part0007

Good investment is often a case of turning conventional wisdom on its head, so let me say at the outset who this book is not for. If you have a pension and some life insurance, and maybe a unit trust or two, and if you are happy with the steady, relatively secure growth they provide, this book will probably not interest you.

You will be reassured by the low risk of your pooled investments, and the fact that their performance is broadly in line with the stock market as a whole. You probably don’t want to spend too much time worrying about your finances.

Now, don’t misunderstand me, there is nothing wrong with that approach – everyone needs to provide a secure financial foundation for themselves and their dependants, and not everyone is prepared to devote a significant proportion of their free time to investment.

If , however, you want more than the average returns offered by passive investments such as unit and investment trusts; if you are prepared to set aside a few hours a week to achieve those extra -ordinary returns; and if you believe, as I do, that you will enjoy doing so, then this book is for you.

I have devoted a substantial amount of my time in recent years to fine-tuning my thoughts on investment and I am very excited about the conclusions I have now reached. I have also enjoyed very good financial returns putting my investment theories into practice; I hope that after reading this book you will too.

You won’t find a get-rich-quick formula in these pages. But I really believe that you will find a tested approach to investment that will give you a good chance of beating professional investors and the market by a substantial margin, year in year out. You will also derive a great deal of enjoyment and satisfaction along the way.

Most people’s first thought is that it would be difficult, if not impossible, to match the performance of professional fund managers. They devote their working lives to investments; they ought to be experts. Bear in mind, however, that investment managers are different from the qualified practitioners at the top of many other professions. Unlike doctors, barristers, architects and accountants, they do not have to study for five or more years, read hundreds of books on their subject and pass a series of difficult examinations. In investment management, it is possible to get by with very little theoretical knowledge and no formal qualifications of any kind. The competition is therefore not so daunting to the private investor as might appear at first sight.

All investors start at a disadvantage when trying to outperform the market. Unlike the indices, all investors have to pay dealing costs and investors in institutional funds have to pay initial and annual management charges. You may be surprised to learn that, for the institutions, these difficulties contribute to lamentable performance figures – less than 10% of fund managers are capable of beating the market on a regular basis. Even when the playing field is level, the institutions are weak opponents and, as it happens, there are several areas where the small private investor actually has an advantage.

Warren Buffett, probably the world’s most successful investor, sums up of the institutions’ problems well: ‘A fat wallet is the enemy of superior investment results. Though there are as many good businesses as ever, it is useless for us to make purchases that are inconsequential in relation to [our] capital. We now consider a security for purchase only if we believe we can deploy at least $100m in it. Given that minimum [our] investment universe has shrunk dramatically.’ In other words, there are some companies that are too small for the institutions to bother about investing in’ even if they believe that the shares will outperform the market by a wide margin.

The private investors’ ‘universe’ is much wider than that of any institution. This is a considerable advantage – with less money to deploy, they can invest meaningfully in smaller companies. As you will see later, expertise is needed and there are greater risks. However, on average over the last 40 years or so, small companies have performed about 4% per annum better than the market. This may not sound very much, but the average return on equities (with dividends reinvested) has been about 12% per annum over the last 75 years. The compounding of an extra 4% would have added a meaningful amount to overall investment performance. Investments growing at 12% per annum take six years to double – growing at 16%, they take only 41⁄2 years.

So, the first advantage of private investors is one of size. The second is one of spread. Not many institutions have to invest as much as Warren Buffett, but in the UK there are several unit and investment trusts with billions under management. Certainly £100m is not in the least bit exceptional, which results in a typical trust’s portfolio having to be spread over as many as 500 shares. Private investors know that, even with a portfolio of ten shares, their first choice is better than their tenth. Obviously, their tenth selection is far better than their hundredth and the five-hundredth does not even bear comparison.

In fact, it is very difficult in the UK to find as many as 100 prime growth shares. Most active private investors need to invest in only about ten at any time, so they have a very substantial further advantage over institutional investors.

The third important edge of private investors is that their ‘circle of competence’ can be more meaningfully applied to a small portfolio. Everyone knows something special. It may arise from a hobby or interest, through a job or just from noticing what is happening in their local environment. A computer buff, for example, might be aware of new developments in networking; an insurance broker would understand the problems facing Lloyds and know the companies most likely to be taken over in the industry; and most people would notice if a new kind of restaurant or shop in their locality was becoming increasingly popular, or if a nearby factory was laying off some of its work force or expanding in a big way.

Everyone has a circle of competence, but active private investors can apply it to the relatively small number of shares in their portfolios, so the impact can be substantial. The institutional manager’s circle of competence may be greater, but his portfolio contains so many shares that the effect is diluted. The private investors’ circle of competence is spread like a pat of butter on just one slice of toast, whereas the fund manager’s pat has to be spread over hundreds.

Investment clubs can be an excellent source of help and inspiration for private investors and sharing the fun with others can increase their enjoyment as well as improving their performance. The legal maximum for members is 20, which might include the manager of a restaurant, a solicitor, an accountant, an estate agent, several married women and perhaps someone in public relations. Every one of these people brings to the group their own circle of competence to add to its overall strength and know-how.

There are other advantages too. Within every club there is always a ‘faster gun’ – someone who knows more about investment than the other members and can add to the knowledge of the group. Also, in a club it is easier to stick to a discipline and to gain moral support from other members. Last but not least, the cost of newsletters and necessary investment services like Company REFS can be shared to reduce the expense to a very affordable level per member.

Anyone interested in joining an investment club, or forming one, should visit: www.proshareclubs.co.uk or contact ProShare, 133 Houndsditch, London, EC3A 7BX England (Tel: 0906 802 2222) (email: info@proshareclubs.co.uk). In particular, they should obtain a copy of the ProShare manual, which costs £25 and explains everything they need to know.

Private investors can also develop their investment expertise by applying the Zulu Principle. This was the name of my first book on investment, taken from an idea I had after observing my wife as she read a four-page article in Reader’s Digest on the subject of Zulus. As a result, within a few minutes she knew more than I did about Zulus and it occurred to me that, if she had then borrowed all the available books on Zulus from the local library, she would have become the leading expert in Surrey. If she had subsequently been invited to stay on a Zulu kraal (by an unsuspecting chief) and read about the history of Zulus at Johannesburg University for another six months, she would have become one of the leading experts in the world.

The key point is that my wife would have applied a disproportionate effort to becoming relatively expert in a very narrow subject. She would have used a laser beam rather than a scattergun and her intellectual and other resources would, in that narrow context, have been used to maximum advantage. So it is with investment – concentrate on an approach, such as buying growth shares or asset situations, or concentrate on a particular sector. That way, you will become relatively expert in your chosen area. It is only necessary to be six inches taller than the other people in a room to see above everyone’s heads. Applying the Zulu Principle helps you grow those extra six inches.

I suggest that for most private investors their first (and possibly final) area of specialisation should be growth shares. They are by far the most rewarding investments. The upside is unlimited and, if the right companies are picked, the shares can be held for many years, during which they should multiply the original stake many times.

There is no doubt that, as a first step, aspiring investors should read as much as possible about investment. In other fields, such as chemistry, medicine, law and accountancy, there are hundreds of British books covering every aspect of these subjects. Investment is different – there are plenty of excellent American books on investment but hardly any British ones. Maybe this is because the art of money-making is more admired in America, where it has become an important part of the national culture. Or perhaps it is because in the UK people feel that the subject of investment is dull and dry. Whatever the reason, in order to dig deeply into investment strategy and tactics, we have to rely upon books imported from America.

Most people who have never cooked before and want to become expert, would at least think about reading a cookery book; Investment is no different. You should read as much as possible about the subject before investing. I have devoted the whole of Chapter 19 to investment reading. Anyone who reads the majority of the books I recommend should quickly gain an important edge over other investors – remember, in the kingdom of the blind the one-eyed man is king.

There are three British primers: Beginner’s Guide to Investment by Bernard Gray, How to Read the Financial Pages by Michael Brett, and my own book Investment Made Easy . All of these give a good grounding in investment and are available in paperback. From this point onwards, I shall assume that readers have studied at least one of them and understand the meaning of terms like price-earnings ratio, dividend yield and scrip issue. I shall also work on the assumption that they have read The Zulu Principle , or at least one other investment book of a similar standard. This will enable me to write at a brisker pace, avoid treading old ground and save boring more experienced readers to death.

In addition to general strategic and tactical advice on investment, active private investors need a regular monthly or quarterly flow of reliable investment statistics. In conjunction with Hemmington Scott, the City information and research organisation and publisher of The Hambro Company Guide , I have devised a new service, Company REFS (REFS), to meet this requirement. I make no apology for advertising REFS here. In my view, and that of the many investors who use it to great effect, it is the definitive single-source investment tool. Private investors can now obtain all the financial statistics and other information they need from one source. The companies volume covers every quoted company (excluding investment trusts) with a very comprehensive full-page company entry including a chart and all of the key financial statistics for the last five years. In addition, whenever available, it shows the consensus of brokers’ forecasts for the next two years together with the individual brokers’ forecasts and details of their buy, sell or hold recommendations.

The tables volume contains directors’ dealings during the last six months, brokers’ consensus forecast changes during the month, chief executive officer changes and over 80 pages of tables seeking to identify investment anomalies. For example, there are tables of shares with attractive price-earnings ratios, price-earnings growth factors, net asset values, cash flows, dividend yields, etc., and detailed sector statistics highlighting the exact position of each company in its peer group and in the market as a whole.

I learned a great deal from the research necessary to devise REFS and from the experience of developing the service. As a result, many of my original criteria have been modified. As we go along, I will not always draw attention to the changes in my thinking; in most cases I will simply outline my ideas as they are today.

In the following chapters, I will show you the characteristics of great growth shares and how to identify, value and select them and when to sell. I have repeated from The Zulu Principle some of the substance of the chapters on Competitive Advantage and Bull and Bear Markets. My thinking on these two topics is almost unchanged but I want this book to be self-contained. In all other respects, I have completely updated The Zulu Principle as far as growth shares are concerned.

1. Private investors have three advantages that should help them beat the institutions:

2. Joining an investment club is an excellent way for private investors to improve their knowledge of investment and widen their circle of competence. ProShare makes joining or forming an investment club very easy.

4. Read as much as possible about investment. If you have not already done so, read one of the three best primers: Beginner’s Guide to Investment , How to Read the Financial Pages or Investment Made Easy . All of them are available in paperback. I also suggest you read The Zulu Principle , or at least one other investment book of a similar standard.

5. Company REFS is the investment service I devised for active private investors. It is available daily on online, or monthly or quarterly in printed form. It gives a regular, reliable and comprehensive flow of the investment statistics that are essential for effective investment.

6. To make this book self-contained, some of the views I have expressed in The Zulu Principle will be repeated. Otherwise, it contains my most recent thinking on growths shares, and supersedes The Zulu Principle in that respect.