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:

• The Red Queen Effect -- Farnam Street
• Why you shouldn't buy stocks from the 52-week low list -- Howard Lindzon
• Just look the other way -- Morgan Housel
• Dividends are the most overlooked part of investing -- Crossing Wall Street
• Good times teach only bad lessons -- Reformed Broker
• The perils of market timing -- Brooklyn Investor
• When perfection is a problem -- Abnormal Returns
• The big cost of running an active mutual fund -- A Wealth of Common Sense
• Professor Aswath Damodaran's updated financial markets data for 2015 -- Damodaran Online

Book I'm currently reading:

• The Last Lion: William Spencer Churchill: Visions of Glory (1874-1932)

Stay patient, stay focused.

Best,

Todd
Follow @ToddWenning

3 Components of Multi-Bagger Success

Earlier this week, I was searching for the recent Charlie Rose interview with Peter Lynch and stumbled across an incredible 1990 interview that featured both Peter Lynch and Sir John Templeton.

As you can imagine, there are a number of great quotes from the interview and some of the investor concerns at the time -- high government debt, weak leadership in Washington, etc. -- reminded me a lot of today. The audio/visual is a bit grainy, but I'm just happy someone had the foresight to record this on VHS and then was gracious enough to share it on YouTube. It's well worth a watch.

What I was originally after when searching for the Charlie Rose/Peter Lynch interview was the following quote from Lynch about investing for multi-bagger opportunities (i.e. stocks that go up many-fold in value).

You want to get in in the first, second, third inning, not when they're drawing up the line-up...you could have bought Wal-Mart 10 years after they went public and they would have went up 50 fold.

There are three key takeaways from this quote:

1. Before investing in a smaller company, make sure the company has a viable business model
2. It's even okay if you're a few years late to the game as long as there's a lot of game left to be played
3. You have to be patient to reap large rewards

In the 1990 interview, when asked how investors should begin to research stocks, Lynch said investors should first make sure the company has sales and profits. The audience laughed, but Lynch was half-serious. 

Too often investors are after the "next big thing" when they're investing in small companies -- whether it be renewable energy, e-commerce, cloud computing, etc. -- and don't check to see if the company with a great story also has a viable business model. There's no point in investing in any company before it's proven its strategy.

To Lynch's second point, even if you recognize the company's promising business model a few years late, as long as the company continues to have a long growth runway, there's still an opportunity to buy. 

This is something that I myself need to put into practice. I've watched a number of promising companies -- Tractor Supply in early 2009 being the most prominent -- run away from me after I did all the research but missed the original opportunity and thought I'd missed the boat.

Great companies with long growth runways don't come along often. If you think you've found one early in its growth cycle, don't be afraid to take a chance.

The final component of Lynch's multi-bagger strategy is to be patient. There's a gem of a quote from the 1990 interview where Lynch says, 

My best stocks have been the third year, the fourth year, the fifth year I've owned them. It's not the third week, the fourth week. People want their money very rapidly, it doesn't happen.

It's easy to get this point confused in markets like we've had over the last two years where volatility has been low and stocks only seem to go up. I think this is part of the reason that retail investors are only now coming back into stocks following the financial crisis -- they see easy money being made and they don't want to miss out. If you want to benefit from a multi-bagger investment, it's absolutely essential to be patient and expect to hold for a number of years. 

Bottom line

Some investors will prefer to avoid swinging for the fences and focus entirely on getting base hits, and that's totally fine. If you are going to swing for the fences, however, Lynch's three-pronged strategy for multi-baggers is the best approach in my opinion.

Will Lynch's strategy always work out? No, not always, but one early investment in a Wal-Mart, Apple, etc. that was patiently held could have more than made up for the investments that didn't go to plan. Something to keep in mind. 

Good Reads this Week

• How to Get Rich, Feel Rich, and Stay Rich - Morgan Housel
• Decoding Mutual Fund Brochures - Reformed Broker 
• Floating Rate Bonds as a Hedge Against Rising Interest Rates - Monevator
• 12 Steps to Fix Your Firm's Investment Committee - Ann Marsh 
• The 180 Rule and Shorting Stocks - Dasan

Quote of the Week 

The main thing that people need to learn is that selecting assets is totally different from almost every other activity. If you go to 10 doctors and they tell you the same medicine that's the thing to take, if you go to 10 engineers to build a bridge that's the bridge but if you go to ten investment advisors and they pick out the same asset you better stay away from it. - Sir John Templeton

Best,

Todd
Follow @ToddWenning