Martin Zweig Winning on Wall Street
Page 21
GRAPH P
Ned Davis Research
GRAPH Q
Ned Davis Research
This situation actually happened with the Dow Jones Industrial Average in 1983. The economic recession, which ended shortly before then, had devastated the earnings of some of the Dow’s major components, especially steel companies. Some of these firms took huge write-offs, and the Dow’s total earnings at one point were less than $10 a share. With the Industrials somewhere over 1200, the P/E ration at one point was over 130. That, of course, is absurd, not because of gross speculation but because of temporarily microscopic earnings. As profits came back to more normal levels in 1984, the Dow’s P/E settled back into a more normal range of 11 to 14. A similar condition existed in 1932, when corporate profits for the entire nation were negative and profits for the Dow Jones Industrials were barely positive.
As you see in the third column in table 35, eight of the bear markets suffered from extremely high P/E ratios. The most noteworthy of these was 1962, when both monetary conditions and economic conditions were reasonably favorable. The only thing really wrong with that market was the market action itself, because speculators drove prices up to insane heights, with the Dow Industrials reaching a record twenty-three times earnings in late 1961 (excluding, of course, those times when the Dow’s earnings were depressed).
The third extremely bearish factor is an inverted yield curve. This is the condition when short-term interest rates rise to levels above longer-term interest rates, an inversion of the normal situation. Usually bond yields, which are long-term rates—say fifteen to thirty years to maturity—carry higher interest rates than such short-term instruments as Treasury bills or money market funds because bonds are much riskier. Thus, investors usually demand an interest rate premium to entice them into accepting the added risk of buying bonds.
However, during a money crunch, in which the Federal Reserve is tightening money conditions, or when a financial crisis is brewing, short-term rates can jump sharply, sometimes to way above long-term rates, thereby generating a negative yield curve. To measure the yield curve I use Moody’s Aaa Corporate Bond Yields as the long-term rate, and six-month commercial paper rates as the short-term rate. You can find these figures in government publications, Barron’s, and other financial periodicals.
Graph R (pp. 192–193) shows the yield curve back to 1960. The shaded area below the zero line shows the times when the yield curve was inverted. For example, in late 1980 short-term rates were as much as four percentage points greater than long-term rates. Conversely, the yield curve was between three to four percentage points positive in 1971–72, 1975–76, and periods in the early 1980s. When the yield curve is negative on a monthly basis (the graph is plotted monthly), I consider that an extremely unfavorable condition for stocks.
Sometimes the negative yield curve will last only a month or two and a bear market might not develop. But if the spread between commercial paper rates and bond yields keeps widening in the negative direction, the odds for stocks get worse and worse. Table 35 shows that nine of the last fifteen bear markets came when the yield curve was negative for at least a fair chunk of the decline and/or near the top of the prior bull market.
As seen in table 35, only one bear market, 1929–32, had all three extremely negative conditions, and not so coincidentally it was the worst bear market in history. Four other bears were devastating: 1919–21, in which the Dow Industrials fell 47.6% 1969-70, when the Dow plunged 36.1% and 1973–74, in which the Industrials collapsed 45.1 %. In the other case, 1966, the Dow fell a more moderate 25.2%. However, that was the beginning of a much greater long-term bear market, which took the Dow downward in real terms all the way into 1982 as described in chapter 3 on the stock market averages. The average of these four bear markets showed a decline of 38.5% on the Dow Industrials, well in excess of the average of the ten bear markets that had only one of the three negative conditions and fell an average of 29.4%.
In sum, there is no guarantee that a bear market will begin when one of the three extremely bearish market conditions is first present. But the longer such a condition persists, or the more severe it becomes, or when a second or third negative condition joins the first, the odds on a bear market become overwhelming. On the other hand, should the major averages experience a decline of, say, 10% or more with none of these three negative conditions present, the odds of that decline’s becoming a major bear market are quite small.
GRAPH R
Ned Davis Research
It would generally pay to begin buying stocks after a 10% decline in all three averages, assuming that the three big negatives are not present. The odds of that decline’s reaching 15% are remote, and except for a few meaningless cases in the extraordinarily volatile period from the mid-1920s to the mid-1930s, it simply has not occurred in at least the past seven decades. So, if the background environment is reasonably decent—that is: no extreme deflation, normal P/E ratios, and a positive yield curve—then a decline of 10% sets in motion a buying opportunity with overwhelming odds that you won’t lose more than 5% before the market begins to rally once more.
CHAPTER 11
How to Pick the Winners—The “Shotgun” and “Rifle” Approaches
There are clearly a number of wrong ways to play the stock market, but there is no single right way. Many approaches can work. By work, I mean achieving a long-term rate of return better than the market’s own performance. Rate of return, of course, would include capital appreciation plus dividends.
We can divide stock-picking methods into two extremely broad categories. First, there’s the “shotgun” approach, with which you systematically compile publicly available data on any number of stocks. You then screen this massive amount of information by predetermined criteria and select the desired stocks more or less mechanically. With this broad approach you can cover nearly the entire stock universe while spending very little time on any one stock. By diversifying your portfolio—say, by buying ten, twenty, or even thirty stocks—you can protect yourself against the normal number of mistakes. The drawback is that no one company is investigated deeply and this may lead to some unwanted results.
The second broad method is the “rifle” approach, in which only a small number of firms are studied, with each carefully selected and analyzed fully. With this procedure you need not rely on the face value of publicly available data. You might dig further into various accounting methods, changes in management, trends in the underlying business, tax law changes, or virtually any other economic variable that might affect the company. Then, if you are capable of synthesizing all of this diverse information, you might be able to pick stocks that would beat the market.
This is really more of an investment approach relying heavily on underlying values. Its disadvantage is that it requires full-time study of the market and is not suitable for the part-time investor. Many Wall Street analysts and some money managers follow this technique. Even so, the investment returns from this rifle method vary enormously according to the analytical ability of the practitioners.
I don’t think this rifle method is suitable for most readers of this book. Frankly, I’m not even that comfortable with it myself. I prefer the shotgun system, where I can systematically study thousands of companies. With this approach, my built-in error rate is about three-eighths. That is, out of eight stocks that I pick, three, or 37%, will underperform the market. Alternatively, it means that I may be right five out of eight times, which is not a bad batting average at all. I doubt that the rifle approach would do any better.
However, both of the stock-picking methods have their various advantages, and, in the closed-end fund (the Zweig Fund and Zweig Total Return Fund) that I run with Joe DiMenna, we integrate the two approaches. Basically, I do the broad market forecasting. Because he is more comfortable with the rifle technique, DiMenna handles the stock targeting, spending nearly all his time poring through financial documents and talking to analysts and company officials. So, worki
ng as a team, we are able to get the best of both worlds. But if I were operating strictly on my own, I would use the shotgun method, the approach I will outline in this chapter.
My stock-picking procedure involves a search for the following variables: strong growth in company earnings and sales; a reasonable price-to-earnings ratio given the company’s growth rate; buying by corporate insiders, or at least the lack of heavy selling by insiders; and relatively strong price action by the stock itself In other words, I tend to favor buying strength and selling weakness. I will go into detail about each of these general areas and provide specific examples of stocks I’ve recommended and tell you exactly where to find the data you will need. All the information for this method is publicly available.
The examples cited in the following pages originally appeared in the previous editions of this book and are still pertinent at this writing. Painstakingly developed through trial and error over the years, these simple-to-use methods of stock selection are very well suited for both conservative investors and those who like to trade more actively.
While the methods described in this chapter work extremely well, I must, in all candor, point out that my current stock selections are based primarily on the use of the latest advances in computer technology. Derived from numerous technical and fundamental variables—each weighted by my proprietary formulas—computer-generated estimates indicate how stocks are likely to perform over the next six to twelve months. I cannot possibly list all the variables I use for picking stocks because it would get hopelessly complicated. However, many of the stocks selected by this method are listed twice monthly in my publication, Zweig Performance Ratings Report. Sample copies are available (P.O. Box 360, Bellmore, New York, 11710-0751).
SCANNING THE FINANCIAL SECTION
Step number one is to obtain the latest quarterly figures on company sales and earnings, and the best place is in the daily financial section of The Wall Street Journal, The New York Times, or any other paper that lists all the earnings reports daily. I prefer the Times myself, but whichever paper you use, stick with it, because a company’s earnings might be reported in, say, the Journal on Monday and not the Times until Tuesday, or vice versa. So, if you skip from paper to paper, you might miss a report. One enormous advantage, by the way, of using the earnings reports in the papers is that it enables you to scan every report that comes out. By the end of a quarter you will have seen the earnings of four thousand or more companies. It is not as much work as it seems because in most cases you’ll merely glance at a report and reject it immediately.
THE NEW YORK TIMES, TUESDAY, JUNE 18,1985
The illustration on page 198 shows some of the earnings reports as found on a typical day in The New York Times (June 18, 1985). You’ll find that I circled four of the reports with a felt-tipped pen, my first step. What I am looking for are reasonable gains in both sales (revenues) and earnings per share. Take the first company listed in that day’s earnings—Amcast Industrial Corp. The little “O” in the brackets after the company’s name stands for over-the-counter, where that stock trades. An “N” in the brackets means the company is listed on the New York Stock Exchange, an “A” signifies the AMEX, and no letter at all means that the common stock either is not traded or does not even appear in the regular over-the-counter listings.
In the case of Amcast we see the results for the quarter ending June 2, 1985. The sales of a bit over $67 million were more than $2½ million below the previous year’s quarter, not indicative of growth. Likewise, earnings per share were 50¢ versus 53¢ in the year-ago quarter. That, too, shows lack of recent growth. Since growth is a key variable, I eliminated Amcast.
Now skip down to Clabir Corp. on the NYSE. Revenues of $10.9 million were up roughly 43% from a year ago, a plus. Unfortunately, as we move down to the earnings per share, we see a net of only 2¢ versus a loss the previous year. While that is clearly an improvement, the earnings are rather insignificant and probably more indicative of a potential turnaround situation than true growth. That’s not what I’m looking for. In addition, notice the lowerbase “b” in front of net income for the April 30, 1985, quarter. The footnote under the report says that the net income is after a tax credit of $531,000. In other words, without that extraordinary item, Clabir would have reported a loss of more than $300,000 for the quarter. So, we’ll forget about that stock.
The next issue, Cogenic Energy Systems, reported a net loss, so I cross that one out too. Finally, we reach the first stock that I have circled, Continental Healthcare Systems, traded over-the-counter. Revenues for the March 31 quarter were up 68% to $3.7 million, a good sign. Next, earnings per share doubled from 8¢ to 16¢ in the quarter, an excellent trend. However, if you read further, there is a negative.
Except for the first quarter in a company’s fiscal year, the other three quarterly reports will have the cumulative total of revenues and earnings for the current fiscal year. In Continental Healthcare’s case, the March quarter was the second of its fiscal year, so the six-month report is also shown. We see on the last line of the report that six-month earnings are 19¢ versus 13¢ a year ago. With a little subtraction (the six-month figure less the second quarter), we can then calculate what the earnings were for the first quarter, the one ending December 31, of the current fiscal year. It works out to 3¢ this year versus 5¢ a year ago. Obviously, that was not such a great quarter. I am not looking for growth in the current quarter, but I prefer steadier growth over a longer time frame. Continental Healthcare failed to show that in the first quarter of the current fiscal year. So, I would eliminate the stock by simply x-ing it out in that day’s newspaper.
I have also circled the next stock, Cullinet Software on the New York Stock Exchange. Revenues were up a nifty 50% to more than $52 million, and earnings per share jumped over 37%, from 160 to 220. So far, so good. As it turns out, this April 30 quarter was the fourth and last quarter in Cullinet’s fiscal year. The results for the entire year are found below. They show revenues of $184 million, up 53% from a year ago. Cullinet’s sales increase for the current quarter was only a tad below the increase for the full year, which is reasonable, but its earnings growth was only 37% for the quarter. By subtracting, we can see that for the first three quarters of the year, Cullinet earned 59¢ versus 38¢ a year ago, an increase of 55%. So earnings growth for the quarter was slowing, a cause for at least a touch of suspicion on our part. Still, that’s a mighty high rate of growth, and if it were to continue at a rate of 30% or so, it would give us a potentially good stock. At this point I would leave Cullinet circled and go on to the rest of the list.
Later, as we move on to studying the price/earnings ratios, we will see that Cullinet’s is much too high at roughly 30, so I would eliminate it on those grounds. But for the earnings report itself, the only negative is a slowdown in the growth in the most recent quarter, but not by enough to eliminate the stock at this point.
The next interesting stock is Ennis Business Forms on the New York Stock Exchange. Ennis, for its May 31 quarter, showed sales growth of about 8% to better than $27 million. As an aside, we know it is Ennis’s first quarter of its fiscal year because there is no entry for the cumulative six months, nine months, or full year below the quarterly figures. An 8% sales increase is not robust; however, earnings per share are up over 23% to 63¢ for the quarter. That’s not bad and it’s worth another look. As it turns out, Ennis was already on my potential buy list, a list I keep on more than a hundred stocks at any point, always updating it by eliminating those with poor reports or some other negative, and adding to it for any new stock that comes along.
To make this potential list relatively easy to keep by hand I use index cards. (I do not use a computer in this part of my approach, nor will you need one.) I separate the cards into three groups, one for each exchange—NYSE, AMEX, and OTC. I then alphabetize each group. When you see a report in the paper on a stock that is already on your list, you will probably remember the name of that company, although occasionally y
ou might not recall it. In any case, when in doubt, shuffle through your cards to see if the stock is already there, as it was for me in the case of Ennis.
Using Ennis as an example, here is a sample card with the information I keep.
My first notation is the ticker symbol, EBF in this case, so that I can recall the stock on my Quotron machine if I want a current quote. Next I write out the name of the company, Ennis Business Forms, and the price at the last time I’ve updated the stock. In this case, it would be Ennis’s price of 37½ on the day of the earnings report. I also note the approximate trading volume—about 10,000 shares for Ennis—because I don’t like to recommend stocks that are too thin. However, you would not have that problem if you are dealing with a normal-sized account for yourself. I also note insider trading, which I’ll get to later, but which, in Ennis’s case, showed no buyers and four sellers, not good news. But that can change over time, so the stock remains on my potential list.
Next I erase the old quarterly earnings (always update your cards in pencil) and put in the new quarterly comparison, 63 versus 51. After that, in brackets, you’ll see $2.85, which is the total earnings over the last four quarters. (I’ll show you later in this chapter where to come up with that number.) Now you’ll see +8 after the brackets, which is the percentage increase in sales for the quarter as gleaned from The New York Times, after which you’ll see +21. When I culled the report on Ennis three months earlier, that latter number was the percentage increase in sales for the prior quarter. So, the not-so-good news for Ennis was that the rate of growth in sales declined from 21% to 8%. I next have the P/E ratio, which is 13, a brief description of the firm’s business, and yearly earnings for the last several years.