Saturday, January 10, 2015

The Benefits of a Focused Investing Approach

When I was working in London a few years ago, I would often hear about a well-regarded investing book called The Zulu Principle by Jim Slater. As an American investor, I'd never come across the book and was curious to figure out what it was all about.

Above all else, the "Zulu Principle" is about focusing as an investor. Indeed, the name itself came to Slater after his wife read a four page article on the Zulu tribe in Readers Digest and he concluded that, from that short article alone, his wife knew much more than he did about the Zulus. Taking it a step further, he reckoned that if she then went to the library and read more about the Zulus, she'd probably know more than anyone in town. If she lived in South Africa to study the Zulus for six months, she'd know more than anyone else in Britain.

In other words, by focusing on a niche, one can more easily become a leading expert on the subject than if they tried to understand everything. This is consistent with Buffett's advice to only invest in companies within your circle of competence.

While Slater discusses a number of investing approaches in the book, he believes that individual investors should spend most of their time researching smaller companies where there are fewer institutional investors to compete with and where an information edge is more likely to be obtained.

One of the things I particularly like about Slater's approach is that his investing process is simple, consistent, and repeatable.

Here are some of the criteria that he looks for in a new investment. The first five he considers mandatory while the latter six he considers to be added "protection."
  1. A positive growth rate in earnings per share in at least four of the last five years.
  2. A low price/earnings ratio relative to its growth rate. Look for a PEG ratio under 0.75, ideally under 0.66.
  3. An optimistic chairman's statement. If management's commentary about the coming year is negative or cautious, don't buy.
  4. Strong liquidity, low borrowings and high cash flow.
  5. A substantial competitive advantage.
  6. Something new. Does the company have a new product or service that the market may not fully appreciate yet? 
  7. A small market capitalization. Are large investors overlooking or unable to buy this stock? 
  8. High relative strength of the shares. Only buy a growth stock within 15% of its 52-week high.
  9. A more than nominal dividend yield. 
  10. A reasonable asset position. 
  11. Management should have a significant shareholding. 
That's a pretty good list if you're looking to invest in smaller growth companies. Of these 11 criteria, the most difficult to be consistently right on is #2. Slater recommends using broker forecasts (which may themselves be biased) to determine the "G" in the PEG ratio, but with smaller companies that have less analyst coverage, you'll need to do more of the work yourself.

If starting from scratch, I'd calculate the company's "sustainable growth rate" (discussed here) to determine what growth rate the company is capable of achieving. Also read through conference call transcripts and any investor presentations to see if management has an earnings growth target.

Slater also recommends a focused portfolio of 10-12 stocks with a maximum 15% invested in any one stock. By owning fewer stocks, it stands to reason that you'll become more expert in those companies than others in the market.

While U.S. investors may struggle with some of the U.K.-focused terminology and some dated company examples in the book, The Zulu Principle is definitely worth a read. I've added it to my recommended reading list.

Finally, here are a few good quotes from the book:
  • "Elephants don't gallop."
  • "Investment is essentially the arbitrage of ignorance."
  • "Do not go bottom-fishing - you can drown that way."
  • "If you are intent upon turning a stampede, you have to wait until the cattle are tiring; otherwise you can be trampled underfoot."
Hard to believe, but this is the 100th Clear Eyes Investing post. Thank you very much for reading! 

What I've been reading/watching this week:
Book I'm currently reading:
Stay patient, stay focused.