business going to be significantly bigger in three years time, five years time or 10 years time?" For anyone who is interested in growth, that's the question you are asking. You are not going to ask whether it is going to grow 10% this year and 15% next year, you don't know because it's not that precise. It's much more about whether it's going to grow at a decent rate year after year after year with the occasional exception. dotDigital is a good example; it recently said it is investing a lot of money in order to grow further down the road which will have a short-term impact on earnings. But you can't be precise about the timing of these things, and it just doesn't matter.
Growth can have a habit of accelerating and slowing down, so how do you approach what, as you say, is a hard thing to define?
What we tend to find is that we have a number of companies which are those really high-quality ones where you are very, very comfortable. You really feel they are just going to do their thing for a very long time and they can compound your money many, many times. They are wonderful but they are very rare.
We are often debating one or two that we don't own, and it's a question of how high you are going to reach in terms of price. Ideally in a portfolio you would just have that kind of company. In practice, they are quite rare, and there is a limit to how much you are going to pay, and sometimes they get very overpriced.
At the other extreme, you might have companies that are growing very rapidly, but may not be able to sustain that rate of growth indefinitely. They can sustain it for a reasonable period after which it will fade, but it's not going to fall off a cliff. I think that kind of company is much more common. They are not easy to find, but they are more common than the wonderful compounders. With these companies, you are looking to capture the period of rapid growth, the period of re-rating and then probably move on within a few years. Occasionally, they will surprise on the upside, and they will continue to do better than you expected. They may gradually get to be long-term compounders, but the majority don't, they will just do their thing for a period, and you come to a point where you have to move on.
Then, I think you have a group of companies in the middle which are not growing at stellar rates. They are growing steadily at high single figure or low-double figure percentage rates, which in today's world is very good. You wouldn't call them super dynamic, they are just steady, and although the growth rate is more modest, the price is more modest too. Often they'll be on the same PEG (price-earnings to growth ratio) as some of the more dynamic companies. You can argue that in risk terms, they may be better in some cases because you're paying much less so there is less downside if things go wrong.
So you can end up with three quite different types of animal in the same portfolio. There are times when you think: "I am definitely paying up for growth to buy this company". There are times when you are thinking: "this company is not going to grow forever but I am going to make quite a lot of money over the next three or four years". Then there are times when you think: "this company is growing nicely, and while it's not going to shoot the lights out it's much better than cash". They are all perfectly valid and they are all under the same umbrella.
On smaller companies...
One of the issues of targeting growth, of course, is that you're often dealing with smaller companies and potentially less experienced management teams. How do you manage that?
When we buy into a growth business, we want to buy into a company that we think is working now. We are not interested if management say that trading is terrible at the moment, but will be better in six months. In that case, we would rather come back in six months. We want everything to be working well today, and that includes having a management team that we believe are able to run the business properly. Obviously the ideal scenario is that the management team have a big shareholding, they aren't excessively greedy with salary and options and have incentive schemes that are aligned properly.
We want all that in there, but the most important thing to us is the business. I really do believe the Warren Buffett line that if you have a business with a reputation for terrible fundamental economics and a management team with a reputation for brilliance, it's the business's reputation that wins out. There is only so much management can do but having said that, really bad management can mess up a good business.
Once we have found a good business, in addition to alignment we want some comfort that the management have a reasonable track record in previous jobs. We meet with them and we ask questions about their objectives for the business. We try and get a feel for how they understand the business, how they think about the business and where they think the risks are. Then we will invest, and I would say we are not looking to do more than that really.
When there are problems, you either sell or you have to do more. When we engage with management, it's typically because there is a problem. It could be a simple thing like they have suggested a new incentive scheme that we think is crazy, in which case we will say so. We have a reasonable track record of engaging with them and winning.
If the problem is more fundamental than that, and things really go wrong - such as a massive profit warning - then we are normally minded to get out. Sometimes you don't want to get out because the price is too low and sometimes you think it can be fixed. Those are the situations where you then engage and become potentially much more active. We try and avoid it really, but if you have to do it, you have to do it. Sometimes you have a position that you simply can't sell because there is no market. In that case, you just have to get it right as best you can.
How do you decide how much of the funds to allocate to individual positions?
We size our investments depending on a whole lot of things. One of the inputs is liquidity, and the other is conviction, and there's normally a trade-off between the two. Typically, if it's a very small company, our view is we either have a 1% unit (1% of the fund) or we don't bother. If it's a very small business that is probably as far as we are going to go. If it's a reasonable sized small company, worth perhaps a few hundred million, then we might go in for 2% at the beginning. Again, that already gives us quite a big shareholding, and we don't want to end up owning the whole company. There are various rules on that, which limit us to 10% of an issue.
If it's a medium-sized company, then our initial holding could be higher, but again we don't tend to wade in straight away. We typically start at 2% with a brand new holding in a larger small-cap or medium-sized company. Over time, partly through share price appreciation and partly because we might be buying more, that holding will start to edge up.
If you look at our top 10 holdings (see below - MFM Slater Growth Fund, January 2016), they are 3-5% shareholdings typically, but it changes over time. If you go back a few years, we were much more concentrated. In 2011 and 2012, we had several holdings at around 8%, but we sold out of most of them completely and moved onto other things. This is a new generation of holdings that we are building up again.
On The Zulu Principle...
Your father wrote The Zulu Principle in 1992. Can you tell me about how and why you worked together on that?
I left university in 1991 where I'd read about 200 investment books. Almost all of them were from the US. I mentioned to my father that there was nothing of any merit in the UK that I was aware of and he agreed and thought he would write one. The original plan was that I was going to do the research and the editing and my father would write it, and that is what happened.
It was a good exercise because it was highly educational for me, and it was quite educational for him. His style of writing was very much that he wanted to say something, which most investment books don't. Some of the better ones do, but the vast majority don't; they tell you the theory, but he was looking to actually say: this is what you have to do. There is a responsibility that comes with that so he wanted to think very carefully about everything, and obviously I had to think very carefully about things.
When you reflect now on the strategy that he set out in the book, do you still agree with it?
Things change a bit around the edges, but I think the fundamental principles haven't changed at all. It is a very sensible idea as an investment strategy to seek out companies that have a reasonable record of earnings growth, that are forecast to grow well in the future, that generate lots of cash, and where you can buy the growth at a sensible price.
Like any measure, the PEG is imperfect, and it doesn't work when it's applied to the wrong thing. But when it's applied to the right thing and you combine cash flow and check the trading and that the most recent Chairman's statement is positive, those sorts of things are extremely sensible. Like anything, I think the main skill is in the interpretation of those principles and applying it. It's not easy to do that.
Following The Zulu Principle, my father developed REFS and that involved a lot of back testing. Again it was interesting that in the back testing, just very basic measures like the PEG and cash flow combined, historically worked really well. You obviously got some rubbish in there too, that's the nature of data, but it actually worked surprisingly well. I have been surprised over the years how the systematic approach is occasionally better than anything else you might be able to do.
In other words, a systematic approach can guide you into areas that you'd otherwise think twice about?
I was very impressed in 2000, the REFS screens captured the house builders which was an area at the time that I was not keen on. It flagged up oil companies in 2004 before a 10-fold run in some of those companies. I have a respect for the pure data. Obviously one has to interpret it and look at businesses carefully, but it (The Zulu Principle) has stood the test of time very well.
Valuations generally are higher than they were then, so arguably you may have to tweak things a tiny bit. But really the fundamental principles are very, very strong. There has been a lot of research since showing that when you combine growth and value filters, you get that combination which is what The Zulu Principle is really about. It's not growth at any price; it's growth at a reasonable price with additional protective filters. When you combine those things, it is one of the most powerful investment strategies in most of the academic works that I have seen.
There is a guy called Richard Tortoriello who wrote a book called Quantitative Strategies for Achieving Alpha. He looked at 1,500 different combinations of statistical criteria to see how they performed over a long period. Growth with value and cash flow filters is one of the top two. It doesn't surprise me, it makes perfect sense.
Looking back, it’s interesting to see how some of the companies singled out in The Zulu Principle went on to perform. Some did better than others.
Some of the companies that are in there as examples had problems many years later, but you are going to get that. At the time, they were good illustrations. In the book, there were companies like JJB Sports, which at the time was the biggest sports retail business in the UK, probably in Europe. The book came out in 1992, I set up Slater Investments in 1994, and we did very well in that between 1994 and 1996-97. We probably made five times our money on that some years after the book was published. But it ended up going bust many, many years later. But I would put that in that category of a company that had a period of super growth and then it really fizzled out because sports retail became a bit of a fad, it became more competitive and the dynamics of the industry changed.
In more recent times Supergroup (OTCPK:SEPGY) was a company we bought at IPO, and it went up three times in a few months. No business is that good, so we got out. It actually had quite a lot of problems after that for a period because it had grown so quickly. But it's now a more stable business, and it has sorted out the problems. You get those sort of dynamics in business, but it doesn't mean they are bad investments. You have to know what they are when you are going in, you have got to accept that it may not go on forever and that's fine.
On investment psychology...
Obviously you have great discipline and control, but are you conscious of some of the psychological biases that can sometimes hinder an investment decision?
Yes, it happens all the time! Take anchoring on price. One can get obsessed on price, you can look at a company, decide you are going to buy it, you have done all the work, and the price moves very slightly against you and goes up a bit. You had it in mind to buy at a certain price, and it's a very human thing to get stuck on the price, and of course, it's very stupid. If it's a brilliant business, a few percent on the price doesn't really matter.
I don't want to give money away, but at the same time, if you have done all the work and it's a great opportunity over the next few years and you are going to make 50% or 100% over 3-5 years, it's very silly not just to get on and buy it. So I am very conscious of that.
I am also particularly conscious of when things go wrong. It's very easy to hope rather than just move on. In our experience, probably eight times out of 10, it pays to cut, almost irrespective of the price. But there are times when it doesn't pay, and that is probably the hardest decision in investment - when should you cut and when should you not cut.
There is an interesting book that came out last year called The Art of Execution. It looked at the characteristics of good fund managers, and the key point was that when things go wrong you should do something. Either you should buy or you should sell, but what you should not do is nothing. We normally sell if we can at a reasonable price, and normally you can at some point if you really want to. Very occasionally, in very illiquid situations, you can't get out and then you've got to try and make it better and you have to get involved and try and move it on.
Occasionally, we decide we are going to keep a holding, but we are not going to buy more of it quite yet, but we will buy more at some point. We have one or two like that. It is very important not to be a rabbit in the headlights, you have got to do something. I think the worst investments are the ones where they just drift down and down and you do nothing. That is the thing people find psychologically very challenging.
I actually find cutting a loss extremely cathartic because you end it and you can put the money into something you like. It's a double whammy, not only are you getting out of something you don't like, but also you can put it into something that is better. A lot of that is about psychology. For most investors the battle to a large extent is with themselves, it's managing their own psychology just as much as researching investments.
A lot of quite good investment decisions might not look right for a period, for whatever reason they don't immediately work out. One has to have the courage of one's convictions, but not be pigheaded about it and be open to the possibility that one might be wrong. You have to have a mixture of conviction and humility, which is very difficult.
On the future...
One of our readers has asked how clients of yours can know that you've not just been lucky over the years, and that your outperformance can continue over the long term. What do you think?
I think a statistician would say they would have to live to about 10,000 to be absolutely sure and so would I. Statistically, they will never get comfort on that issue in a normal human lifespan, so I think you have to take a view. As a business, we have a nearly 22-year track record, and we have outperformed most of the time. I would say that typically we have one year in five where we are out of sync and lag. It isn't precise, but that is broadly what happens.
When we are out of sync, it's not because the companies that we own suddenly become bad companies. It's normally because other things are more in favour, but what it does is set you up for the next period of strong performance.
Our numbers have been very strong since we started, and I am confident that's because we are doing something sensible. I think for anyone assessing a fund manager or a fund, the key is to look at what they actually do, how they make their money and whether they are doing it consistently - and we are. We are looking for a certain type of company, and we are pretty good at finding them. We are pretty good at running our profits when we should be, and we are not bad at cutting our losses when we ought to.
In investing you need a methodology; if you haven't got one, I think it is punting really. We definitely have a methodology and we stick to it. It's about getting good at it and not veering off in different directions when it doesn't work quite as well - and there will be times when it won't work quite as well.
Finally, when you look at the market now, are you optimistic or cautious?
I think valuations are still at the upper end of reasonable and they have been for quite some time. They are more reasonable than they were a few months ago, so there is some improvement, but I don't feel there has been proper sell off. I think most people haven't actually sold, which normally means there is more to come. The flip side is there is a lot of cash on the sidelines, and the alternative uses of money are not very attractive.
I am not terribly bullish, but I am not hugely worried about things either. I think the markets might drift sideways, they might go slightly down for a period, but I don't have an extreme view one way or another. I am always conscious of the fact that if markets are drifting, it doesn't take very long for islands of extreme value to appear, and then it's very exciting. At the moment, I would say we are not really there yet, but it could happen any day, the market doesn't have to fall a lot for that to happen. Markets are just averages so you get interesting things happening all the time.
I would also say that people who are not good at market timing - i.e. everybody - shouldn't worry too much about market timing! If they find a good investment, they should buy it - there are very few people who make a lot of money being negative all the time.
Mark, thank you very much for your time.