3 keys to by-the-numbers stock-picking

By Harry Domash

Unless you're a longtime investor, Martin Zweig is probably the most famous guru that you've never heard of. He doesn't get much attention these days. Although his name still appears on several mutual funds, he discontinued his Zweig Forecast newsletter several years ago. That's too bad, because the newsletter was ranked No. 1 for risk-adjusted returns over the 15 years that it was monitored by Hulbert Financial Digest.

But Zweig, who has a Ph.D. in finance, is well-known to market professionals for his disciplined approach to the market. He has examined the relationship between stock market action and just about every conceivable economic or market indicator. In fact, he's credited with inventing the put/call ratio market-sentiment indicator.

Zweig described the results of much of his research in his best-selling book, "Martin Zweig's Winning on Wall Street."

Much of the book covers Zweig's market-timing indicators, but he also details how he picks individual stocks. By all accounts, those strategies are worth your attention. According to Street Stories Market Wizards Index, Zweig's top-rated stocks returned 25%, on average, over the 19-year period from May 1976 to March 1995.

Zweig on stocks

As with the market in general, when it comes to picking individual stocks, Zweig goes strictly by the numbers. As he puts it, "I don't get involved in the product being produced. If a company can show nice consistent earnings, I don't care if it makes broomsticks or computer parts." Zweig doesn't spend much time examining financial statements or meeting with management. Instead, he focuses on three main criteria to pinpoint potential winners:

• A history of consistently strong sales and earnings growth

• A reasonable price

• Strong price action relative to the market

Zweig also pays close attention to insider trading. He eliminates candidates with significant insider selling and gives preference to stocks with insider buying. He avoids stocks that have recently disappointed the market and frowns on companies carrying high debt.

Zweig doesn't try to catch a stock at its low. Instead, he wants to see a stock prove itself by "performing well" relative to the market before he jumps in. Says Zweig, "buying on strength gives you an edge. You must pay a premium, but you increase the probability of being right."

I'll explain more as I describe my screen for finding stocks meeting Zweig's criteria. Let's start with sales and earnings growth, arguably Zweig's most important criteria.

Long-term growth

Zweig doesn't look for hot initial public offerings (IPOs) or instant wonders. He insists on a history of consistent growth in both sales and earnings going back four or five years. He considers 15% annual growth acceptable, but he seems to prefer higher. In his book, he gives numerous examples of stocks with 30% to 50% historical growth rates.

In my screen, I specified a 15% minimum for both 5-year average annual revenue (sales) and 5-year annual EPS growth. But I'm sure that Zweig wouldn't mind if you increased those minimums if you get too many hits.

• Screening Parameter: (5-year) Annual EPS Growth Rate >= 15%

• Screening Parameter: 5-Year Revenue Growth >= 15%

Recent growth

Zweig looks for consistent or accelerating growth. The most recent quarter's year-over-year EPS growth rate should be in the same ballpark as the long-term rate and, in the best case, higher. However, he's not dogmatic and is willing to cut the stock a little slack depending on conditions.

I required the most recent quarter's year-over-year EPS growth to be at least 75% of the long-term growth rate. However, I'm sure Zweig would want you to check further if the recent growth rate was near that minimum.

• Screening Parameter: EPS Growth Qtr vs. Qtr >= 0.75* (5-year) Annual EPS Growth

Revenue growth vs. EPS growth

While they won't track every quarter, Zweig wants to see stocks with revenue and EPS long-term growth rates in the same ballpark. Revenues growing faster than earnings signal declining profit margins, which often indicates that the company is cutting prices to ward off increasing competition. Conversely, earnings growth without corresponding revenue growth also spells trouble. It means that the earnings growth is coming more from cost-cutting than organic growth. If that's the case, eventually, the company will run out of places to cut costs, and earnings growth will slow.

I insured that the long-term revenue and EPS growth rates reasonably tracked each other by requiring each to be at least 75% of the other.

• Screening Parameter: (5-year) Annual EPS Growth Rate >= 0.75*5-Year Revenue Growth

• Screening Parameter: 5-Year Revenue Growth + 0.75* (5-year) Annual EPS Growth Rate

Maximum valuation

Zweig avoids overpriced stocks. He uses P/E to measure valuation, but his definition of overvalued depends on the market. In his examples, Zweig accepts fast-growing companies with P/Es as much as 50% higher than the overall market. Based on those examples, I use the S&P 500 average P/E to represent the market and reject stocks trading with P/Es more than 50% above the S&P.

• Screening Parameter: P/E Ratio: Current <= 1.5*S&P 500 Average P/E Ratio: Current

Minimum valuation

In Zweig's view, a stock's P/E can be too low as well as too high. He says that very low P/Es signal problems and generally means that investors are abandoning ship. But he doesn't spend much time worrying about the reasons. He says he's looking for "stable and reasonable growth," and he sees little chance of finding such stocks in the low P/E arena.

In his book, Zweig advised shunning stocks with P/Es below 5. Since his maximum P/E varies with the market, I took liberties with his definition and used that same criterion for the minimum P/E. When he wrote the book, a 5 P/E equated to roughly 40% of the market average, which translates to 7 or so in the current market. If you want to be a Zweig purist, change the minimum P/E to a fixed value of 5.

• Screening Parameter: P/E Ratio: Current >= 0.4*S&P 5000 Average P/E Ratio Current

Strong price action

Zweig wants to put the odds in his favor by homing in on stocks that are already showing strong price action relative to the market. He avoids stocks near their lows or in a clear downtrend. He prefers stocks that are "acting better than the market," but will accept stocks "acting at least as well as the market."

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