Friday, April 20, 2018

Book Review #35: The Zulu Principle: Jim Slater

This is the review of the book 'The Zulu Principle - Making Extraordinary Profits from Ordinary Shares'. This book is written by Jim Slater. 

There are two ways by which an investor can make money in the market. Invest either in stocks or in bonds. Zulu principle is all about focus. So at the outset, the author informs us that this book will focus on the former (investing in stocks) and will ignore the latter. 

The first edition of this book was published in 1992, the author outlines the objectives of this book which is to explain five methods by which an investor can make money by investing in stock market. 

The five methods are to invest in:

1. Small dynamic growth companies with a market capitalization between £5m to £100m
2. Turnaround situations and cyclicals.
3. Shells, listed small companies (Penny Stocks)
4. Asset Situations (Asset plays)
5. Leading stocks in the FTSE-100 (Large Cap Stocks)

Zulu principle expects the investor to be proficient in one or two of the above methods and focus on them.
James Derrick Slater

19 Chapters in this book are broadly divided into three parts. The favorite method of author is to invest in small dynamic growth companies and hence this method is discussed in detail in part 1. Second part consists of detailing the other four methods. The third part consists of general discussion on portfolio management, what to expect from your broker, investing in overseas markets (Global Investing), Market Cycles etc. The book winds off by providing a set of 10 guidelines to make you a better investor. 

Ensure to invest in your own house first before you invest anywhere else. Also you must use only 'Patient Money', one that is available over and above your 'emergency fund'. To win the investment game, you should develop a set of skills. This means that you should be ready to spend real time, at least 30 minutes a day reading and analysing. In addition, you have to find a market niche that is under-exploited by experts. Once you identify that niche, learn everything you can about it and stay invested within that
niche. As the author says, investment is an 'arbitrage over ignorance' (isn't it the 'greater fools theory'?). The more you learn, the more you win that game of arbitrage.

Small, dynamic growth companies are those under researched companies in exciting businesses with significant growth potential. To identify these companies, first we have to look for a tail wind, these stocks will be normally found in industries with favourable prospects. PEG factor is used as a measure for the return potential. The PE ratio is compared with the potential earnings growth and those stocks with PEG less than 0.75, preferably less than 0.66 is selected for further analysis. 
There are eleven criteria used for analysing the selected companies. The following five criteria are mandatory. These are Five Year Record of annual earnings growth of 15% or above, Low prospective PEG Factor, Optimistic Chairman’s Statement, Strong Financial Position, Competitive Advantage etc. The other criteria are, Something New, Small Market Capitalisation, Relative Strength, (Important) Dividend Yield, Reasonable Asset Position and Management Shareholding (Nice to have). 

When it comes to turnarounds and cyclicals, timing is of great importance. You must be able to buy into a turnaround at an early phase and sell them as soon as the market acknowledges the same. In case of cyclicals, one should enter at the bottom of the cycle and ride till the market has realized that the cycle has changed. In both the above cases the investor should maintain a strict discipline of not waiting for the market top to sell. A 25% fall from the top should be a reason enough to sell a cyclical or a turnaround.

Shells are small  listed companies with reasonable amount of liquidity. They are very risky investments. One should look for a new management to buy into a shell and then invest. In the case of shell the investor should sell if the price has fallen by 40% or ride the profit for one year before doing a review. 

While large cap companies are less risky and has good liquidity, it is difficult to get them within the strict set of criteria laid out in the book. For these companies, one can consider a PEG factor of 1 to be considered for investment. There are very few shares in this category with a potential to double your returns in a short time. As the author says repeatedly, 'Elephants can't gallop'. 

Author sites extensively from Mark Faber's 'Gloom and Doom' report to discuss overseas investing. There are 6 phases in the lifecycle of an emerging market. They start with Phase 0 where there is absolute 'gloom and doom', through gradual improvements in phase 1 and 2 leading up to a bubble in phase 3, slowdown in phase 4, crash in phase 5 and ending up with extreme depression in phase 6.

Then the cycle repeats itself.

An investor who enters early in the cycle, in phase 1 and 2 can make exceptional returns of about 2500% (25-30 times) (Note: I think Saudi Arabia is currently in the Phase 2).

When selecting a broker, do not be a penny pincher. Pay for good quality of brokerage services including recommendations, availability and quality of service. A good broker should have access to most of the trade journals and trade magazines and should make them available to you on demand or as the case may be.

What should be the size of your portfolio? Author recommends 10 to 12 stocks with a maximum investment of 15% of your portfolio in any one of the stocks. Also be an active investor. Attend
AGMs as much as possible. Another key recommendation is to 'Never average down'. When to sell is a key decision of an investor. Some helpful suggestions are given. For growth stocks, run the profits till the story changes. For cyclicals and turnarounds, sell as soon as market acknowledges the changing situation. Buy asset plays at 50% discount to the net asset value and sell when price equals the net asset value.

One of the critical question that any any investor will have is 'How do I identify a market top and market bottom?'. Author gives some pointers to identify a bull market top including, increase in interest rate, reduction in broad money supply, market not reacting to good news etc. Signs of bear market bottoming out are exactly the reverse, lowering of interest rates, increase in broad money supply, market not falling on bad news etc. 

How should an investor handle his portfolio when he expects a bull market reversal? Author recommends that at least 50% of your portfolio should be invested in market during the bear market. Regarding stocks there are two suggestions. One, do not sell your super growth stocks, even in bear markets. Two, retain your defensive stocks, for example Pharma stocks. 

The last chapter summarizes this book with a set of 10 Guidelines for an investor.

This book is very good. Highly detailed with a lot of practical examples to illustrate many of the points made. While it took me multiple readings to get the structure of this book in my mind, I consider the time well spent. This being the first investment book that I was reading on Kindle, it took some reading and note taking before I could come up with this output. You can see the results of the labour in the 'Notes and references' section below this review. 

This is one of the few books that I will give a score of 5/5.

Mr.Slater is from England and this book is written from a British Stock Market perspective. Some of the terminologies are different from that is commonly used in US and India. Large Cap Companies are referred to as 'Leading Shares', 'Listing', as 'Quotation', 'Asset Plays' as 'Asset Situation' etc. In addition, many of the resources mentioned in the book may not be available in India and elsewhere.

There are other small differences that make this book distinctly British. For example, Benjamin Graham, whom Americans refer to as the 'father of value investing' is referred to as 'american investor'

And quaint, as they say there...


Notes and references

Beginning of preface to 92 edition
There are a number of different methods and areas of investment, some of which I will explain to you in much more detail in later chapters:
Small dynamic growth companies Fast-growing companies with market capitalisations ranging from £5m to £100m are not researched frequently by the investment community, so their shares are often exceptionally attractive.
Turnaround situations and cyclicals Companies that have been hit hard by a recessionary environment or other exceptional factors are often due for a rebound. These situations involve cyclical companies and those which have recently had a change of management.

Shells Shells are another exciting medium of investment. These are often very small companies that have a quotation, a small, nondescript business of little account and occasionally some cash.

Asset situations Some of my friends invest solely in companies in which the shares have a market value less than the worth of the underlying businesses on a break-up. These value investors wait for a trigger, such as a bid or the arrival of new management, to revitalise the assets and bring them up to their full earnings potential. The shares then begin to appreciate in value.

Leading stocks Companies in the FT-SE 100 Index usually offer the comfort of size and rarely fail completely. They are, however, well analysed by the investment community, increasing the difficulty of finding a real bargain. I intend to give you some selective criteria that should improve your investment performance with leading shares in this country.

I am anxious to show you how to make some money by using an approach that I have named ‘The Zulu Principle’. You will not be spending any time on gilts, preference shares, loan stocks and the Japanese market. Instead, you will concentrate upon five different ways of making money by investing in ordinary shares before you finally select one method or perhaps two that suit your temperament.

Begin preface to 2008 edition

The Zulu Principle explains how important it is to focus when investing.

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

I have always focused on small and micro-cap stocks. The reasons are obvious – first, they are under-researched so better bargains are available and second, on average they perform very much better than larger-cap stocks. In fact over the last fifty years micro-cap stocks have outperformed the

First, I look for a tailwind. If you are in the right business at the right time it is very difficult not to make a lot of money. If you are in the wrong business at the wrong time you are bound to lose money. One way of ensuring that you are in a business with a favourable outlook is to make sure that the relative strength of the sector and the stock you fancy in it is very positive in the previous year compared with the market as a whole.

As part of my Zulu Principle focus I concentrate on growth shares.

I also look for shares which are a relative bargain at the time of purchase. This is determined by comparing the prospective price-earnings ratio with the forecast growth rate.

Ideally you want to ensure that the prospective price-earnings ratio is well below the growth rate.

It is vitally important that the company should have a reasonable record of growth. At the very least there should be two years’ past growth and two years’ forecast growth.

Another very important criterion is to make sure that cash flow is in excess of earnings per share.

Another vital criterion is to ensure that the directors are not selling their shares.

About eight years ago, James O’Shaughnessy wrote a very interesting book, What Works on Wall Street, in which he analysed the performance of shares with different characteristics over a forty year period. He found that by following one sensible criterion such as strong cash flow or good relative strength in the previous year, you would have outperformed the market by a considerable margin.

A strong growth record An optimistic future outlook and forecast A low price-earnings ratio in relation to the forecast growth rate Strong cash flow well in excess of earnings per share Moderate as opposed to excessive gearing Positive relative strength in the previous year Directors buying

End of preface. He explains Zulu principle, basically focussed appproach. He also talks about  his main criteria for investing

Chapter 1: Winning

Before you participate in the game of investment, you should make sure that you acquire the necessary skill and that you can afford the stakes.

I strongly recommend that you first invest in your own house or flat. In

You also need to ensure that you have some money set aside for school fees, illness and a rainy day.

The money that you are going to use for investment in shares has to be patient money that will not need to be withdrawn suddenly.

There is a way to win, but unless you are prepared to dedicate a few hours a week to your investments, you will have no hope of succeeding. I suggest an average of at least half an hour a day –

To compete you need to develop an edge, so let me encourage you now with a few ideas. First you must find a market niche that is under-exploited by the professionals.

First you must find a market niche that is under-exploited by the professionals.

Investment is essentially the arbitrage of ignorance. There is very little that is unknown about leading stocks, so in that area of the market there is hardly any ignorance to arbitrage.

The second factor that gives you an advantage over professionals is that they usually have to invest a massive amount of money.

A further aid to overcoming expert competition is to apply The Zulu Principle to investment within your chosen niche market. I will show you five different approaches and suggest that you specialise in one of them. To begin with, we will look at a method of investing in relatively small companies that have shown strong past earnings growth, have future potential and appear to be rated inadequately by the market.

Let us now look at smaller growth stocks in more detail. You are searching for those that appear to be inadequately rated by the market.

There are two basic reasons for growth shares increasing in price and providing you with substantial capital profits in the process. The first is the earnings growth itself.

During the few months following the results, the market would be very likely to re-rate the shares to a more appropriate multiple,

In summary,
1. Make a conscious decision to devote at least three hours a week to your investments. 
2. Read the whole of this book before selecting an approach to investment that you feel would be most suitable for your temperament.
3. When you have selected your niche market become as expert as possible in that particular area of investment.
As Warren Buffett, the legendary American investor, says, it is not necessary for an investor to know more than one thing, but he certainly has to know that.

Chapter 2. Small Dynamic Growth Shares

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 liquidity, low borrowings and high cash flow. There are two ways of checking liquidity. The first is very simple – see if the company usually has a positive cash balance. Watch out for overdrafts and short-term loans on the other side of the balance sheet. You are looking for net cash. The second method is to determine the cash flow by analysing the accounts.

You are trying to identify businesses which are not operating in an over-crowded market where intense competition will erode margins.

The key points are that the product or service the company is supplying should not be easy to substitute; and new entries into the industry should be hard to envisage.

quick way of obtaining an idea of a company’s relative strength in its industry is to examine pre-tax profit
margins and the return on capital employed.

Something new You want shares to have a story.

A small capitalisation As elephants don’t gallop,

High relative strength of the shares compared with the market

At the time of purchase, as a quick rule-of-thumb cross-check, make sure that the growth shares you select are within 15% of their maximum prices during the previous two years.

A dividend yield

A reasonable asset position Very few UK growth shares

Management should have a significant shareholding. You are looking for shareholder-orientated management that will look after your interests with the ‘owner’s eye’.

Chapter 3: Earnings, Growth Rates and the PEG Factor

You should also bear in mind that P/E ratios are usually higher in a non-inflationary climate.

Clearly, the ideal investment is a company in which earnings per share are growing annually at a high and sustainable rate.

If this kind of share can be purchased on a price earnings ratio below the market average, you have discovered a jewel

If the price earnings ratio is above the average of the market but modest in relation to the growth rate, you have still found a rare gem. Remember that there are only two

The past history of the P/E ratio for the company year by year indicates the level other investors believe to be normal. The average P/E ratio for the industry. For an above average company you do not mind paying more, but not ridiculously so. The average P/E ratio of the market as a whole is another basis for comparison.

The P/E ratio can often simply be compared with the prospective growth rate.

the aim being to find shares which have a PEG of well under one.

Our target is a prospective PEG of not more than 0.75 and preferably less than 0.66.

Do not under-estimate the PEG factor as a measuring instrument and as a very important investment

Chairman’s statement on the future outlook helps both at the year end and half-yearly. The ‘body language’ of the Chairman is also important.

critical factor is the estimated future growth rate.

The most reliable indicator for the future is probably the brokers’ consensus estimate of future earnings.

If you have invested in a company growing steadily each year, your main concern should be any slowing down in the rate of growth.

There are few worse investments than a growth share going ex-growth.

Some businesses are highly seasonal – for example Farepak, a leading company in the hamper business, invariably reports a loss for the first half. The full year’s results are made or broken by Christmas.

We deal with this reservation by simply comparing the current half year’s results with those of exactly the same period in the previous year and the current year’s results with those of previous years. Some businesses are highly cyclical. These are not true growth shares,

Some businesses are highly cyclical. These are not true growth shares,

Allowance has to be made for times of deep recession.

there should be some tolerance for a diminution in the rate of growth during an extreme recessionary period.

You are seeking shares with an earnings growth rate of 15% per annum compound or more and a prospective PEG of not more than 0.75 and preferably less than 0.66.

ideally, you want there to be recent acceleration in the earnings growth rate.

The key point is to look for companies that are still in a dynamic growth phase.

A further very important factor in buying a rapidly-growing stock, and in judging whether or not the P/E ratio is expensive, is the exact timing of your purchase. Let us return to MTL Instruments and assume

When a baton is passed in a relay race attention focuses on the next runner and the next lap – moving from the historic to the prospective P/E ratio.

By purchasing fast-growing shares near the end of one financial year (or half year) you frequently enjoy a one-off gain as the market adjusts to absorb the results of the previous year and digests the news that next year should be even better.

A number of points in this chapter are worth repeating for both emphasis and clarification. You are seeking to identify shares with the following characteristics:
1. Increased earnings per share over the last five years at a compound rate of about 15% per annum or more. A shorter period is allowable when there is a recent acceleration in earnings, preferably with an easily identifiable and sustainable source such as new management.

2. A P/E ratio that is very attractive in relation to the growth rate with a target of a prospective PEG of not more than 0.75 and preferably under 0.66. Put another way, the prospective multiple should be not more than three-quarters of the estimated future growth rate and should preferably be under two-thirds.
3. A P/E ratio that is attractive in relation to the past history for the company, the average for the industry and the average for the market as a whole.
4. The chairman’s yearly and half-yearly statements must be optimistic in tone and the dividend policy must be consistent with this. The market consensus of profit forecasts must also be optimistic.
Other important points to remember:
1. The price of growth shares can only increase due to earnings growth and a status change in the multiple. The latter is often much more important than the former.
2. Avoid stocks on astronomic multiples.
3. When considering the half-yearly results pay particular attention to seasonal factors and bear in mind that some stocks traditionally have a better first six months.
4. Beware of confusing cyclical stocks in a recovery phase with growth stocks. Cyclical stocks are the subject of a separate system in a later chapter.
5. Fast-growing shares can often be purchased advantageously just before they announce their yearly or half-yearly results, when attention will shift from the historic to the prospective P/E ratio.

Chapter 4: Creative Accounting

The simplest example of creative accounting is an invoice for services rendered which can be issued just after or just before the end of a financial year.

You can readily see that many an entrepreneur anxious to preserve his company’s unbroken record of earnings per share growth would make every effort to sell the house in a year in which profits were poor. Conversely, if business had been excellent and the future outlook appeared murky, our entrepreneur might deliberately delay a sale by a few days to swing the profits into the more difficult period ahead.

Provisions are another area which offer scope for transferring profits to another year.

Any qualification of the Auditor’s Report can be a sign that the company is heading for trouble. You must also be on the alert for proposed changes in the company’s auditor, especially from a leading firm to a small and obscure one.

a) Research and Development Costs Development costs may be deferred to future periods in respect of defined projects, the outcome of which can be assessed with reasonable certainty as to their technical feasibility and commercial viability. Otherwise all research and development costs should be written off in the financial period during which they are incurred.

The words ‘reasonable certainty as to their technical feasibility’ offer scope for an opinion as to what is or is not ‘reasonable’.

b) Advertising Expenditure In June 1992, there was no SSAP or other definitive guideline about the treatment of advertising expenditure. The normal conservative accounting approach is to write off the expenditure as incurred. An equally acceptable alternative in the case of a major campaign for a new product is to write off the expenditure over several years.

c) Currency Fluctuations: In case of cross-currency loans, any profit due to interest rate differential will be added to p&l and any exchange rate losses wkill be moved to balance sheet

d) Re-organisation Expenses The UITF has recommended that re-organisation costs should in future be presented as exceptional, and charged against earnings per share, unless they result from the closure of a segment of a special part of the business sufficiently large to have its own management accounts.
e) Methods of Stock Valuation Last-in-first-out (LIFO) is more conservative in inflationary times than first-in-first-out (FIFO). A

f) Changes in Method of Depreciation Some methods are faster than others, so always look to see if there is a change.

g) Sale of Fixed Assets The profit or loss on the sale of a fixed asset is part of the company’s ordinary operations. If particularly large, it should be shown as exceptional.

You will have to make your own judgement on whether or not you consider such a profit or loss to be a true part of the company’s earnings for the year in question.

h) Capitalisation of Interest Normally interest is charged against profit, but on occasions the interest cost of a particular project is added to the capital cost.

The use of this technique flatters both the asset value in the Balance Sheet and the profits in the Profit and Loss Account. Obviously, there is considerable scope for abuse, especially by over-geared property companies anxious to reassure their bankers and loan stockholders.

i) Earn-Outs (Contingent liabilities)

j) Change of Financial Year End By changing a financial period, year to year comparison of earnings growth is made more difficult. With most companies there will be a good reason for doing so but on occasions the motive might be more covert. You must be alert to this possibility.

Before you accept the earnings per share figure, you must examine each exceptional item in detail to see if any profits should be eliminated. You should also look at the items charged as exceptional expenses in case any of them should be added back to increase profits.

Where does all this leave the investor? The rules of the game are being tightened, but meanwhile you have to make judgements of earnings per share and growth rates. How extraordinary is extraordinary, and how exceptional is exceptional must be your constant questions.

One of the most reliable cross-checks on earnings is a company’s cash flow during the same period. When there is a large divergence the wrong way, you will know that creative accounting has been at work.

keep an eye open for profit boosting by the methods I have mentioned, cross-check with cash flow and always read the annual report and accounts from beginning to end.

British Aerospace had PBTEI of £154m, and operating cash inflow of minus £95m. A prize also goes to Polly Peck, which in its farewell set of accounts showed pre-tax profits up 44% at £161m – but in the new style of cash flow statements, County Nat West calculated that the operating cash outflow would have been £129m. The main reason was a staggering increase in working capital of £288m. When there is a large divergence the wrong way, you will know that creative accounting has been at work. Whatever else you do, keep an eye open for profit boosting by the methods I have mentioned, cross-check with cash flow and always read the annual report and accounts from beginning to end. Remember that footnote 34 (d) or even 63 (c) might contain a very important message for you.

Any calculation of earnings per share should allow for convertible loan stocks, bonds and preference shares being converted and options and warrants being exercised. Such dilution can turn out to be significant with a consequent depressing effect on the growth of earnings per share.

Taxation Frequently, companies have tax losses brought forward and available to set off against current profits. This can result in an abnormally low tax charge for the year during which the tax loss is used.

Let me summarise for you the main points that have been made in this chapter:
1. The accountancy profession is putting its house in order, but there will always be scope for creative accounting.
2. You must make a point of reading the detailed notes to the Report and Accounts as well as the Chairman’s Statement. Read all documents you receive from your selected companies from cover to cover. Be on the alert for warning signals, especially qualifications of the Auditor’s Report or a proposed change of auditor.
3. Earnings per share will in future be shown after extraordinary and exceptional items which will be clearly explained. Your task must be to decide if any of them should be added back or eliminated to give you a truer picture of the company’s growth prospects.
4. Keep your eye open for profit-boosting by the methods I have outlined. Your best cross-check is to compare trading profits with operating cash flow. Any large divergence between the two will warn you that creative accounting may have been at work.
5. Whenever convertibles, options and warrants total more than 10% of the share capital, adjust earnings figures by assuming dilution and potential interest savings.
6. With acquisitive companies make sure by studying the Notes to the Accounts that the liabilities for deferred consideration on earn-outs have not become excessively onerous.
7. Adjust earnings to allow for a normal tax charge if the tax for the year has been reduced as a result of a non-recurring event.
We can now move on to the first of my protective criteria, which, taken together, will form a safety net under any shares you buy.
Since writing this chapter, an excellent book on the subject of creative accounting has been published. Accounting for Growth by Terry Smith gives, among other things, a comprehensive account of the many ways of boosting a company’s earnings per share growth. If you are seriously interested in mastering the complexities of company accounting, you should read this book.

Chapter 5. Liquidity, Cash Flow and Borrowings

The word 'liquidity' refers to assts that are easily converted into cash. the assets in question are usually short term loans, debtors (less creditors), gilts, quoted investmentand of course cash.
Obviously  a company is in a strong financial position if it has substantial cash balances and no debt. In case there is debt, the key questions are, how pressing is the debt, is the company a cash generator? What is the interest coverage? What is the financial charges coverage?

When operating profit exceeds net cash inflow from operating activities, you know that creative accounting is at play.

Why is cash flow so important? First, as a check that trading profits and therefore earnings are in order, and second, because free cash flow funds the expansion of a company. By the term ‘free cash flow’ I mean cash flow after dividends and after capital expenditure.

Capital expenditure falls into two main categories. The first is the replacement of an old asset such as plant and machinery, which is in a bad state of repair or has become obsolete.

The second category of capital expenditure is far more up-beat – a brand new, additional factory, together with the most modern equipment – the stuff that makes for real expansion.
Companies with very strong business franchises are more fortunate. They can invest in new products, new technology and new businesses, all of which should help to increase, as opposed to maintain, annual profits.

These are the conclusions we have reached
1. The ideal company, particularly in recessionary times, is one with high net cash flow, substantial cash balances and no debt.
2. Our outside limit for borrowings is 50% of net assets and this is only if all other criteria are very much in place.
3. The quick ratio of net current assets, less stocks and work in progress, to current liabilities should be at least 1:1 and preferably 1.5:1.
4. An eye must be kept open for distorted cash positions in contracting companies, which often have substantial deposits from customers paid in advance.
5. The Cash Flow Statement of a company should always be studied. In particular, double-check that the net operating cash flow is at least the same, and preferably more, than the net operating profits. If there is a material discrepancy the wrong way, creative accounting has been at work.
6. Companies that need to spend heavily on capital equipment simply to stay alive should be avoided. Companies which generate plenty of free cash flow to expand future earnings are far more attractive.

Chapter 6: Something New

There are four main categories of new factors which are of sufficient importance to have a major impact upon share prices:

New management. New products or technology. New events in the industry as a whole, including new legislation. New acquisitions.

New management is the most important of all. The reason is simple – the impact of excellent new management can be both far-reaching and on-going.

It is important for you to distinguish between patented new products and those that can be more easily displaced by market forces. Sometimes a new product might be a tremendous success but will have little impact upon the company’s earnings due to the relative unimportance of the new product within the group. Your task is to use your best judgement to determine whether or not a new product will be a winner and to evaluate its likely effect upon a company’s earnings. This is not always easy, so I suggest that when looking for something new you only consider products that obviously constitute a substantial proportion of the company’s business, are central to the main activity and will have a major impact upon future earnings.
The other consideration for new products is to distinguish between gimmicks that will have a short lifespan and those that might last indefinitely

New events in an industry would of course include the collapse of a main competitor.

As you read the details of a major new development or product, make a conscious effort to decide whether or not it is likely to be a long-term winner and consider the probable effect upon the shares in your existing portfolio and any future selections you might have under review.

new acquisition can often have a major impact upon a company’s earnings and status.

There is an added advantage of identifying something new. The story of the stock becomes much more interesting and easy to relate to, resulting in quicker acceptance by the market.

A good story is a powerful catalyst to help the share price on its upward path. The market likes a good story, and something new adds both piquancy and interest. The story is also important as a cross-check for you. If you buy a share with passable fundamentals and a good story, you must constantly check that the status quo is unchanged.

Let me summarise for you the main points made in this chapter:
1. Something new is highly desirable but not absolutely mandatory, especially when the company fulfills most of my other criteria.
2. The main categories of something new are new management, products or technology, a new acquisition or a new event in the industry as a whole, including legislation.
3. New management is the best of these because the effects can be so far-reaching and are on-going.
4. New products, events and acquisitions have to be of sufficient importance to the company in question to increase future earnings substantially.
5. A distinction has to be made between gimmicky one-off products and others that are likely to be long-lasting.
6. The effect of new events like the collapse of a competitor in an industry can be limited to one or two years’ earnings. New legislation can be much longer lasting.
7. An added advantage of something new is that it provides a ready-made story for the stock, which helps the shares to gain market acceptance and can be used as a way of monitoring future developments. A good story is most important when present fundamentals are poor, as future hopes aided by the story will be the fuel to drive the share price upwards.
8. As you read about a major new development, product or event make a conscious effort to think of the likely effect upon the shares in your existing portfolio and upon any future selections.
9. Something new is often a superb confirmation that my other criteria are satisfied. For example, something new will frequently be the cause of accelerating earnings, a higher prospective growth rate, a lower PEG and high relative strength of the shares in the market. Frequently something new is the missing piece of the jigsaw.

Chapter 7: Competitive Advantage

Let us go back to the important proviso, that earnings must grow at 20% per annum. This assumption would have to be based upon as much supporting evidence as possible. I know that you would check the consensus of brokers’ estimates, the outlook for the industry, the past record of the company and the Chairman’s forecast, but there is also another vital criterion that you should apply. You should seek to establish the company’s competitive advantage, which will underpin your earnings growth projections

A company has a considerable advantage over competitors through owning one or more great brand names. Coca Cola comes immediately to mind as one of the best-known products in the world.

Copyrights last fifty years and can be extraordinarily valuable.

Film libraries are also becoming increasingly valuable with the worldwide growth of cable and satellite television, coupled with the inflated cost of making comparable films today.

Government legislation sometimes creates monopolies and oligopolies by granting business franchises.

A different kind of edge over competitors can be achieved by having a niche business with a substantial market share.

A less precise area is the position some companies achieve by simply being by far the biggest and most dominant in their industry.

I am also surprised that anyone invests in companies with earnings in decline, companies that have an unattractive P/E ratio, companies that are borrowing far too much and companies that have rapidly declining profit margins.

Smaller companies are more likely to own lesser-known brand names, patents and copyrights that will eventually become very wellknown if they continue to be successful. They are more likely to be in a dominant or very strong position in a niche business. Recognising these characteristics is very difficult. The first step is to narrow down the field.

Companies with strong business franchises usually enjoy an excellent return on capital employed.

The capacity to employ capital at a high rate of return is one of the surest marks of a true growth stock.

I just mentioned a five year average for Rentokil and Glaxo. This is a far more reliable way of judging the capacity of a business to employ capital exceptionally well.

Another interesting way of looking at a share that produces a high rate of return on capital on a regular and reliable basis is to compare it with a gilt.

A number of important points have been made in this chapter:
1. The competitive advantage of a company underpins future earnings estimates and increases the reliability of profit forecasts.
2. Competitive advantage, sometimes called ‘business franchise’, arises in several different ways:
i. Excellent brand names
ii. Patents or copyrights
iii. Government legislation creating franchises (although usually with some regulation) iv. An established position in a niche market
v. Dominance in an industry This list is broadly in order of invulnerability to competition.
3. Leading companies are more likely to possess excellent brand names, patents and copyrights. Smaller companies will tend to have products with this kind of potential and/or an established position in a niche business.
4. Avoid companies that are too dependent upon one main supplier or customer, and companies in an industry which is well-known for the intense rivalry between competitors. Also beware of products that might easily be substituted.
5. Dislike companies in the general engineering and electrical business, textiles, building and contracting and the motor industry. Prefer businesses in health and household products, food retailing and manufacture, and brewers and distillers.
6. A cross-check on competitive advantage, especially in niche businesses, is through profit margins. Expressed as a percentage of turnover, these should be at least 7.5% and preferably 10% to 20%. Avoid companies with very low profit margins and look especially for increasing profit margins.
7. The most reliable evidence of a company with a strong competitive advantage is the ability of the management to employ capital at a well above average rate of return. Over 20% per annum is your target for industrial companies. Your broker should be able to obtain five year figures from Datastream.
8. When my system of stock market investment works at its best, all the criteria inter-relate. If you have identified a company with a strong business franchise, the return on capital employed is likely to be above average, the earnings record first class, the growth prospects reliable and the shares should have high relative strength in the stock market.

To find a company with a business franchise is not too difficult, but if you are one of the last people to see the potential the multiple will already be astronomic. We are seeking perfection – a strong business franchise at a reasonable price.

Chapter 8: Momentum and Relative Strength
This is a chapter on Technical Analysis to determine the right time to buy a chosen stock.

Charts provide me with further confirmation that I am proceeding along the right lines, or, alternatively, gives me a warning signal

Another rule-of-thumb is to invest in this kind of growth share only when the price is within 15% of its high. This may sound paradoxical. However, if a growth share is more than 15% below its high there could be something wrong with the fundamentals – some news that you have not yet heard that is being signalled to you by the poor price action of the shares.

You should never average down when buying a growth share.

‘Great Lies of the City’. They are still pertinent today: ‘All the loose stock is now in firm hands.’

if the stock falls below the 63 day average and then rallies above it, the share is only likely to prove vulnerable if it makes a new reaction low. If the share falls beneath its 63 day average and doesn’t rally above it, then a prolonged period of weakness is likely.

Chapter 9: Other Criteria

Small market capitalisation It is a fact of life that elephants don’t gallop and small companies have much greater scope for future growth than very large ones.

Dividend yield I prefer companies to pay a dividend, as most institutions need an income stream from their investments. Also dividend payments show management confidence in the future.

Any reduction in a company’s dividend is a major event, with serious implications for the share price.

Reasonable asset position There is a special chapter on value investing which deals with assets in much more detail.

Any company that is growing reliably and well will tend to have an above average P/E ratio that will result in the shares being priced at well above asset value.

No-one is bothered about the assets per share, nor are they ever likely to be, provided the company has sufficient working capital, is not being over-geared and has a relatively strong balance sheet.

Management Shareholding. I like the Directors to own a number of shares substantial enough to give them the “owner’s eye”, but not so many that they have control, can sit back and could at some future stage block a bid.

Directors’ sales are of great interest.

Chapter 10: Weighing the criteria

Following are the criteria that we discussed to assess a small cap growth stock.

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 the growth rate.
3. An optimistic chairman’s statement.
4. Strong liquidity, low borrowings and high cash flow.
5. A substantial competitive advantage.
6. Something new.
7. A small market capitalisation.
8. High relative strength of the shares.
9. A more than nominal dividend yield.
10. A reasonable asset position.
11. Management should have a significant shareholding.

It is important to understand that the first five criteria are the essence of the system and are all mandatory.
small market capitalisation is classified as important but not mandatory. If all my other criteria were met, I would be delighted to invest in a larger company,

1. Five Year Record
2. Low PEG Factor
3. Optimistic Chairman’s Statement
4. Strong Financial Position
5. Competitive Advantage
6. Something New
7. Small Market Capitalisation
8. Relative Strength
9. Dividend Yield
10. Reasonable Asset Position
11. Management Shareholding

if you time your purchase well, a rapidly growing share can often be bought very cheaply just before the market’s perception of the share moves from the historic to the prospective multiple.

The most important single point to grasp is that it is difficult to find a share with a very low P/E ratio in relation to the growth rate.

Poor relative strength on its own should not put you off, but any weakness in the share price should alert you to the possibility that something could be going wrong.

You should only begin to worry when a number of the non-mandatory criteria are not in place. Taken together they form a safety net, which will only break if several of the strands are frayed or missing.

Chapter 11: Cyclicals and Turnarounds

There is a lot of money to be made in cyclical stocks only if you understand the anatomy of the business cycles.

Clearly, the time to buy is before profits rise and the time to sell is when conditions are obviously improving. The important point to grasp is that a cyclical stock should never command a very high multiple and a low dividend yield near to the top of the cycle.

The important point to grasp is that a cyclical stock should never command a very high multiple and a low dividend yield near to the top of the cycle.

Obviously, you want to time your purchases so that you buy near the bottom of the cycle, but you also want to make sure that your selection is going to survive.

The riskier companies usually have very high borrowings at the bottom of a cycle.

Companies with well-known, national names have a better chance of survival, if only because there seems to be greater reluctance to let them fail.

Seek out companies with familiar brand names and other kinds of strong business franchises.

Look particularly for those companies which usually have a high return on capital employed.

Keep an eye open for major competitors going out of business.

Seek out companies with asset backing in excess of market price.

With the hope of a takeover in mind, you should give preference to companies with a widely based shareholding and no control blocks.

You should draw the limit at total indebtedness exceeding the net asset value.

It is absolutely essential that the forecast for the year ahead shows rising profits or a return to profits.

Timing is of atmost importance. Wait until you are really sure that the cycle has hit bottom

you need to ensure, as far as you possibly can, that the company’s main infrastructure has remained intact throughout the recession.

Further pointers:

a) Ensure that the company has maintained capacity and that major factories have not been sold off.
b) Look for turnover being largely upheld with only margins suffering. This is an excellent indicator as margins can recover quickly.
c) Check if there has been substantial cost cutting. You want your company to be lean and mean in the upturn.
d) Look for companies that are usually good cash generators. If tax losses are allowable for set-off against future profits, short-term debts could be repaid very speedily.
Directors’ share dealings are very important when considering cyclical situations. Seeing a number of Directors buying shares near the low point of the cycle is obviously a very encouraging sign. They might be wrong, but they ought to know. Buying at the time of a rights issue can be a very attractive way of participating in a recovery. You have the great advantage of being able to study an up-to-date circular to shareholders in which you can see what the Directors are doing with their entitlement, see how much debt remains, and obtain an instant fix on the outlook for future profits.

Buying at the time of a rights issue can be a very attractive way of participating in a recovery.

Above all, you are looking for a company that under normal conditions is a substantial force in its chosen field.

When should you sell a cyclical? With a growth share you might stay to enjoy a long ride, but with a cyclical your target price tends to be more limited.

You also sell when the multiple on the forecast profit in the second year of recovery has risen to 75% of the highest multiple the company has ever achieved. In essence, you sell on general recognition that the company has survived the downturn and is now enjoying far better trading conditions. Do not wait until there is an inevitable increase in competition, costs are beginning to rise again and demand is on the brink of flagging.

Inexplicable falls in price have to be assessed on their merits and become more a question of judgement and feel.

There are, however, large profits to be made if you are expert in both timing and selection.

There is of course a risk, so you should never put more than 10% of your portfolio in any one situation of this kind.

As you can see from the examples of Next and English China Clays, there are very large gains to be made by identifying a promising cyclical or turnaround, especially when new management has taken charge. There is of course a risk, so you should never put more than 10% of your portfolio in any one situation of this kind.

The time to sell a turnaround is delightfully obvious – when the company has turned around and is making good profit

Chapter 12: Shells

A shell is a very small company that usually owns a small and nondescript business of little account and which, above all, has a stock market quotation. The idea of the incoming entrepreneur is simply to obtain a backdoor quotation for his own company, which usually has too short a record or some other shortcoming that precludes obtaining a stock market quotation by a more conventional route.

Investing in shells is more of an art than a science. To decide whether a company is a shell or simply a very small business with a quotation is very much a matter of opinion.

guidelines for judging the value of a shell and selecting a suitable one to add to your portfolio is almost impossible. I say almost because I am going to try:

1. First, second and third is the provenance of the incoming management. Look for quality. Look for a heavyweight board joining a lightweight company. Look for previous positive achievement upon which to build your future hopes.

2. As an important adjunct to my first criterion, I like to make sure that the new management is buying a substantial stake in the company.

3. As the future progress of the shell will depend to a large extent upon share placings, the calibre of the company’s stockbroker, merchant banker and investing institutions is a material consideration.

4. The record of the business being reversed into the shell has to be one of increasing profits and earnings per share, unless of course it is a property company, when different considerations apply.

5. Make sure that, following the merger, the shell has resultant earnings per share sufficient to provide a reasonable starting base for the company. You cannot use the PEG factor to measure the price you are paying.

6. From the above comparison, you will readily appreciate that a little shell, capitalised at £1m and with an underlying business worth £500,000, might be a gem.

7. I much prefer low-priced shares. Companies often lose their shell-like quality as their share prices rise over £1.

8. Avoid any shell unless it has a full listing or is on the USM.

9. My last criterion is the liquidity of the company. Shells are obviously a much riskier kind of investment than leading companies.

The first rule of shell portfolio management is to spread your investments over at least ten shares, preferably in equal amounts

The second rule is to cut losses when shares drop by 40% from your cost.

The third and most difficult rule is to run profits. My suggestion is to run the profits for a year, unless of course the story changes

Chapter 13: Asset Situations and Value Investing:

This chapter is divided into two parts, one, asset situations (asset plays) and value investing.

Investors who concentrate upon asset situations are not so interested in immediate earnings. They reason that if a company holds the right kind of assets, earnings will flow from them eventually.

Determining the real asset value of a company is not an easy task,

Another asset that is difficult to value is plant and machinery.

Brand names are difficult if not impossible to value.

Goodwill is another thorny issue. I recommend writing it off when you calculate the net asset value of a company in which you are interested.

When investing in an asset situation, look for net assets to be at least 50% more than the present share price.

There are also a number of further protective criteria, which have to be satisfied: Total debt must not be more than 50% of net asset value. There must be moderate earnings. Do not buy into substantial loss makers, however strong the asset position. The basic business of the company must be reasonably attractive and there must be obvious scope for recovery. Avoid shipbuilders for example.

Companies of particular attraction to predators are those that have several disparate parts.

Graham’s most famous investment formula is to buy shares at a price that represented not more than two-thirds of a company’s net current assets deducting all prior charges and giving no credit for any of the fixed assets of the company such as property, plant and machinery, brand names and goodwill.

Graham recommended selling when the share price advanced to a price equal to the net current assets less all prior charges.

When you buy shares in a dynamic growth company on a low P/E ratio, with a consequently low PEG factor, you are buying growth prospects at a discount.

Similarly, when you invest in a turnaround just as the action starts or in a cyclical before the cycle turns up, you are buying into a company at a substantial discount to its full potential.

The market price of a share and the underlying value of that share are two very distinct animals. The value is always subjective – what are the assets worth, always open to many different interpretations – what are the future earnings going to be, again very much a matter of opinion.

That is why Graham concentrated his first system around net current assets, which could be converted into cash, the one asset that has an indisputable value.

Graham’s second most well-known system was to buy shares which had an earnings yield (the reciprocal of the P/E ratio – for example a share on a P/E of 8 has an earnings yield of 12.5%) of not less than double the yield on a triple A bond.

In addition, Graham used an extra protective caveat insisting that the total debt of the company should not exceed its tangible net worth.

Graham’s third approach was to buy shares with a dividend yield of not less than two-thirds of the triple A bond yield.

An important feature of Graham’s method was that every qualifying stock had to be bought.

In all three cases, Graham sold stocks either if they had risen 50% or a two year period

Chapter 14: Leading Shares

One advantage of dealing in leading stocks is that there is undoubtedly a greater degree of safety.

One advantage of dealing in leading stocks is that there is undoubtedly a greater degree of safety.

A disadvantage of leading shares is that they are usually more expensive as they have invariably been heavily researched.

A further disadvantage of leading shares is, of course, that elephants don’t gallop,

To keep the formula simple, I suggest a limit of one – the prospective multiple should not be more than the estimated growth rate.
Note: For large companies author suggests a PEG of 1

If you are interested in recovery stocks you should read the book by Michael O’Higgins – Beating the Dow.

His basic system is to take the ten highest yielding Dow thirty share stocks at the beginning of each year and then select the five with the lowest dollar prices.

If you decide that you want to concentrate your investments in larger companies, I recommend that you confine your activity to the top five hundred shares. The next step would be to determine your investment criteria for the kind of share you are trying to identify.

Chapter 15: Overseas Markets My system for investment

Dr. Marc Faber in The Gloom, Boom & Doom Report gives a very interesting summary of the life cycle of emerging markets. As he says, ‘First, stocks are in an embryonic stage. Then, when they reach adolescence, they grow very rapidly (bullish phase). During this stage, they are accident-prone (crashes). Later, markets mature, lose some of their energy and volatility, then become tired and finally die (bear markets)... Fortunately for stock markets, there is usually life after death. A new cycle begins which, like life after reincarnation, is very different in nature from the previous cycle.’ His six phases are depicted in the following graph.

Phase zero Events • Long-lasting economic stagnation or slow contraction in real terms. • Real per capita incomes are flat or have been falling for some years.

Little capital spending, and international competitive position is deteriorating. • Unstable political and social conditions (strikes, high inflation, continuous devaluations, terrorism, border conflicts, etc.) • Corporate profits are depressed. • No foreign direct or portfolio investments. • Capital flight. Symptons • Little tourism (unsafe). • Hotel occupancy is only 30%, and no new hotels have been built for 30 years.

Hotels are run-down. • Curfews at night. • Little volume on the stock exchange. • Stock market has been moving sideways or moderately down for several years. • In real terms, stocks have become ridiculously under-valued.

No foreign fund managers visit the country. • Headlines in the press are negative. No foreign brokers have established an office, no country funds are launched, and no brokerage research reports have been published for a long time. Examples • Argentina in the eighties. • Middle East prior to the seventies. • Communist countries after world war 2 until recently. • Sri Lanka prior to 1990.

Chapter 16: Your broker and you

You should try to find a broker who is value-minded, not quotation-minded.

You also have to be on guard against brokers who have a favourite share that they keep tipping.

you should expect your broker to provide a copy of the Datastream relative strength chart for any share in which you are interested,

Also, your broker should be able to supply the last six months’ press cuttings and a copy of any recent circulars by other major brokers.

Your other aid to investment is your daily, weekly and monthly reading.

Chapter 17: Portfolio Management

Why is investing in ten stocks an advantage over investing in a hundred? Your first choice is obviously far better than your tenth, which in turn should be considerably better than your hundredth. Secondly, the fewer stocks in your portfolio, the easier it is for you to keep a really keen eye on them all.

I always try to keep a watching brief over the few stocks that constitute my portfolio.

attend the Annual General Meeting.

The reason for selling the dropouts and the hopeless horses is that their story has changed.

my advice is never to average down.

if a company’s story changes for the worse to a material extent, I immediately sell.

By far the most difficult task is to decide when to take a profit. At different times in their lives, shares are either a buy, a hold or a sell.

Turnarounds, cyclicals and asset situations mature more quickly than growth shares.

As soon as the turnaround has been recognised by one and all, the cyclical has benefited substantially from an up-turn in the economy or shares in the asset situation have appreciated to a level more in line with the underlying worth, the shares should be sold.

If, after a long period of trial and error, you have managed to identify a few excellent growth shares that are churning out earnings per share growth at an exceptional rate of say 20% per annum, you must not let go of them lightly.

You have to try to strike a nice balance between running the profit on a super-growth share and operating within a reasonable safety factor.

Perhaps the best way of expressing this is to say that cyclicals, turnarounds and asset situations should be sold on recognition, but with super-growth shares you should wait for adulation.

In fact, one of the most reliable tests of an impending bear market is that you will find it extremely difficult to identify shares that fit your highly selective criteria.

At the risk of over-reminding you about the safety factor, let me reiterate how it applies to all the systems we have examined.

Growth shares are bought on low multiples and low PEG factors

Turnarounds and cyclicals should be bought near the bottom, where there is good reason to hope for a recovery or an upturn in cycle.  Turnarounds should be sold when the companies have been turned around and are making good profits.  Cyclicals should be sold when there is a general recognition that the company has survived the downturn and is enjoying far better trading conditions.

Asset situations should be bought at a substantial discount to realizable values and should be sold when these values are understood and fully appreciated by other investors.

The main safety factor in Shells is top quality management coupled with a small hot air gap and reasonable liquidity.

Important points made in this Chapter

1. Your portfolio should not be more than 12 shares funded by patient money. Ten is the recommended minimum with a maximum of 15% invested in one share
2. Maintain a hands-on approach after buying.
3. Run profits and cut losses
4. Profits should be taken on turnarounds, cyclicals and asset situations when turnaround is acknowledged, cycle is well advanced or when share price is very near the asset value.
5. Profits on growth shares should be booked more reluctantly. Ideally such shares should be bought at a PEG of <.5 and sold off when PEG becomes >1.2
6. Profits on shells should be run for a year and then reviewed
7. Losses should be cut on all shares when the story changes for t he worse or it reaches your target on the downside
8. The recommended downside limit is 25% for turnarounds, cyclicals and growth stocks and 40% for shells
9. In case of an impending bear market, move to 50% cash. With shells definitely move to 50% cash if markets are looking dangerous
10. Do not trade in Derivatives.

Chapter 18: The Market

I will attempt to show you how to recognise the top of a bull market and the bottom of a bear market, but whatever your view, you should always have at least 50% of your patient money invested in the market.

The obvious conclusion is to select the right super-growth stock and stay with it through thick and thin.

If you are intent upon turning a stampede, you have to wait until the cattle are tiring;

Tulipomania has always been my favourite. In the early seventeenth century, many people in Holland were collecting tulips to such an extent that it was proof of bad taste for a man of fortune to be without a rare tulip bulb collection. The desire to possess tulip bulbs spread to the Dutch middle classes. By the year 1636, the demand for rare tulip bulbs increased so much that regular marts for their sale were established on the Stock Exchange in many of the principal cities. As prices continued to rise, many individuals who had speculated in tulips suddenly became very rich. People in all walks of life began to convert their hard-earned money into tulip bulbs. Tulipomania became rampant. You may wonder how the Dutch people allowed themselves to be so carried away from reality. Your wonderment would have been shared by an unfortunate sailor who stole a tulip bulb from a merchant’s store, thinking that it was an onion, which a few hours later he ate with his herring breakfast. The tulip bulb in question was a Semper Augustus then worth about 3000 Florins, which would have been sufficient to feed his entire ship’s crew for over a year. The poor fellow had plenty of time to think about tulip bulbs during the months he spent in prison on the felony charge. After a while, some of the more conservative rich people began to have some doubts. They ceased buying bulbs and began to sell a few. The worry spread, confidence was lost, and prices tumbled, never to recover. At the height of the mania a Semper Augustus tulip bulb commanded a price of 5500 Florins. The low price, after a 99% fall, was a mere 50 Florins.

The cycle of a financial mania is easy to understand:
1. An image of instant wealth attracts and forms the financial, psychological ‘crowd’.
2. People see what they want to see – a mixture of both facts and fancy which builds an image in their minds. A few examples of exceptional gains in the new area of interest are put forward as being representative of the kind of profits that can be made by one and all.
3. Acknowledged experts in the field urge the crowd on its way.
4. The crowd begins to act irrationally and becomes blind to danger, ignoring fundamentals and all traditional measures of value. Throughout these developments, prices continue to rise rapidly – a self-feeding process that encourages more and more buyers to participate.
5. As if a new slide has been placed in the projector, the image that has attracted and formed the financial crowd is suddenly changed.
6. Fear replaces greed as the bubble bursts with disastrous financial consequences for those who invested anywhere near the top.

For example, when the bull is rampant, shares usually sell on historically high P/E ratios and at large premiums to book value. Furthermore, there is a high degree of speculation and a plethora of new issues of dubious value.

Signs of the top of a bull market

1. Cash is trash: In early April 1992, this was the consensus view of a large number of American fund managers, who coined the phrase. The consequent very low institutional cash holdings are an obvious danger signal for that market.
2. Value is hard to find: Average PE ratios of market is at historically high levels. The price to book will be hig and dividend yield will be low.
3. Interest rates are about to rise
4. Broad money supply starts contracting
5. Consensus estimates will be bullish
6. Abundance of IPOs
7. Markets fail to respond to good news

Signs of the bottom of a bear market
1. Cash is king
2. Value is easy to find
3. Interest rates are tending to fall
4. Broad money supply is increasing
5. Consensus estimates tend to be bearish
6. Hardly any IPOs
7. Markets fail to respond to bad news

Bull markets last longer than bear markets
Great amount of money can be lost in a short amount of time in a vicious bear market

Stages of bear market:

Stage 1: Sharp fall in market when economic conditions remain positive
Stage 2: Economic conditions deteriorate, but market is oversold
Stage 3: Economic news is awful. Investors panic and fled the market

Summary on General Market Strategy

1. By reading daily and weekly newspapers, keep your finger on the pulse of the market
2. Based on the warning signals, make up your mind about the direction of market
3. If you are bullish, invest 100% of your patient money, if bearish, invest 50%
4. When pruning your portfolio during bearish times, keep the defensive stocks
5. Do not consider shorting stocks
6. Avoid derivatives
7. Do not take money of the super growth stocks during bear market.

Chapter 19: 10 Guidelines

If it is accepted that predicting future earnings is difficult, if not impossible, you must surely agree that there must be an advantage in buying shares in a systematic way –

shares with excellent growth records that satisfy highly selective criteria and have a built-in safety factor.

best performing companies all shared the competitive advantage of a strong business franchise, evidenced by their excellent rate of return on capital employed.

It also pays to be systematic with your investment policy so that you have a base to refer back to when measuring your performance.

By concentrating and focusing your investment approach, you should become more and more expert in the particular method

ten very broad and basic guidelines which should help you to improve your investment performance:
1. Select a system of investment that suits your temperament and concentrate upon it. Whichever system you choose, the essential ingredient must be that the shares you select provide you with a margin of safety – a safety factor created by the very stringent criteria of your system.
2. Set aside at least three hours a week to apply The Zulu Principle to your chosen system so that you become an expert in that relatively narrow area of the market. Use most of the time for analysis and always read the accounts of selected companies from beginning to end. Refine and improve your system as you learn from both your successes and your mistakes.
3. Allocate from your available resources a sum to invest – patient money that you can spare and afford. Your aim is to avoid being pressurised into having to make a premature sale. Invest between 50% and 100% of your patient money at all times. When you believe the outlook to be exceptionally bearish you can reduce your investments to 50% of your portfolio if you feel more comfortable doing so. With a shell company system in a very bearish climate you should definitely move into 50% cash.
4. Choose a broker who understands your objectives and is out to help you. Your broker can be an invaluable ally.
5. Invest in a maximum of twelve shares which meet your criteria. Ten is the recommended mimimum, with a maximum investment of 15% in any one share.
6. With any system based on small to medium-sized growth stocks, you are seeking to identify a few super-growth shares and hold on to them through thick and thin. Selection is far more important than timing. Buy shares which have low P/E ratios in relation to their growth rates and consequently low PEG factors – not more than 0.75 and preferably below 0.66. You are searching for companies with strong business franchises that enjoy an excellent return on capital employed and generate plenty of cash. In addition, you must ensure that the other criteria set out in detail in earlier chapters are satisfied to a sufficient extent to provide you with an adequate safety net. Always reconcile a selected company’s trading profits with its net operating cash flow. Remember that cash is the only indisputable asset and that when making an investment you should look down first.
7. After you have purchased a share, maintain a really hands-on approach. You will soon find someone who knows someone who can answer your questions about most companies. Be very active in monitoring your portfolio.
8. Growth shares should be sold if the market goes mad and in the process awards any of your investments an absurd multiple. With smaller companies, you should plan to exit when the PEG is around 1.2, but subsequently keep an eye on excellent growth stocks in the hope of finding a better opportunity to repurchase them.
9. The converse of running profits is to cut losses. Shares should be sold the moment the story changes to such an extent that the shares no longer satisfy your buying criteria.
10. With turnarounds, cyclicals and asset situations, you have more limited investment objectives. Once the crowd recognizes a company has turnaround, the cycle is rebounding or the share price is in line with the asset price, you would have made sufficient money for you to get out of these situations.

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