The Zweig Method: 10 Growth Investments for a Tough Market

[Taken from the March 6, 2009 issue of The Validea Hot List]

If you’ve been a reader of mine for any significant amount of time, you know that my Guru Strategies have a distinct value bias. The majority of these models — ranging from my Benjamin Graham approach to my Warren Buffett model to my Joseph Piotroski strategy — are focused on finding good, often beaten-down stocks selling at bargain prices; that is, they target value stocks.

But that doesn’t mean that all of my gurus were cemented on the value side of the growth/value pendulum. In fact, the guru we’ll examine today, Martin Zweig, used a methodology that was dominated by earnings-based criteria. He looked at a stock’s earnings from a myriad of angles, wanting to ensure that he was getting stocks that had been producing strong growth over the long haul and even better growth recently — and that their growth was coming from the right sources.

Zweig’s thoroughness paid off. His Zweig Forecast was one of the most highly regarded investment newsletters in the country, ranking number one for risk-adjusted returns during the 15 years that Hulbert Financial Digest monitored it. It produced an impressive 15.9 percent annualized return during that time. Zweig has also managed several mutual funds, and was co-founder of Zweig Dimenna Partners, a multibillion-dollar New York-based firm that has been ranked in the top 15 of Barron’s list of the most successful hedge funds.

Before we delve into Zweig’s strategy, a few words about the man himself. While some of the gurus we’ve looked at in recent Guru Spotights — Buffett and John Neff in particular come to mind — lived modest lifestyles, Zweig put his fortune to use in some pretty fun, flashy ways. He has owned what Forbes reported was the most expensive apartment in New York City, a penthouse atop Manhattan’s Pierre Hotel that was at one time valued at more than $70 million. He’s also an avid collector of a variety of different kinds of memorabilia. The Wall Street Journal has reported that he’s owned such one-of–a-kind items as Buddy Holly’s guitar, the gun from Dirty Harry, the motorcycle from Easy Rider, and Michael Jordan’s jersey from his rookie season with the Chicago Bulls. He even owns the sperm costume from Woody Allen’s film Everything You Always Wanted to Know About Sex. His collecting interests also span the historic (several old stock certificates, including one signed by Commodore Vanderbilt) as well as the nostalgic (like the two old-fashioned gas pumps that are almost identical to those he’d seen at the nearby Mobil station while growing up in Cleveland), Financial World has reported.

Zweig may spend his cash on some flashy, fun items, but the strategy he used to compile that cash was a disciplined, methodical approach. His earnings examination of a firm spanned several categories:

Trend of Earnings: Earnings should be higher in the current quarter than they were a year ago in the same quarter.

Earnings Persistence: Earnings per share should have increased in each year of the past five-year period; EPS should also have grown in each of the past four quarters (vs. the respective year-ago quarters).

Long-Term Growth: EPS should be growing by at least 15 percent over the long term; a growth rate over 30 percent is exceptional.

Earnings Acceleration: EPS growth for the current quarter (vs. the same quarter last year) should be greater than the average growth for the previous three quarters (vs. the respective three quarters from a year ago). EPS growth in the current quarter also should be greater than the long-term growth rate. These criteria made sure that Zweig wasn’t getting in late on a stock that had great long-term growth numbers, but which was coming to the end of its growth run.

While Zweig’s EPS focus certainly puts him on the “growth” side of the growth/value spectrum, his approach was by no means a growth-at-all-costs strategy. Like all of the gurus I follow, he included a key value-based component in his method. He made sure that a stock’s price/earnings ratio was no greater than three times the market average, and no greater than 43, regardless of what the market average was. (He also didn’t like stocks with P/Es less than 5, because they could be indicative of an outright dog that investors were wisely avoiding.)

In addition, Zweig wanted to know that a firm’s earnings growth was sustainable over the long haul. And that meant that the growth was coming primarily from sales — not cost-cutting or other non-sales measures. My Zweig model requires a firm’s revenue growth to be at least 85 percent of EPS growth. If a stock fails that test but its revenues are growing by at least 30 percent a year, it passes, however, since that is still a very strong revenue growth rate.

Like earnings growth, Zweig believed sales growth should be increasing. My model thus requires that a stock’s sales growth for the most recent quarter (vs. the year-ago quarter) to be greater than the previous quarter’s sales growth rate (vs. the year-ago quarter).

Finally, Zweig also wanted to make sure a firm’s growth wasn’t driven by unsustainable amounts of leverage (a key observation given all that’s happened recently). Realizing that different industries require different debt loads, he looked for stocks whose debt/equity ratios were lower than their industry average.

There’s one more thing you should know about Zweig. He relied a good amount on technical factors to adjust how much of his portfolio he put into stocks. Some of the indicators he used to move in and out of the market included the Federal Reserve’s discount rate; installment debt levels; and the prime rate. His mottos included “Don’t fight the Fed” (meaning investors should be more bullish when interest rates were low or falling) and “Don’t fight the tape” (which related to his practice of getting more bullish or bearish based on market trends).

Those rules are tough for an individual investor to put into practice; Zweig used what he called a “Super Model” that meshed all of his indicators into a system that determined how bullish or bearish he was. But over the years, I’ve found that using only the quantitative, fundamental-based criteria Zweig outlined in his book can produce very strong results. My Zweig-inspired model has been one of my best performers since its July 2003 inception, returning 14.2 percent while the S&P 500 has fallen nearly 29 percent.

The model tends to choose stocks from a variety of areas. Currently, my 10-stock Zweig-based portfolio’s holdings range from retailers to energy firms to healthcare companies to metal miners:

As you might expect with a growth strategy, the Zweig portfolio tends not to hold on to stocks for a long time. Usually it will hold a stock for a few months, though it is not averse to longer periods if the stock continues to be a prospect for more growth.

What I really like about the Zweig strategy is that, while it certainly would qualify as a growth approach, it doesn’t look at growth in a vacuum. As you’ve seen, it examines earnings growth from a variety of angles, making sure that it is strong, improving, and sustainable. In doing so, it allows you to find some fast-growing growth stocks that are not paper tigers, but instead solid prospects for continued long-term success.

Disclosure: At the time of publication, John Reese and his private clients at Validea Capital are long all ten stocks mentioned in this article.

Comments

[bobbobwhite:]

Miss seeing Marty Zweig on the late Louis Rukeyser's show. His was a serious, non-nonsense approach to investing that I always admired, and now even more so.

Mar 10 11:14 AM

[Larry House:]

I too remember Marty fondly. The only problem is no stocks do well when the macro conditions are so negative. It takes investor confidence in addition to fundamentals to make money in stocks. That is why we see stock prices languishing for so many good companies.

Mar 10 12:04 PM

[bricki:]

I enjoyed watching Marty as well. It was obvious that he was a careful thinker. It's a shame we don't seem to have time for shows like Rukeyser's Wall Street Week any more.

For what it's worth the AAII has implemented the Zweig methodology in it's investing software package. It is a very strong performer.

Mar 10 12:13 PM

[Diego Monta...:]

"Miss seeing Marty Zweig on the late Louis Rukeyser's show"; ah yes ... really appreciated that over time Marty grew wise with humility whenever discussing mkts; one of the good guys.

Mar 10 12:30 PM

[oldasiahand:]

Is Marty still around? I met him once at his office in 1994 or 4. he was having a bad day over an imminent divorce but still a star.

Mar 11 10:57 AM

[stockstalker32:]

My zweig fund got killed this past year, so I don't know how much I buy into it.

Mar 11 06:16 PM

[Don-n-ABQ:]

John, have you thought about adding Ken Heebner to your stable of gurus? How has he been holding up?

And what ever happened to Mario Gabelli? He just loved the cable and media stocks.

I MISS LOU!

I have had three TV father figures in my life:

1970s: James Garner
1980s: Johnny Carson
1990s: Louis Rukeyser

Now where did I put my time machine....

Mar 11 08:22 PM

[socphd71:]

I looked the stocks up on Yahoo. For Brinks Home security (CFL), Yahoo gave an EPS of $28.55 for an astonishing 0.74 PE. I looked up the financial statement. The company has only been spun off for a few months. The pro forma non-GAAP eps is $1.58 while the GAAP eps is $1.25 for a PE of 17. These figures assume that the company had been, for the year, separated from its parent. I didn't find anything on dividend policy.

www.investors.brinksho...=

Mar 11 08:38 PM

[Mafeking:]

Problem is these 'fundamental analysis' schemes simply don't work in a ferocious bear market. All the clever Ben Graham derivatives approaches lose money. Zweig's approach is great in an up or flat market, but pretty useless now (though 2 out of 3 ain't bad).

Maybe not Zweig's approach, but many of these stock filtering schemes would have coughed up such illustrious stocks as GE.

For all the cynicism about technical analysis a simple 50 week moving average or 200 day moving average would have got you out of the market almost a year ago.

Mar 12 11:06 AM

[bricki:]

Marty generally used technical analysis to assess the overall state of the market, and fundamentals for individual stocks. He was famous for calling the 1987 crash based on technical analysis.

My gut is that he would have been out of this market in good time.

www.martinzweig.org/

Mar 12 05:29 PM

[Jeffmiles:]

Value based investing works in bull market but not in bearish conditions like this.

The key is knowing when to get out before you lose big and get in only when you see a clear uptrend...not short but false rallies.

The key is to have reliable source of god investment tips from analysts with proven track record and a clear exit strategy.

Mar 13 03:52 PM

[ain't no fo...:]

Marty Zweig was a great read too... I bought one of his books when I was a new broker in 1986 and it really helped me pick some winners.

He also had a fantastic rule for market timing that worked great in those days before hedging with VIX and futures and the single and double leveraged ETF's skewed volume statistics to much.

It was the 9 to 1 rule. If the market had been in a protracted correction or weakness, the first day a rally attempt achieved 9 to 1 up over down volume, you had the signal to get long.

And if it did a DOUBLE 9 to 1 (two 9 to 1 up volume days) over a 2 week period of time, you backed up and loaded the truck, as they say now. Right at the end of 1986 and the beginning of 1987 I witnessed to back to back 9 to 1 up volume days (actually more like a 10 to 1 and 15 to 1 up day) and that set off a fantastic rally that lasted into the early summer of 1987. It was a barn burner.

Of course, the barn really did end up burning down on October 19, but that is a different story - that rally was sweet.

Mar 13 09:30 PM

[User 376724:]

I thought this was a moderately interesting article, until I read, "My Zweig-inspired model has been one of my best performers since its July 2003 inception, returning 14.2 percent while the S&P 500 has fallen nearly 29 percent."

So that's a return of [(1.142)^(1/(5&2/3 yrs)) - 1] per year compounded. Or 2.37% per year compounded since its inception! (You can check this using (1 + 0.0237) raised to the power of 5.666 yrs).

All that work for 2.4% per YEAR!!!

I think a better clue to how he won his great wealth comes from, "Zweig has also managed several mutual funds... etc." I don't mean to decry HIS success, because for a hedge fund to rank so highly is no mean achievement. But why would anyone be remotely financially tempted to do all the research work such an approach would require for such paltry, soul-destroying returns? And at greater risk than alternatives that can yield so much more, and at less risk? Unless it was during the appropriate stage of a long cycle, and they were running a fund (and thus able to transfer risks TO clients, and transfer returns FROM them)?

And why on earth compare it to a lousy benchmark that would have lost you money? Just because the fund managers do this to make their clients feel less bad about the losses they have suffered by being unfortunate to have put their money with money mismanagers in the first place hardly makes the S&P a suitable benchmark. How about using "cash under your mattress or in a bank account" as your comparison?

I don't mean to be harsh. (To achieve a +ve return using bets that are restricted to shares during that period is an achievement). But surely the only lesson from this article is either that (i) if you are going to go about betting on shares, then it is going to be very difficult for almost all people to achieve +ve risk-adjusted returns, or (ii) that even when you get it right, if you are doing it during the 'wrong' stages of the larger business or economic cycle (ref., credit / Kondratief / Elliott etc., etc), then you have the odds stacked against you. Share 'investing' right now = the emperor; the returns you have 'achieved' are supposed to be his fine clothes?

PS: There ARE ways to make a lot from betting on shares (etc), even right now. If anyone is really determined, and not under any illusion that it is 'quite easy', then I'd point to better alternatives such as shorting companies that are certain to go bust - still quite risky, or finding the best technical analysis (and I'm not talking about moving averages / heads and shoulders / double bottoms / momentum indicators / almost all indicators ...)

Mar 15 10:19 AM

[greenline:]

To user 376724:

What are those technical indicators that provide the best technical analysis?

Mar 15 03:53 PM