How Martin Zweig grew rich

Accelerating earnings growth is the key criterion for this market guru, who was into the stock martet by the age of 13.

When he was just a teenager, Martin Zweig decided that he would one day become a millionaire. The thought itself probably isn't all that different from the daydreams of many other teens, but what made Zweig different was that he knew exactly how he was going to make his money: the stock market. Before long, young Zweig -- who had gotten interested in stocks when his uncle gave him six shares of General Motors for his 13th birthday -- was wowing his high school teachers with his knowledge of the market. By the time he was in college he was buying and selling stocks, and by the time he was in graduate school he had begun performing groundbreaking research in the field of stock analysis.

Soon, Zweig hadn't just reached his goal of becoming a millionaire; he had far surpassed it, becoming one of the richest men in the world thanks to his incredible success in picking stocks. To give you an idea of just how well Zweig has made out in the market, consider this: Forbes has reported that his $70 million penthouse is the most expensive apartment in New York City -- and that's just one of the homes he owns.

In addition to making himself a fortune, Zweig's advice has also helped many other investors. During the 15 years that it was monitored, his stock recommendation newsletter returned an average of 15.9 percent per year, during which time it was ranked number one based on risk-adjusted returns by Hulbert Financial Digest, a publication that tracks the records of investment newsletters. Because of that track record, I made Zweig's book, "Winning on Wall Street", the basis for one of my "Guru Strategies" -- computer models that are each based on the published methodology of a different investing great.

Before we get into the stock-specific criteria that he uses to select stocks, I should note that Zweig is very much a student of the broader economy. In his book, he says that stock prices are driven largely by monetary conditions. He even developed a model that assesses current monetary conditions, including interest rates and installment debt levels, and uses it to decide how invested in the market one should be.

There's an extensive amount of research involved in Zweig's use of these broader "market indicators", and he makes a compelling case for their use. Still, I think market timing of any kind is a risky proposition. Moreover, what I've found is that by using just Zweig's stock-specific criteria you can enjoy excellent results. Since July 2003, I've tracked a portfolio composed of the stocks that score highest on my Zweig-based model (which uses only Zweig's stock-specific criteria). In that time, the portfolio has gained 160 percent -- more than tripling the gains of the S&P 500. With results like that, it seems wise to focus on Zweig's analysis of individual stocks, and not get involved in the sometimes complicated market timing aspects of his strategy.

Focus on earnings

In his analysis of individual stocks, Zweig is first and foremost concerned with the company's earnings. "I don't get that much involved in the product being produced," he wrote in Winning on Wall Street. "If a company can show nice consistent earnings for four or five years, I don't care if it makes broomsticks or computer parts."

Unlike many investors, however, Zweig doesn't simply look at earnings growth over one fixed period; instead, he dissects a company's earnings from a variety of different angles, trying to find firms that have shown steady and "reasonable" long-term growth that has been accelerating in recent quarters. I've broken his earnings analysis down into two main categories below.

  • Long-term earnings: These criteria include long-term earnings per share growth and "earnings persistence". To show sufficient long-term growth, a company must have increased its EPS by an average of 15 percent per year, with long-term growth of 30 percent or more the best case. To show "earnings persistence", meanwhile, it must have increased its EPS in every year for a five-year period.

    A good example of a stock that meets these standards is American clothier Aeropostale (NYSE:ARO), a New York-based mid-cap ($1.52 billion market cap) whose 700-plus stores sell a variety of casual clothing targeted at 14- to 17-year-olds. Aeropostale has a long-term growth rate of 32.37 percent (based on the average of its three-, four-, and five-year EPS figures). What's more, its per-share earnings for the past five years have been $0.36, $0.62, $0.98, $1.00, and, most recently, $1.32, showing the kind of continuous increases that pass this test. •

  • Recent earnings: Zweig wants the current quarter's earnings to be positive, and wants the current quarter growth (over the same quarter last year) to be positive. But he doesn't just want to see growth; he also wants the rate of growth to be accelerating. He doesn't want to jump on the train too late, after earnings growth has peaked.

To find companies with accelerating earnings growth, my Zweig-based model first requires the current quarter growth rate (over the same period a year ago) to be greater than the company's long-term growth rate. In addition, the current quarter growth rate must be greater than the average growth rate for the most recent three quarters (compared with the same three quarters last year). The last-three-quarters criterion can be ignored if current quarter growth is 30 percent or more.

Again, let's take Aeropostale. The company's long-term growth rate is 32.37 percent, and, in the three quarters prior to the current quarter, its EPS has grown by an average of 42.39 percent (over the same three quarters last year). Both figures are impressive, but Aeropostale's growth in the current quarter -- 90 percent (over the same quarter last year) -- is even better. Earnings are growing more rapidly than they have been in the long-term and the short-term, so the stock passes both tests.

The P/E ratio: A different take

Like many investors, Zweig also focuses on the P/E ratio. But unlike most others, he doesn't just target stocks with low P/E figures. In fact, to Zweig there is such a thing as a P/E that is too low. His reasoning: a very low P/E may be very low for a reason -- that the company is weak and doesn't have the ability or potential to command higher share prices from investors. The model I base on his approach thus requires stocks to have P/Es greater than 5, to protect against such weak companies.

Because he targets companies with steady and reasonable growth -- the type of companies that aren't likely to go unnoticed on Wall Street -- Zweig is willing to buy stocks with above-average P/E ratios. Still, there is a point at which price can get too high relative to earnings for him, and the model I base on his writings sets that upper limit at three times the market average. As a way to make sure that the market itself isn't too overpriced, this model also sets an absolute limit of 43 for a company's P/E ratio.

Currently, the market P/E is 19.0. Aeropostale, meanwhile, has a P/E of 13.2, based on trailing 12-month earnings, passing this test.

Don’t forget sales, debt, and insiders

It's important to note that, while Zweig focuses a good deal on earnings, he acknowledges that earnings sometimes don't tell the whole story. In order to keep growing over the long-term, Zweig believes that earnings must be accompanied by a comparable or better increase in sales; cost-cutting measures are fine, but by themselves they can't sustain good growth over the long haul.

Let's look again at Aeropostale. The firm's earnings growth is 32.37 percent (based on the average of the three-, four-, and five-year earnings per share figures), and its revenue growth over that period has averaged 29.49 percent. That's close enough to pass this test.

Just as with earnings, Zweig also wants to see sales numbers that aren't just growing, but also accelerating. The sales growth in the current quarter (over the same quarter last year) should thus be greater than the sales growth from last quarter (over the same quarter last year).

For Aeropostale, sales in the current quarter are 13.3 percent greater than they were in the same quarter a year ago. Last quarter, sales increased 12 percent over the year-ago period. Sales growth appears to be accelerating, so Aeropostale passes this test.

Another factor that can make good earnings misleading, Zweig says, is debt. A lot of debt means a company has significant fixed interest payments, and if business slows, those payments can whittle away profits. Zweig makes a very smart point here: that debt levels vary by industry. The model I base on his approach thus makes sure that a company's debt/equity ratio is less than its industry average. In this regard Aeropostale excels: While other retail apparel firms average 48.95 percent debt/equity ratios, Aeropostale has no debt.

One final Zweig-based category: insider transactions. Zweig believes that those who work for a company know the business best. If a lot of them are selling their shares, and no one buying shares, it could mean trouble; conversely, if a lot of them are buying, but no one selling, it could bode well.

My Zweig model rewards stocks that have had more than three insider "buy" transactions over the past three months, with no insider "sell" transactions during that period. A stock can have several sell transactions and not be penalized, however, provided there has been at least one insider buy during that period. That's the case with Aeropostale, which has six insider sell transactions but also has one insider buy transaction in the past three months.

Currently, Aeropostale is one of only about a dozen companies that get strong interest from my Zweig-based model. Here's a look at a few others:

Banco Santander, S.A. (NYSE:STD): With a market cap of $124.8 billion and offices throughout Europe, the U.K., and Latin America, Santander is one of the largest banks in the world. My Zweig-based model likes its P/E (12.43), long-term earnings and sales growth (17.16 percent and 15.31 percent, respectively), and the fact that its present quarter earnings growth is higher (29.73 percent) than that long-term EPS growth rate, and higher than its average growth rate for the past three quarters (26.67 percent).

Copart, Inc. (NASD:CPRT): Copart, which has a market cap of $3.3 billion, operates 120 facilities in the U.S. and Canada, providing vehicle suppliers -- primarily insurance companies -- with a range of services to process and sell salvage vehicles. My Zweig-based model likes that its earnings have increased every year over the past five years, and that its growth rate for the current quarter (21.21 percent) is greater than its long-term growth rate (20.42 percent) and its average growth rate for the last three quarters (17.98).

American Oriental Bioengineering, Inc. (NYSE:AOB): This biotech firm makes plant-based pharmaceuticals and traditional Chinese medicines, and has a market cap of $933 million. My Zweig model likes its long-term earnings growth (38.83 percent), its excellent revenue growth rate (74.71 percent), and its low debt/equity ratio (6.27 percent, compared with its industry average of 34.2 percent).

Leave your ego behind

One final key part of Zweig's approach is his belief in stop-losses, which I don't include in my model. Essentially, Zweig set downside limits on his investments, and if the stock ever fell to these levels, it was automatically sold, as a means to limit losses.

I'm not a big believer in stop-losses, because my analysis has found that, regardless of their level (10 percent loss, 15 percent loss, etc.) they don't substantially help returns in portfolios that hold at least 10 stocks. Instead, I limit risk by performing a monthly rebalancing of all my guru-based portfolios, ensuring that each contains only the highest-rated stocks according to the portfolio's underlying guru strategy.

While our methods differ here, I think Zweig's use of stop-losses and my monthly rebalancing both touch on a similar point: There's no point in sticking with a stock that no longer meets your investment criteria, a lesson that many investors don't grasp, preferring instead to hang onto bad investments in the vain hope that they'll somehow recover. "Ego prevents them from admitting a mistake," Zweig says.

And the mistakes will come, for sure. "No one on this planet will ever know all there is to know about the market -- and no one can expect to be right all of the time or even most of the time," Zweig writes, and I agree. But the key is to be right more often than you're wrong. If you're willing to follow a successful strategy like the one I've discussed above, you should be able to do that, and add nicely to your portfolio over the long haul.

Published by Globes [online], Israel business news - www.globes.co.il - on November 1, 2007

© Copyright of Globes Publisher Itonut (1983) Ltd. 2007

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