QUALIPORT
Long-Term Lessons From The Zulu Principle

By Maynard Paton (TMFMayn)
February 7, 2002

Carburton Street, London -- The most important point to consider when making a long-term share investment is the company's competitive advantage. While plenty of businesses may have an impressive earnings growth record, the key is to determine whether that record of profitability can be sustained through a durable competitive advantage.

Jim Slater's book The Zulu Principle and its follow-up, Beyond the Zulu Principle, both highlight the dangers of focusing on growth rather than on competitive strengths. Published in the mid-1990s, most of the 'attractive' companies featured in the books have disappointed long-term shareholders over the intervening years. As discussed on Monday, it's clear that Slater's Zulu system was pre-occupied in finding short-term share price re-ratings, rather than longer-term investment success.

After applying the refined Zulu principles, here are four shares that Slater put forward in Beyond the Zulu Principle:

Company                       Share price         Share price
                               27/11/95             07/02/02

British-Borneo Petroleum         87p                   70p*
Parity                           58p                   38p
Business Post                   354p                  406p
Rutland Trust                    38p                   35p

(* final price before acquisition in August 2000)

After six years, only Business Post (LSE: BPG) has made any headway. That said, all four companies did allow for sizeable gains at some point. Indeed, if you'd ridden the dotcom bubble to the full, Parity (LSE: PTY) could have been a ten-bagger. However, frenzied speculation aside, the long-term economics of those four businesses have not been overly spectacular.

For example, Slater wrote:

"[British-Borneo Petroleum] has extensive oil interests in the Gulf of Mexico, generally regarded as one of the safest and best oil plays in the world -- both politically and geologically."

But wherever the drilling takes place, an oil company's profit is largely determined by the oil price. And when the oil price collapsed in late 1998, earnings forecasts quickly went out of the window. A somewhat distressed British-Borneo was bought by Italian firm Eni during August 2000. 

And on Parity, Slater commented:

"Parity is involved in the computer consultancy business...This is a very difficult business to enter without massive teething problems, so Parity appears to have established for itself a niche in a fast-growing market in an excellent sector."

The slump in demand for IT services over the past two years has hit Parity hard. Earnings are expected to fall 80% in the current year, with strategic reviews and management upheavals suggesting little in the way of an industry niche.

New Year tips

Slater also provided a New Year portfolio for 1996 in Beyond the Zulu Principle. Alongside Business Post and Parity, the selections included:

Company                       Share price          Share price
                               29/12/95             07/02/02

JJB Sports                       95p                  382p
Grosvenor Inns                  248p                  218p*
Pressac                         120p                   24p
Pelican                         124p                  175p**
Independent Insurance            75p                    0p

(* final price before acquisition in August 2000)
(** final price before acquisition in September 1996)

Other companies revealed in Beyond the Zulu Principle as a Slater-owned share were Photobition, Oasis Stores, Azlan (LSE: AZL) and Groupe Chez Gerard (LSE: GCZ).

Photobition went bankrupt last year, while Azlan never recovered from an accounting scandal in 1997. The tricky restaurant industry has proved very problematic for Groupe Chez Gerard over the years, while ladies fashion was never going to lead to much profit predictability at Oasis. Needless to say, these four shares are significantly below the June 1996 valuations highlighted in the second Zulu book.

Lessons

So what does all this hindsight tell investors?

* Beware of investment 'systems'. There's more to successful stock market investment than relying on past statistics. Although the simplicity of a low PEG and following share price momentum may have worked for a while, the long-term earnings performance of the companies featured in the Zulu books is generally poor. That's because...

* Not every company is suitable as a long-term investment. In fact, most companies are not suitable. Smaller companies with a growth record behind them are particular prone to disappointing investors. The competition will always latch on to, and try to cash in on, their profit formulas. If you have a long-term investing horizon, ensure your company's products and management have sufficient staying power to fend off rivals.

* Earnings growth is not always what it seems. Investors need to do more than just check historic and prospective earnings per share figures. Poor cash flow was an accounting feature of Photobition, Azlan and Independent Insurance well before their troubles finally surfaced.

More: Is The Zulu Principle Suitable For Long-Term Investors? | Books Foolish And Financial discussion board