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QUALIPORT
Is The Zulu Principle Suitable For Long-Term Investors?

By Maynard Paton (TMFMayn)
February 4, 2002

Carburton Street, London -- Perhaps the most famous book concerning the UK stock market is Jim Slater's The Zulu Principle. Published in the early 1990s, the book laid down a straightforward investment 'system' that quickly proved popular amongst private investors. Indeed, such was the success of The Zulu Principle, it spawned the creation of Really Essential Financial Statistics, a tipsheet, a Foolish series of articles and a sequel, Beyond the Zulu Principle.

But with five years having passed since the publication of the Beyond the Zulu Principle follow-up, has the system weathered the test of time?

Today's Qualiport will consider the main criteria used in the two books. Thursday's Qualiport will review the shares featured in the books and check up on their longer-term progress.

Refining

After laying down his original investment criteria in the Sunday Telegraph during 1963, Jim Slater has gradually refined his stock picking technique over the years. Taken from Beyond the Zulu Principle, the following criteria are the most up-to-date:

Mandatory
* A PEG with a relatively low cut-off such as 0.75;
* A prospective price to earnings (P/E) ratio of not more than 20. The preferred range for a P/E is 10-20 with forecast growth rates of 15-30%;
* Cash flow per share in excess of earnings per share (EPS), both for the last reported year and for the five-year average;
* Positive cash or gearing below 50%;
* High relative strength for the previous twelve months;
* A competitive advantage, which will be usually evidenced by a high return on capital employed (ROCE) and good operating margins, and;
* No selling of shares by a cluster of directors.

Highly desirable
* Accelerating EPS, especially if it is a result of activities being cloned;
* A cluster of directors buying shares;
* A small market capitalisation in the 30m-250m range, and;
* A dividend yield.

Bonus
*  A low price to sales ratio (PSR);
* Something new;
* A low price to research ratio (PRR), and;
* A reasonable asset position.

All the criteria have their merit. Of the mandatory points, Slater commendably tells investors to check a company's cash flow and debt level. However, Slater is most celebrated for his liking of the PEG.

Peg Problems

To recap, the Price Earnings Growth ratio is calculated by dividing a company's prospective P/E by its estimated future growth rate. Companies with a PEG of well under one, as Slater writes, "are usually worth examining in much more detail with a view to a purchase". However, shares with PEGs of over one "tend to be unappealing". The theory is that shares with PEGs below one have a greater chance of an upward P/E re-rating (and commensurate price rise) should the forecast earnings growth materialise.

But there are two notable problems with the PEG valuation measure.

Firstly, it's reasonably clear that a company growing at 20% per annum sitting on a forward P/E of 10 (equating to a PEG of 0.5) appears cheap. But should a company growing at 5% per annum have a P/E of 5 to be considered fairly valued (i.e. have a PEG of 1)?

(That said, Slater did specify a range of preferred P/Es and growth rates in his second Zulu book, so as to catch only the more obviously undervalued higher growth companies.)

But the main PEG problem lies with the growth expectations used. All too often, investors blindly use brokers' two-year earnings forecasts, rather than a suitable sustainable earnings growth rate. And with Slater favouring reasonably high 15-30% growth rates, the companies that tend to meet the PEG criteria are those having a few years in the sun, rather than 'great businesses for a long-term investor'. The quality aspect is also hindered by Slater considering companies with just two years of past earnings growth, too.

Relative values

Of the other mandatory points, the one stipulating a high relative strength (i.e. the shares have outperformed the overall stock market) over the past twelve months should raise an eyebrow.

Does the past performance of a share price have any bearing on the company's future performance?  Of course not. Yet Slater argued, with varying degrees of statistical 'proof', that past share price performance did matter. In fact, he even wrote: "The month of the year can be an important factor in deciding when to buy shares".

Short-term

On reflection, Slater's Zulu system has a bias towards shorter term holding periods. The focus on near-term earnings forecasts and essentially following share price momentum suggests Zulu shares should be held only for one or two years in order to capture the anticipated P/E re-rating. The fact that Slater only uses six-month timescales for various performance tables underpins this suggestion.

Now, there's nothing wrong with the Zulu principles if you like short-term 'value' or 're-rating' strategies. But with quotes from Warren Buffett liberally spread around the two books, there is a confusing mix of a short-term statistical-based strategy interspersed with long-term Buffett wisdom.

Indeed, Slater does write about the attractions of 'business franchises' and the important of competitive advantages in both of his books. But it's the poor application of this mandatory criterion that proved to be the downfall of the strategy for long-term investors.

While the above comments on PEGs and relative strength is just opinion, the real test of whether the strategy is suitable for long-term shareholders is how the selections subsequently fared over many years. Thursday's Qualiport will thus look at the shares highlighted in the Zulu books and ask "Where are they now?"

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