Invest within your circle of competence, it's not how big the circle that counts, it's how you define the parameters. - Warren Buffett

The Zulu Principle is both the name of a book by Jim Slater and an insight he had when his wife did some reading. As he tells the story, his wife was reading a four page article on Zulus in Reader's Digest. If she had gone to the library and borrowed as many books on the subject as she could find, she would have become one of the leading experts in her city on the subject. If she had flown to South Africa and lived in a Zulu kraal for a couple of months and studied all the literature at a South African university she would have gone on to become one of the great experts of her country, and possibly the world on that subject.

Slater realised that the more you focus your attention on an area, in particular an area neglected by the wider community, the easier it would be to become an eminent expert in that subject. Slater's books are all about investing in small growth companies that are ignored by the institutions. He suggests a form of specialisation that will enable you to outperform the markets by gaining a massive competitive edge in areas neglected by most investors.

Slater says that small investors have a big edge over large ones. These are the advantages the little guy has:

PEGs

Slater's method is designed to find growth stocks before they hit the big time. The hope is that by using this method you can buy some little company just before it becomes the next super stock. It is a method that combines growth investment with value investing, and then proceeds to whittle down the selection with a series of filters for quality. These filters are summarised in point form in the article on Slater's purchase criteria.

Slater's approach is one of finding undervalued growth stocks. Rather than a one dimensional factor like the price/earnings ratio (PER) or projected growth in earnings-per-share (EPS), Slater realised that a high PER doesn't mean an expensive stock if the growth rate is high, a low growth in EPS doesn't mean a bad stock if it can be bought really cheaply.

Slater related PER to EPS by dividing the PER buy the growth in EPS. He calls this a price-earnings-growth ratio, or PEG.

              Prospective PER   
       PEG =  ---------------   
              Forecast growth
(A variation on this is used by John Neff).

Note that he uses prospective values and forecasts. Unlike most great investors, Slater actually does listen to his broker(s), and makes extensive use of their research reports.

Slater points out that when you look at PEGs, a company with a prospective growth of 20% per annum and a PER of 20 has the same peg (1) as one projected to grow at 40% on a PER of 40. On the other hand, very high rates of growth of 50% or more are probably not sustainable, so as a rule Slater buys companies with a PER between 12 and 20 and EPS growth in the range of 15 to 25%. By the PEG measure, a company with a peg of one is fairly priced, those with a PEG below one are cheap. Slater aggressively seeks out stocks with a PEG below 0.75.

For PEGs to be meaningful, you have to make sure that the PEGs cover exactly the same period of time. The business cycle can change a lot in a few months, so make sure you are using figures covering the same period. Slater rolls forward the figures so he is always looking at forecasts for the next 12 months.

To get a forecast for the next twelve months, have a look at the consensus broker forecasts for this year and next. If today was September 1, 2001 one would track down forecasts for the company you want for year ending December 31, 2001 and December 31, 2002. As September is the 9th month, we have three months to go in 2001. We want an EPS forecast that will go to September 1, 2002. We take the consensus forecast for 2001 and multiply it by 3/12, and the consensus forecast for 2002 and multiply that by 9/12. Add them together and you have the consensus forecast for the next 12 months. It isn't exact, but at least all comparisons cover the same period of time.

Next, you divide this by the today's share price, which gives you a prospective PER.

The future EPS growth rate has to be calculated in two steps. First you calculate the EPS for the 12 months prior to today (9/12 times the year-to-date results plus 3/12 times last year's EPS result). Then you calculate a percentage gain, gain in EPS this year vs last year, divided by last year's EPS x 100.

If the number you calculate as a PEG is below one, short-list it and then apply some of the other qualitative and quantitative factors Slater talks about to end up with a very small number of stocks for your portfolio.

Obviously, a company can only meaningfully have a PEG if it has earned a profit and has grown in value. Being able to calculate a PEG is one of the first sieves Slater applies.

The practice of rolling forward figures 12 months is one of Slater's innovations, however it has never really been widely adopted by the investment community. You can use rolling forward on any measure, including dividend yield, price to sales ratio, book values etc.

A variety of investors use a PEG ratio, Peter Lynch makes the observation that when a PER equals the forecast growth, a stock is fairly priced, and the Motley Fool people call this the "Fool ratio", but it is calculated differently for other investors, usually it is today's PER (not 12 month rolling ahead) or a subtle variation. Some search utilities on the web give PEGs as a percentage. Which is to say, if someone quotes you a PEG, make sure you figure out what it really means by figuring out how it is calculated.

Slater is also experimenting with a variation on PEGs. Borrowing Warren Buffett's notion of owner earnings, you can also construct a price-to-owner earnings ratio (POER) and an owner earnings PEG, (POEG). I've tried to find out how Slater uses this, or even if he still does, but I haven't been able to track down this info. Last I've heard was just comments on pg 59 of Beyond the Zulu Principle, which was written in August 1996, Slater was still looking into it.