Screening on Jim Slater's Zulu Principle

In the 15-plus years I have been reading investing texts—especially related to stock screening—I have found the subject to be decidedly centered in the U.S. Therefore, when I ran across a book written on the other side of the pond in England, I jumped at the chance to see what it had to say.

First published in 1992, “The Zulu Principle,” by Jim Slater, is founded on the premise that individual investors can be successful by focusing their analysis on a narrow area.

Slater began his career as a chartered account and in 1964 founded Slater Walker Securities. However, during the U.K.’s 1973–1974 recession, Slater Walker collapsed, leaving Slater bankrupt. Following this, Slater turned to financial writing, penning an investment column, “The Capitalist,” in London’s Sunday Telegraph. It was in this column that Slater honed his stock-picking strategy that became the Zulu Principle.

In the second edition of “The Zulu Principle,” published in 2008 (Harriman House), Slater admits to fine-tuning his methods over the previous 16 years. However, he has stuck with the key tenets: a focus on growth shares of small-cap stocks with strong relative price strength that are still relative bargains at the time of purchase. In this article, we define Slater’s Zulu principles and outline a stock screen based on them.

Developing an Edge

Slater came up with the name for his strategy when his wife was reading an article on Zulu, the South African ethnic group, in Reader’s Digest. He felt that if she had gone to the library and read as many books as she could find on the subject, she could have become one of the leading experts in her town on the Zulu people. If she had flown to South Africa to live in a Zulu kraal for a few months and studied the available resources at a South African university, she might have become one of the foremost experts of her country, or possibly the world, on that subject.

Slater concluded that if you focused your attention on an area, particularly if that area is neglected by the larger community, it is easier to become an expert in that area. As Slater puts it:

“It is no good trying to be master of the universe. It is better to specialize in a narrow area and become relatively expert in it.”

Developing such an edge is important, since individual investors are up against full-time professionals. In order to gain a leg up on the professional investors, Slater suggests investors focus on a market niche that is underexploited by professionals. The niche that Slater prefers is the small- and micro-cap segment.

While Slater admits that professional investors do have definite advantages over individual investors, he also points out some advantages we have over the professionals:

• By focusing on smaller stocks, individuals are more likely to find a bargain since these firms tend to have less coverage;
• Professional investors have too much money to invest to allow them to invest in smaller stocks without impacting the price;
• Individual investors can focus on a smaller number of stocks, whereas professional investors typically must invest in hundreds, with the 100th selection being infinitely less attractive than their first choice.

The Zulu Principles

Slater divides his 11 Zulu Principles into categories based on their relative importance:

Mandatory Criteria

• A positive growth rate in earnings per share in at least four of the last five years;
• A low price-earnings ratio relative to the growth rate;
• The chairman’s statement must be optimistic;
• Strong financial liquidity, low borrowings and high cash flow; and
• Competitive advantage.

Important Criteria

• Something new;
• A small capitalization;
• High relative strength of the shares compared with the market; and
• A dividend yield;

Desirable Criteria

• A reasonable asset position; and
• Management has a significant shareholding.

Earnings, Growth Rates and the PEG Ratio

According to Slater, there are two basic reasons for growth shares to appreciate in price:

• Earnings growth; and
• An increase in the price multiple (price-earnings ratio) the stock market awards to the company.

For Slater, a strong earnings history gives him greater confidence in future earnings, which will ultimately dictate future price movements.

The price-earnings ratio is driven by the historical growth and projected future growth in earnings. It is a measure of how much you are paying for future earnings growth and how much others have paid before you.

While he would like to see positive earnings growth in four of the last five years, Slater is willing to overlook the “odd hiccup.” Furthermore, he is willing to forgo a longer history of rising earnings if there has been strong recent acceleration in earnings growth that he feels will continue. Steady growth of at least 15% a year should help to eliminate cyclical companies, provided that the period covers a complete economic cycle. The key for Slater is to find companies that are still in a “dynamic” growth phase.

He finds growth stocks with a price-earnings ratio that is below the market average even more attractive. However, what Slater is ultimately searching for are the “rare gems” where the price-earnings ratio is “modest in relation to the growth rate.” Slater looks for price-earnings ratios that are no more than three-quarters the estimated future earnings growth rate and preferably under two-thirds (called the PEG ratio). Buying stocks with low PEG ratios, according to Slater, provides investors with a “safety factor.”

Chairman Optimism

Each year in a company’s annual report, the chairman offers his or her overview of the past year and outlook for the future (in the U.S., this is often called the Letter from the Chairman).

Slater is looking for an optimistic statement from the chairman about the firm’s prospects, since one of the major determinants of a stock’s price is its earnings and, more specifically, the future growth of its earnings. If the chairman is pessimistic about the future, Slater views it as a possible signal that earnings growth is at or near an end.

Furthermore, Slater pays attention to corporate earnings guidance through the course of the year, which may also offer insights into the future earnings growth of the firm.

Strong Financial Position

After finding growth stocks with price multiples well below their prospective earnings growth rate, Slater shifts his attention to the financial position of the firm—specifically, financial liquidity and cash flow.

Financial Liquidity

Slater defines liquid assets as those that are “easily converted into cash.” Such assets typically reside on the short-term asset portion of the balance sheet—inventory, accounts receivable, short-term investments, and cash. Common sense tells us that a company with a substantial cash balance and no debt is in a stronger financial position than a firm with debt levels that exceed its cash position.

Slater also likes to look at a company’s “quick ratio”—the ratio of current assets, less inventories, to current liabilities. He prefers companies with a quick ratio of at least 1.0, but preferably 1.5 or higher.

Finally, Slater examines a company’s debt relative to its equity, using his own definitions of both items. For this analysis, Slater defines equity as the net tangible asset value attributable to common shareholders:

Equity = total assets – goodwill & intangibles – total liabilities

Slater’s definition of debt includes any short-term and long-term interest-bearing obligations as well as financial leases. From this he then deducts cash in hand to arrive at an “overall debt” figure.

He then takes the ratio of net debt to tangible equity and looks for growth companies with a value less than 50%.

Cash Flow

Cash flow helps determine the future financial position of the firm. It is the net amount of cash a company generates during its fiscal year. Slater looks at cash from operating activities, which is net income adjusted for changes in working capital items (current assets and current liabilities) and non-cash items, mainly depreciation.

Slater points out that there should not be a material difference between cash from operating activities and net income. When he finds net income exceeding cash from operations, he cautions that the company could be using “creative accounting.”

Slater sees cash from operating activities as important for two reasons. First, it is from this cash that a company pays its bills. A company can have positive earnings but still be depleting its cash. Furthermore, capital expenditures and dividends deducted from cash from operations results in free cash flow, which is what companies use to expand and which, in turn, should boost future earnings. Slater avoids companies with high capital expenditures that merely allow them to maintain the status quo. Instead, he prefers companies with high levels of free cash flow that will allow them to grow future earnings and, ultimately, drive the stock’s price higher.

Something New

While not mandatory, Slater prefers to invest in stocks with “something new” that captures the market’s attention. He offers three categories of something new:

• New management;
• New products or technology; and
• New acquisition or new event in the industry as a whole, including legislation.

New Management

For Slater, new management is the most important of all because the impact of new quality managers joining a company can be far-reaching and long-lasting.

New Product or Technology

The gains a company enjoys from developing a new product or technology can also be ongoing. The key for Slater is whether the new product or technology will have a meaningful impact on the company’s overall earnings.

However, Slater points out that it is important to differentiate between “gimmicks” with a short shelf life and products with staying power.

New Acquisition or Event

Slater cites a variety of news items that would impact an industry: for example, a major offshore oil discovery would benefit oil rig suppliers; wars benefit defense contractors; and so on. He includes the effect that the collapse of a major competitor would have on the remaining firms in an industry.

He also discusses how a new acquisition can have a major impact on a company: It can boost the company’s status in the industry and offer synergies that can be beneficial to long-term earnings.

Slater feels that something new is confirmation that his other criteria are satisfied. It’s often the cause of accelerating earnings, a higher prospective earnings growth rate, a lower PEG ratio, and high relative strength of the stock price.

When reading the details of a new development, Slater suggests thinking about the probable effects on stocks you already hold as well as on those on your watch list.

Competitive Advantage

For Slater, competitive advantage is of vital importance, as it underpins earnings growth projections and lends a greater degree of reliability to those projections. A company with a distinct advantage over its competitors is desirable because it is less susceptible to competitive forces. Slater quotes Warren Buffett:

“There are some businesses that have very large moats around them with crocodiles, sharks and piranhas in [them]. Those are the sorts of businesses you want.”

There are a variety of ways a company can enjoy a competitive advantage. Slater begins with companies owning one or more great brands. He cites Coca-Cola (KO), Nestlé (NSRGY) and Sony (SNE)—companies offering quality products that have reinforced their image through massive advertising campaigns. For companies such as these, the brand names themselves are valuable assets.

Another type of competitive advantage comes in the form of patents and copyrights. In the U.S., a pharmaceutical patent is valid for 20 years. Drug companies usually apply for patent protection before they actually begin producing the drug. However, by the time a drug comes to market, there may only be eight to 10 years of patent protection remaining, which is significantly less than the 20 years offered by the patent.

Government legislation can sometimes create monopolies and oligopolies, effectively limiting the amount of competition a company faces. Slater cites utilities and cable TV companies as well-known examples. However, in exchange for limited competition, these companies are usually closely regulated, which limits their pricing power. Here again, Slater quotes Warren Buffett:

“If I had the only water company in Omaha, I would do fine if I didn’t have a regulator. What you are looking for is an unregulated water company.”

Companies can also achieve a competitive advantage by having a niche business with a substantial market share. By achieving a large market share while producing a unique product, a company is somewhat insulated from competitors who face a high cost of entry into the market. The risk of competition will grow, however, as the market becomes bigger.

Another, albeit less precise, source of competitive advantage is being the biggest and most dominant company in an industry. Here, the idea of going up against such a dominant player may keep potential competitors from entering the industry.

Generally speaking, leading firms are more likely to possess excellent brand names, patents and copyrights. When looking for the smaller growth firms he prefers, Slater believes that you are more likely to find them in a dominant or very strong position in a niche market rather than having strong brand names or patent protection.

To help identify firms with a potential competitive advantage, Slater uses two metrics—profit margin and return on capital employed (ROCE).

Profit Margin

Slater explains that one way to identify a well-managed company operating in a growing niche business is to examine its trend in profit margin (Slater uses pretax margin, which is pretax income divided by sales revenue). He goes so far as to say that “the capacity to employ capital at a high rate of return is one of the surest marks of a true growth stock.” If a company fits into this category, profit margins will be positive and rising.

For Slater, a profit margin of 7.5% is a minimum hurdle, with 10% to 20% being preferable.

Return on Capital Employed

Slater also points out that companies with strong business franchises usually have excellent returns on capital employed (ROCE). ROCE is a useful measure for comparing the relative profitability of companies. Furthermore, ROCE measures how efficiently a company uses its capital.

Return on capital employed is the ratio of earnings before interest and taxes (EBIT) to capital employed. Capital employed is often defined as the sum of all common and preferred equity, all debt and finance lease obligations, as well as minority interests and provisions. In addition, Slater uses the average capital employed, which is the average of the capital employed at the beginning and at the end of the fiscal year.

As a rule, industrial firms tend to have lower returns than service-oriented firms. For small industrial businesses, Slater looks for an average return on capital employed of at least 20% over the last five years. Such returns, in his opinion, are not too high as to attract excessive competition, yet are sufficient to generate strong future growth.

Momentum & Relative Strength

Earlier in his career, Slater did not hold chartists—those who invested based on charts and technical analysis—in high regard. However, over time he gained an appreciation for this analysis to the point where he now looks upon charts as an important tool in his kit. He uses charts to offer confirmation that he is on the right path or as a warning that the fundamentals may be in decline.

Slater points out that dynamic growth companies with strong fundamentals should be performing better than the average of the market as a whole. Therefore, he looks at relative price charts that plot the price of an individual stock relative to a broad market index.

Another method of identifying growth stocks with strong price momentum that Slater uses is to invest only when the price is within 15% of its two-year high. Slater feels that if a growth stock is more than 15% below its high, there may be something he is missing in the fundamentals that is being signaled by the poor price action.

When using relative strength, Slater points out the dangers of ignoring the price chart itself, especially in a down market. During a bear market, a stock can still have excellent price strength relative to the overall market. However, this may only mean that the stock is not falling as quickly as the market index.

Small Market Capitalization

Throughout his book, Slater repeats the mantra that “elephants don’t gallop.” What he means is that smaller companies have a greater potential for strong future growth than large firms. While not every small stock becomes a market giant, the large firms of today were not “born” that way. They started small and grew to where they are today.

In “The Zulu Principle,” Slater mentions a limit of £100 million market capitalization (approximately $150 million). However, he is willing to relax this requirement to £200 or even £300 million (roughly $300 million to $450 million) if all of his other criteria are met.

Dividend Yield

As an institutional investor, Slater preferred dividend-paying stocks. Furthermore, he felt that dividend payments signaled management’s confidence in the future. Ideally, a company is able to steadily increase dividends in conjunction with its rising earnings.

However, Slater is also a pragmatist. If he finds a growth company that can employ capital at 20% a year, he would much rather the company retain its earnings and reinvest them in their operations.

Reasonable Asset Position

One consideration Slater mentions is the company’s “asset position,” whereby he compares the stock price to book value. Ideally, he would like to see the share price roughly equal to book value per share. However, he says this is of limited importance when investing in growth stocks. Instead, he feels that how much a firm is worth—the value of its assets—is of greater importance for value investors. He points out that companies with strong growth tend to have high price multiples, meaning the shares will be priced well above net asset or book value. As long as a company continues growing at an above-average pace, Slater is not overly concerned with the relationship between the share price and net asset value.

Management Shareholdings

Slater prefers the insiders of a company to own enough shares to give them the “owner’s eye” In other words, their interests are aligned with those of the typical shareholder. However, he does not want insider ownership to be so great that management controls the firm and is a potential roadblock to a future takeover bid.

He also pays close attention to insider sales. However, he considers the amount of shares sold relative to the overall number of shares held by the insider. When an insider sells a significant portion of holdings, a red flag is raised for Slater. However, he recognizes that insiders can sell shares for reasons other than declining company prospects.

Building a Screen

Table 1 summarizes Slater’s Zulu Principle approach to stock selection. Based on these principles, as well as the weightings he assigned to them, we set out to build a stock screen. To assist us, we used AAII’s Stock Investor Pro fundamental stock screening and research database program.

We began by implementing those mandatory Zulu principles that can be captured in a quantitative screen.

Earnings Growth

For our Zulu Principle screen, we captured two elements of earnings growth discussed by Slater. While he looks for companies that have increased earnings in at least four of the last five years, Stock Investor has a field that looks for the number of earnings increases over the last seven years. To take into account the longer time period covered, our Zulu screen requires earnings increases in at least five of the last seven years.

Therefore, for the second element of earnings growth (Slater’s criterion of 15% a year earnings growth), we also allow a company to pass our Zulu Principle screen if it has been growing fully diluted earnings per share from continuing operations by at least 15% a year over the last five years—even if it has not had at least five annual earnings increases over the last seven years. Most screening services offer long-term earnings growth as a screening variable.

PEG Ratio

While Slater uses the estimated or prospective earnings growth rate for the PEG ratio, we feel that this is counterintuitive given his penchant for investing in small companies. Although he prefers small companies because of their lack of coverage by analysts (which increases the likelihood that individual investors can capitalize on the mispricing by the market), a company must be followed by analysts in order to have an estimated earnings growth rate.

Therefore, our criterion looks for a low price-earnings ratio in relation to the historical earnings growth rate over the last five years. Slater looks for a PEG ratio of no more than 0.75, although he prefers 0.67. For our Zulu Principle screen, we set the PEG bar at 0.75, using the average annual earnings growth rate over the last five years.

PEG ratios using the historical earnings growth rate are common among screening services. However, if you wish to use a PEG ratio based on projected earnings growth, as Slater does, you may have trouble finding a service that offers it.

Chairman’s Statement

Sifting through the chairman’s statement or letter is beyond the scope of any screening service. Therefore, this is a step we will have to perform after we have run the quantifiable elements of our Zulu Principle screen.

Financial Liquidity

For our Zulu screen, we require companies to have a quick ratio for the latest fiscal quarter of at least 1.0.

Most screening services should offer the quick ratio as a screening variable.

Low Borrowings

Slater uses a custom measure of indebtedness that is a variation on the traditional debt-to-equity measure. As a proxy, we use long-term-debt-to-equity for our Zulu Principle screen. This variable is also widely available among screening services. In order to pass our Zulu Principle screen, a company’s level of long-term debt cannot exceed 50% of its total shareholders’ equity (long-term debt-to-equity of 50% or less).

Competitive Advantage

We use two different criteria to identify companies with potential competitive advantages. The first calls for the company’s operating margin to average at least 10% over the last five years (Slater uses pretax margin in his examples, but Stock Investor does not track pretax margin over the last five years). Using an average will smooth results over time and reduces the turnover based on this variable. While five-year average operating margin may not be widely available as a screening variable, most services will offer a “current” operating margin filter.

In addition, we look at the company’s return on invested capital ROIC for the latest fiscal year. ROIC is very similar to Slater’s return on capital employed. In order to pass our Zulu Principle screen, a company must have an average return on invested capital of at least 20% for the last five years. In Slater’s own words, a five-year average return “is a far more reliable way of judging the capacity of a business to employ capital exceptionally well.”

Since ROIC is not typically found in screen services, you may wish to use return on equity or return on assets as a proxy.

Additional Criteria

Slater rated his “important” and “desirable” criteria on a scale from one to 10, with a higher rating indicating greater importance. Of the remaining six criteria, three—something new, small market capitalization, and high relative strength—rate six or higher.

Something New

Like the positive chairman’s statement criterion, looking for something new is a subjective endeavor. Therefore, once we have our set of passing Zulu Principle companies, we would want to scan company and industry news for any indications of developments that will spur earnings growth and share prices going forward.

Small Market Capitalization

Once again, “elephants don’t gallop.” While Slater doesn’t have a problem investing in larger firms that meet his other Zulu principles, he admits that they are highly unlikely. In order to pass our Zulu Principle screen, a company must have a market capitalization of no more than $450 million, which equates to his £300 million cap based on current exchange rates.

Passing Companies

Table 2 summarizes the filters used in building a Zulu screen, and Table 3 lists the criteria as used specifically in Stock Investor Pro.

Table 4 shows the five companies passing our Zulu Principle screen as of April 23, 2010. They are ranked in descending order by share price as a percentage of two-year high. Slater views high relative strength as confirmation that his other criteria are capturing the companies he is seeking. In the book, he says high relative strength helps reduce the risk of any “nasty surprises.” Slater feels that weak price action can often be a warning sign of trouble in the underlying company.

However, of the five companies passing our Zulu Principle screen, only two would meet Slater’s criterion of having a current share price within 15% of the two-year high—premium heating/cooling equipment manufacturer AAON, Inc. (AAON) and Span-America Medical Systems (SPAN), a maker of therapeutic mattress systems, seat cushions and skin care products along with specialty foam products. iMERGENT, Inc. (IIG), which provides e-commerce solutions for online businesses, is at the bottom of the list, as its current share price is only half its two-year high.

All of the passing companies have seen average earnings growth of at least 15% a year over the last five years, with Transcend Services, Inc. (TRCR) pacing the group at 80.2%. The company provides medical transcription outsourcing and voice recognition solutions to the healthcare industry. However, all but one of the companies has seen earnings growth drop off significantly over the trailing 12 months—not the kind of earnings acceleration Slater desires. The sole exception is iMERGENT, which has seen earnings expand by over 173% over the last four quarters. The company earned $1.00 a share for the last four quarters compared to a loss of the $1.35 per share for the prior four quarters.

Life Partners Holdings, Inc. (LPHI), a life settlement provider, has the lowest PEG ratio at 0.2. The company acquires life insurance policies, paying a percentage of the net death benefit of the policy. The company has a current price-earnings ratio of 11.8 and has seen earnings increase from $0.17 per share in 2004 to $1.83 per share in 2009—an average annual rate of 60.8%.

Life Partners also has the highest average operating margin of 22.7% over the last five years. Furthermore, the margin has increased over each of the last three years.

iMERGENT, Inc. has an impressive five-year average return on invested capital of 63.2%. This figure is misleading, however, given that the company has generated negative returns in each of the last three years. The average is skewed by the 357.5% return on invested capital the company generated five years ago. This highlights the importance of delving deeper into financial data instead of relying solely on summary figures such as these.

Conclusion

Jim Slater’s Zulu Principle is designed to help individual investors identify reasonably priced growth shares of companies that are small enough to be out of the reach of professional investors. As a result, in Slater’s opinion, there is a better chance of finding mispriced (in your favor) stocks.

As our current results indicate, you could be left wanting for prospects depending on the current market conditions. Further analysis in backtesting is needed to see if enough stocks pass this screen over time to make it a worthwhile strategy for building a viable investment portfolio.

Remember, as always, that stock screening is only the first step in the stock analysis process. We may think we have come up with reasonable criteria to find worthwhile investments, but we can only be sure once we roll up our sleeves and start digging deeper into the data.