Investment Strategy #3 - Zulu Principle

The Zulu Principle is about dedicating a disproportionate amount of effort to become an expert within a narrow subject though learning. From Slater (2008), this name is applied to the investment strategy because the Jim Slater’s wife read an Reader’s Digest article on the Zulu people and subsequently she had more knowledge than him within a few minutes. He thought that if she carried on studying on the same subject and lived in a Zulu village from a fixed period of time she would become a leading expert. The investor can be very successful by applying the same principle to the stock market. One can become an expert in blue chips, growth companies, turnarounds and/or cyclical companies.

The strategy I use is based on Slater (1998) and Slater (2008):

Buying

Mandatory:

1. A positive growth rate of at least 15%, 12% for large companies, in EPS in at least four of the last five years. Shorter record will suffice if there has been a sharp acceleration in EPS growth from an easily identifiable and sustainable source.
2. Prospective PEG less than 1 for large companies and less than 0.75 for smaller companies. Preferably PEG below 0.66.
3. Optimistic chairman’s statement. If usually cautious, accept a mildly positive forecast.
4. Strong liquidity, low borrowings and high cash flow. Ideal company is one with high net cash flow, substantial cash balances and no debt. For latter two, net gearing at most 50% and quick ratio at least 1 (preferably at least 1.5).
5. Strong competitive advantage. Evidence is shown in the form of high ROCE.

Highly desirable: 

1. Something new. Necessary when earnings record is shorter than usual.
2. Market capitalisation up to £300m.
3. High relative strength. Price within 15% of its high.

Desirable: 

1. A dividend yield. Low yield is fine as long there is growth in line with earnings.
2. A reasonable asset position. P/BV of around 1 or below.
3. Substantial management shareholding but not controlling. No substantial selling. 

Selling 

Only sell when the situation changes to the extent that the company no longer satisfies the above criteria and when PEG reaches 1.2. Examples of situation changes are profit warnings, pessimistic statements, loss of competitive advantage, creative accounting and so on.

Notes

Something new: 

1. Something new is highly desirable, not mandatory.
2. New management, products or technology, new acquisition, new event in industry as a whole.
3. New management is the most effective.
4. New products, events and acquisitions have to be sufficient importance to firm in question to increase future earnings substantially.
5. Distinction should be made between gimmicky one-off products and others that are likely to be long lasting.
6. New events, such as collapse of a competitor - short term. New legislation - long term.
7. Added advantage of something new is that it provides a ready-made story for the stock. Most important when fundamentals are poor.
8. When reading about a new major development, I think the likely effect it may have on existing portfolio and future selections.
9. Something new - superb confirmation when all other criteria are satisfied. 

Competitive advantage:

1. Competitive advantage underpins future earnings estimate and increases reliability of profit forecasts.
2. Forms of competitive advantage in order of invulnerability to competition: brand names, patents and copyrights, government legislation creating franchises, established position in niche market and dominance in industry.
3. Leading firms more likely to possess excellent brand names, patents and copyrights. Smaller firms tend to have products with this kind of potential and/or established position in niche business.
4. Avoid those that are too dependent upon one main supplier or customer, and firms in industry with intense competition. Also beware of products that might be easily substituted.
5. Dislike firms in general engineering and electrical business, textiles, building and contracting and motor industry. Prefer businesses in health and household products, food retailing and manufacture, and brewers and distillers.
6. A cross check on competitive advantage is profit margins. As percentage of turnover, at least 7.5% and preferably 10% to 20%.
7. Most reliable evidence of a firm with strong competitive advantage is ability of management to employ capital at a well above average rate of return, ROCE. 20% per year for industrials.
8. If identified a firm with strong business franchise, ROCE above average, earnings record first class, growth prospects reliable and shares should have high relative strength in the stock market.

I am strict regarding mandatory criteria and flexible on others.

Source:

Slater, J. (1998). Beyond the Zulu Principle: Extraordinary Profits from Growth Shares (1st ed.). London: Orion Business.

Slater, J. (2008). The Zulu Principle: Making Extraordinary Profits from Ordinary Shares (Revised 1st ed.). Petersfield, UK: Harriman House.