Zweig Approach Likes Earnings -- and Apple

Includes: AAPL, LKQ, PNRA, SPY
by: John P. Reese

Over the past two years, the stock market has been driven largely by macroeconomic factors. That's not surprising, given just how powerful the economic winds have been. In late 2008 and early 2009, we experienced one of the worst financial crises in the country's history as the credit and housing bubbles burst. Then, the U.S. and other governments around the world sent an unprecedented wave of stimulus around the globe, helping to stabilize and jumpstart the stalled economy. Given the extreme emotions such major economic events cause, it's easy to see why hordes of investors have moved in near-lock-step in and out of the market.

Today, there are still big macroeconomic factors in play -- the skyrocketing levels of debt at the federal and state levels is a good example. But as we move further from the epicenter of the crisis, it seems likely that we'll start to see less correlation among stocks. As is usually the case in the markets, earnings results will separate the winners from the losers. And, with many fearing a period of slower-than-usual growth, firms producing strong earnings growth figure to be particularly prized by investors.

If you're looking for companies likely to generating strong growth, you'd be wise to consider the writings of Martin Zweig. Zweig's stock recommendation newsletter was ranked number one based on risk-adjusted returns by Hulbert Financial Digest during the 15 years Hulbert monitored it, and the growth-rich strategy Zweig laid out in his Winning on Wall Street forms the basis for one of my more successful "Guru Strategy" computer models. In the seven-plus years I've been tracking it, a 10-stock portfolio picked with this strategy has gained 48.2%, or 5.7% per year. Over the same period, the S&P 500 has gained just 8.3%, or 1.1% per year.

While many investors rely on simple earnings growth metrics like the five-year or trailing 12-month earnings per share growth rates, the approach Zweig lays out in his writings is far more thorough. My Zweig-inspired model dissects earnings in a number of different ways, looking not only for strong long-term growth of at least 15% (I use an average of the three-, four-, and five-year EPS growth to determine a long-term rate), but also for accelerating growth. It targets firms whose EPS growth for the current quarter (vs. the same quarter last year) is greater than the average growth for the previous three quarters (vs. the respective three year-ago quarters), and greater than the long-term growth rate. By using criteria like these, Zweig made sure he wasn't getting in late on a stock that was coming to the end of a strong growth run.

In addition, Zweig was concerned not only with magnitude of growth, but also with the type of growth a firm was producing. He didn't want strong earnings growth figures to be propped up by unsustainable one-time windfalls or cost-cutting measures -- or by excessive leverage. My Zweig-based model thus looks for firms that are producing strong revenue growth and have debt/equity ratios lower than their industry average.

One last thing about Zweig's approach to growth: He was willing to pay a premium for it -- to a point. The model I base on his writings requires a firm to have a price/earnings ratio no greater than three times the market average, and never more than 43. The P/E also can't be under 5 -- Zweig found that very low P/Es were indications that a firm was a dog, and that everyone knew it was a dog.

As you can see, the Zweig method's earnings assessment is quite rigorous, and usually there aren't a whole lot of stocks that pass all its tests. Here are a few that currently do have what it takes to make the grade.

Apple Inc. (NASDAQ:AAPL): My Zweig model just upgraded this tech giant and earnings juggernaut last week. It likes the $230-billion-market-cap firm's strong long-term earnings growth rate (68.8%) and long-term revenue growth rate (33.9%, based on an average of the three-, four-, and five-year revenue growth figures), and the fact that earnings growth accelerated to 74.6% in the most recent quarter. In addition, Apple has no long-term debt, and its shares sell for about 19 times trailing 12-month earnings. That's higher than the market average, but quite reasonable when you consider the growth the company is producing.

Panera Bread Co. (NASDAQ:PNRA): This Missouri-based bakery/café chain operates close to 1,400 stores in 40 states and Canada under the Panera Bread, Saint Louis Bread Co. and Paradise Bakery & Café names. The $2.4-billion-market-cap firm gets a perfect 100% score from my Zweig-based model. A few reasons: Its strong, accelerating earnings growth (30.8% in the most recent quarter, up from 28% in the three previous quarters, which is up from 16.2% over the long haul); its 20.4% long-term revenue growth rate; and its lack of any long-term debt. The stock also trades for about 23.4 times trailing 12-month earnings, not bad considering its strong growth history.

LKQ Corporation (LKQX): This $2.8-billion-market-cap auto part firm is the largest nationwide provider of recycled light vehicle OEM products and related services, and the largest provider of aftermarket collision replacement products. Based in Chicago, it has a history of stellar earnings growth, upping EPS at a 29.8% rate over the long haul, and an even-better 30.0% rate in the most recent quarter. It's also been growing revenues at a 37.7% clip over the long haul, and sells for a reasonable 18 times trailing 12-month earnings. The lone flaw my Zweig-based model sees with LKQ is that its debt/equity ratio is higher than its industry average. The difference isn't particularly troublesome, however -- LKQ's D/E is 46.1%, while its industry average is 39.9%.

Disclosure: I'm long AAPL, PNRA, and LKQX.

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