Yahoo Finance Can investors use the Zulu Principle to beat the S&P 500?
When we asked our subscribers to name their favourite book on investing, most responded with Jim Slater's Zulu Principle. This was interesting. Many of the world's most successful investors have been American; from Graham and Buffett to Greenblatt and O'Neil. Jim Slater on the other hand is an example of British home-grown talent. So today we'll explore whether a British investment strategy can work on the other side of the pond. Can investors use Slater's methods to beat the S&P 500?
What is Jim Slater's Zulu Principle?
Jim Slater first became famous in the 1960s, writing an investment column for The Telegraph under the pseudo name, Capitalist. Many investors may already be familiar with Slater's best selling book, The Zulu Principle (1992), where he lays out his strategy for identifying cheap stocks with dynamic earnings growth. To find investment opportunities, Slater uses a number of quantitative metrics, including the PEG ratio, which measures the trade-off between a stock's price, its earnings per share (EPS), and the expected growth of the company. He also uses qualitative criteria. For example, he likes companies with a competitive advantage, including excellent brand names, patents or an established position in a niche market.
There is a wealth of content explaining Slater's approach to investing, but in an a nutshell, he blends four factors: Quality, Value, Momentum and Growth. He likes good, cheap companies that are growing their profits and beating the market. How has the strategy performed over the last few months?
Can investors hunt or farm Zulu stocks?
Over the last few months, you could have done quite well by investing in a basket US stocks that qualify for Stockopedia's Zulu screen (ie. Zulu stocks). The screen has returned 17% since July, while the S&P 500 only appreciated by 3.4% - though it should be noted that there have been only 8 stocks qualifying, so the strategy has been quite concentrated and thus high risk.
The Zulu screen is a very forward looking screen that uses forecasts growth rates extensively in the calculation of the PEG, PE and EPS Growth metrics. In more bullish environments where brokers have generally been edging up their numbers it has done well, not only in the US, but also in the UK and Europe. However, just remember that because the screen is forward looking, it may become vulnerable in market environments where brokers are reducing estimates.
It is very often the case that a large chunk of a portfolio's profits are attributable to one or two stocks. For example, Elecsys and John B Sanfilippo have returned 61% and 24% respectively since they qualified for the Zulu Screen on 30 September. If we took them out of the portfolio, the Zulu Screen would only have returned 4.8% since September - struggling to beat the S&P 500 (4.1%). The overall distribution of returns of individual Zulu stocks has been broad, on average being 14% higher or lower than the returns of the whole screen, as Table 1 shows.
This is why it's so important to invest in a wide basket of shares when using any systematic strategy. If you were only going to invest in a handful of Zulu stocks, would you really have chosen the right ones? Research by Joel Greenblatt has shown that invariably people pick the wrong stocks from stock screens, as it's often the most unusual or unpopular picks that end up performing the best.
Table 1: Portfolio tracked since 30/09/2014
Returns (%) since 30 Sept | Deviation from portfolio return | |
-4.70% | 17.86% | |
60.70% | 47.54% | |
1.80% | 11.36% | |
9.40% | 3.76% | |
24.10% | 10.94% | |
18.90% | 5.74% | |
-0.70% | 13.86% | |
6.20% | 6.96% | |
2.70% | 10.46% | |
Average | 13.16% | 14.28% (Mean Average Deviation) |
Where is the growth coming from?
Our Zulu Principle screen only applies quantitative filters, which can be found here. However, Slater uses qualitative criteria too. In The Zulu Principle, Slater outlines that he likes to invest in firms with a competitive advantage. Some investors see a high ROCE (ie. over 12%) as a sign that a company has a strong competitive advantage. But is there a story behind the numbers?
Lets take a look at John B Sanfilippo - a processor and distributor of peanuts. The company has a ROCE of 16% - higher than nearly 90% of US companies. Their annual report notes that their vertically integrated nut processing operations enable them to purchase nuts at a lower cost, as opposed to purchasing from other sellers. John B Sanfilippo is growing quickly, but remains cheap. Sales have grown each year since 2009, but the company has a P/S Ratio of just 0.5 - cheaper than 85% of US stocks. Earnings have also had a long growth streak, stretching back to 2012 when they grew by more than 160%. Again however, this growth is not fully reflected in the price. The company's forward P/E ratio is 14, against an S&P 500 average of 17.
The other top performer in the Zulu screen has been Elecsys, a provider of communication technology solutions. Elecsys was trading at around $10 until 4 November, but then it shot up towards $17. Why? The company announced that Lindsay Corporation was about to acquire Elecsys for $17.50 per share. What made Elecsys such an attractive target? The company has a high ROCE (21%) and their annual report suggests that the company has an established position in a niche market. Indeed, Elecsys' most recent 10-K filing notes that 'we participate in certain specialised industrial sectors of the market where we believe our proprietary products have a significant portion of the market.'
Want to learn more?
So the Zulu Principle screen has returned nearly 20% in the US, while the S&P 500 climbed a mere 5%. The strategy has also done well in the UK, returning 59% over the last two years while the FTSE 100 appreciated by 17%.
However, investors should consider that we have only tested the strategy in the US over a very short time-frame, starting towards the end of July. We have not tested the Zulu Principle in more bearish conditions, where the portfolio could behave differently. Furthermore, the US portfolio has on average only had around 8 qualifying stocks, meaning the strategy is highly concentrated and therefore high risk.
If you are not a Stockopedia subscriber, but would like to see the shares that currently qualify for the Zulu screen, click here for a free trial.
We encourage readers to do their own research to inform their own investment decisions. You can read more about portfolio diversification here. Furthermore, if you want to learn more about finding bargains amongst cheap stocks, feel free to download our free e-book, "How to Make Money in Value Stocks", where we go into a lot more detail about the PEG ratio and other Value metrics.
Safe investing.
Alex
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