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    Martin Zweig's Winning Approach to Investing in Long-Term Growth Stocks

    by Wayne A. Thorp

    When looking for growth investment prospects, you want to find companies that are leading the pack.

    However, just as important, you want companies that will maintain that lead in the quarters and years ahead—in other words, “everything in moderation.”

    For that reason, it is preferable to search for companies exhibiting strong sustainable growth—in sales or earnings—when following a growth-oriented stock-picking approach.

    Rarely, however, will you find methodologies that are purely growth- or value-oriented. Growth-at-a-reasonable-price (GARP) and value-on-the-move are examples of the blending of growth and value elements.

    Another example is the methodology set forth in the book “Martin Zweig’s Winning on Wall Street” (Warner Books, 1997).

    This article is adapted from the principles outlined in Martin Zweig’s book.

    Zweig Overview

    Zweig follows what he considers a “shotgun approach” to stock picking—screening publicly available data on a number of stocks using predetermined criteria. He feels that a mechanical approach such as this allows individuals to follow a large number of stocks at the same time, without having to spend a great deal of time on any one company.

    His approach isolates stocks with:

    • Strong growth in earnings and sales;
    • A reasonable price-earnings ratio given the company’s growth;
    • Strong relative price performance; and
    • Strong insider buying (or an absence of strong insider selling).

    A screen based on Zweig’s approach and adapted from his book is built into Stock Investor Pro, AAII’s fundamental stock screening and research database program.

    Screen Performance

    Each month, the AAII.com Web site provides a listing of the companies passing the Zweig screen and tracks the performance of these stocks in a hypothetical portfolio.

    Figure 1 illustrates that the Zweig screen has produced returns that are significantly higher than that of large-cap companies over the study period, which began in January of 1998. In fact, as of the end of March 2008, the Zweig methodology had the second-highest long-term price performance among all of the screens tracked at AAII.com. Since 1998, the Zweig screen has generated a cumulative return of 2,107.6%, for an impressive average annual return of 35.2%. By comparison, the S&P 500 has gained a cumulative total of 36.3% over the same time period.

    Figure 1.
    Performance of
    Martin Zweig Approach
    CLICK ON IMAGE TO
    SEE FULL SIZE.

    Profile of Passing Companies

    Table 1 highlights some of the characteristics of the companies passing the Zweig screen as of April 11, 2008, compared to the typical exchange-listed company in the database.

    The median current price-earnings ratio (current share price divided by earnings per share for the last 12 months) is slightly lower than that of the typical exchange-listed firm (15.5 versus 16.6).

    The Zweig screen is unique in that it requires a minimum price-earnings ratio. Zweig believes a price-earnings ratio can be too low, with such instances often pointing toward financial difficulties for the company or a company in a neglected industry.

    Zweig also avoids companies with extremely high price-earnings ratios, as the consequences of not meeting such high market expectations can be devastating to a stock’s price. The price-earnings ratio ceiling for our Zweig screen is one-and-a-half times the median price-earnings ratio of all stocks in the Stock Investor database. As of April 11, 2008, the median price-earnings ratio for the entire database was 15.9, so the maximum price-earnings ratio for the Zweig screen is currently 23.9.

    When looking at historical earnings growth, the stocks currently passing the Zweig screen have easily outpaced exchange-listed stocks. Over the last five years, the Zweig stocks have grown their earnings on a median basis by an average of 32.6% a year, compared to 14.0% for exchange-listed stocks. This is probably not surprising, given the quarterly and annual earnings growth requirements of the Zweig screen.

    As we have shown, the Zweig screen has handily outperformed the S&P 500 index over the last 10 years and the current group of passing companies continues the tradition.

    Over the last 52 weeks, the current Zweig companies have outperformed the S&P 500, on a median basis, by 33%, while the typical exchange-listed stock has lagged the large-cap index by 12%. However, the Zweig screen also has one of the higher monthly turnover rates among the screens tracked at AAII.com—42.5%.

    Table 1. Martin Zweig Portfolio Characteristics
    Portfolio Characteristics (Median) Martin Zweig
    Approach
    Exchange-
    Listed
    Stocks
    Price-earnings ratio (X) 15.5 16.6
    Price-to-book-value ratio (X) 2.8 1.6
    EPS 5-yr. historical growth rate (%) 32.6 14.0
    EPS 3-5 yr. estimated growth rate (%) 17.8 14.3
    Market cap ($ million) 1,626.2 376.9
    Relative strength vs. S&P (S&P=0) (%) 33.0 –12.0
    Monthly Observations
    Average no. of passing stocks 15  
    Highest no. of passing stocks 32  
    Lowest no. of passing stocks 1  
    Monthly turnover (%) 42.5  

    Passing Companies

    Table 2 lists the 15 companies currently passing the Zweig screen, ranked in descending order by their 26-week relative strength. This matches the historical average number of companies that have passed the screen each month since January of 1998.

    Zweig is interested in companies exhibiting “reasonable gains in sales and earnings” and examines these factors from a variety of angles.

    Looking at short-term earnings growth over the last fiscal quarter, Aehr Test Systems (AEHR) leads all the current Zweig companies with 666.7% growth. The developer and manufacturer of memory device testing equipment saw its earnings jump from three cents a share one year ago to 23 cents a share for the latest fiscal quarter.

    Longer term, heat transfer equipment maker Graham Corp. (GHM) has the highest average annual growth rate in earnings over the last three years at 98.7%.

    As stated earlier, the companies currently passing the Zweig screen must have a price-earnings ratio greater than 5.0 but lower than 23.9.

    Gardner Denver, Inc. (GDI) has the lowest price-earnings ratio for the group at 10.1. The company produces and sells vacuums, compressors, and other fluid transfer products.

    At the other end of the spectrum, marine transportation and diesel engine services company Kirby Corporation (KEX) barely sneaks under the hurdle with a price-earnings ratio of 23.5.

     

     

    Conclusion

    When following a quantitative screening strategy such as Zweig’s, it is important to understand that stock screening is only the first step in the stock-picking process.

    As Zweig states, the advantage of such “shotgun investing” is that it allows an individual to sift quickly through a large database of companies to arrive at all those that match the underlying criteria. From there, however, it is up to the end-user to perform additional analysis on the passing companies in order to decide whether any match their investing tolerance and constraints.

    What It Takes: The Martin Zweig Approach

    • Positive same-quarter growth in fully diluted earnings from continuing operations for each of the last four fiscal quarters
    • Positive same-quarter growth in sales for the last two fiscal quarters
    • Current fully diluted earnings from continuing operations is greater than or equal to the fully diluted earnings from continuing operations for the last fiscal year
    • Rising fully diluted earnings from continuing operations for each of the last two fiscal years
    • Annualized growth in fully diluted earnings from continuing operations of at least 15% over the last three fiscal years
    • Annualized growth rate in sales of at least 15% over the last three fiscal years
    • Same-quarter growth in fully diluted earnings for the last fiscal quarter is greater than the growth rate in fully diluted earnings from continuing operations between the sum total of the prior three fiscal quarters and the same three quarters one year earlier; OR, same-quarter growth in fully diluted earnings from continuing operations for the last fiscal quarter of at least 30%
    • Same-quarter growth in fully diluted earnings from continuing operations for the last fiscal quarter is greater than the average annual growth rate in fully diluted earnings from continuing operations over the last three fiscal years
    • The price-earnings ratio is greater than 5.0 but less than 1.5 times the median price-earnings ratio for the entire stock universe
    • The relative price strength versus the S&P 500 over the last 26 weeks is positive
    • The stock is not an ADR/ADS stock—a foreign company listed on a U.S. exchange
    • The company is not a REIT or closed-end fund
    • The average trading volume for the last three months ranks in the top 75% of the entire stock universe



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