Martin Zweig Winning on Wall Street

by Martin Zweig

  Another factor you occasionally might deal with is the amount of debt that a company has. The little Standard & Poor’s stock guide will give you the figure of long-term debt as well as the short-term debt measured by current assets minus current liabilities. More details would appear in Value Line or Standard & Poor’s other publications. If a company has a tremendously high level of debt, the earnings or earnings growth rate would be worth less because of the potential risk. Companies with high amounts of debt have high interest expense, and interest expense is a fixed cost. If business turns down moderately, the high fixed cost can have a very negative effect on earnings. So be careful not to overpay for companies with high debt. Indeed, you may want to avoid them entirely.

  PRICE ACTION

  We’ve now screened stocks for earnings and sales growth and for P/E ratios. The next screen is right there in your chartbook, the price action of the stock itself. Recall our Four Percent Model using the Value Line stock price index as described in chapter 5. Even though that study was for the market as a whole, it showed rather clearly that one can achieve excellent results—well above the market’s rate of return—by buying strength and selling weakness. The same applies to individual stocks. After all, the market is no more than the sum of all the individual stocks.

  I have no hard-and-fast rule on price action for stocks themselves. It’s more of an art than a science, although if you have access to a computer and a large data bank, you could employ any number of mechanical rules for screening stocks that have been acting well. When I look at a stock chart I am not specifically looking for the types of chart formations that most technicians follow, such as head-and-shoulder tops and bottoms, rising wedges, or triangle formations. I’m not convinced that stuff works. But I do want to find stocks that are acting better than the market. So, the first place to start is with the market’s recent action as a whole.

  Suppose the market has been very strong of late. Obviously, then I am going to eliminate any stock that hasn’t been keeping pace. Stocks wallowing near their lows, or in obvious downtrends on the charts, are definitely out. Stocks that have been rising but in a very lukewarm way, and that perhaps have not broken out above previous peaks of the last year or so, are probably also not good purchase candidates. After all, if the market is strong, say up 15% or 20% in the past six or eight months, then one has to look askance at any stock that has significantly underperformed that pace. My theory is that if a stock really is so good, it should be acting at least as well as the market. If it hasn’t been, that’s a caution sign in itself.

  In a very strong market, the very best kind of action is a clear uptrend on a chart where you see a series of higher highs and higher lows—sort of a stepladder on the way up. The best buying spots are short-term pullbacks of 5% to 10% from a high, provided that the small downmove does not violate a recent prior low. If the market as a whole is moving sideways for some period, then a worthwhile buy candidate might be one that is just breaking out from a long basing period.

  For example, suppose that a stock has been trading between $20 and $25 for a year or so, with the market as a whole generally moving sideways. Now suppose that stock suddenly has managed to break above $25. Clearly, it’s suddenly doing better than the market, a positive sign. That’s the type of stock I like to buy, especially if it dips back a point or two.

  Finally, suppose the market has been bombed out, as it was by mid-1982, with the Dow all the way down to 777 from a peak in 1981 of well over 1000. When prices began to firm in mid-August that year, I began to buy aggressively. Hundreds of stocks had been making new lows, but I was not interested in anything appearing in that list. I wanted stocks that had been outperforming the market in recent months. Back in late September of 1981 the market temporarily bottomed after a 200-point drubbing in the summer. Many stocks made their lows then and rallied in the fall. When the general market slowly sank to lower lows in the spring and early summer of 1982, numerous stocks held well above their September 1981 lows. To me that was an excellent sign of relative strength for those issues, and I bought many of them in the summer of ’82.

  In some cases the stocks had fallen that summer, but they were falling at a slower rate than the market and had held above a prior low. That indicated the possibility that the worst of the selling was over and that strong buying was beginning to develop in those issues. In fact, many of the defensive-type stocks that were benefiting from the disinflation that had begun at that time were acting very well in late 1981 and early 1982, even as the major averages made new lows. Among such groups were department stores, food stocks, and utilities. Interestingly, in the three years following the major market low in 1982, these groups continued to be leaders, outperforming the broad averages during that stretch. Their early strength before the final mid-1982 bottom proved an excellent harbinger.

  Recognizing the relationship between trends and the industries that might benefit from them can lead to above-normal returns. That is what will happen from time to time if you do a lot of reading and thinking. In other words, a major economic trend might develop, such as inflation, disinflation, low interest rates, foreign competition, weak dollar, etc., which may lead to excellent long-term investment opportunities in certain industries. In the late 1970s when inflation was running wild, gold stocks, other precious metals, oil stocks, and forest products responded handsomely. Conversely, utilities, airlines, and automobile firms—oil consumers—were hurt.

  If you can latch on to a long-term economic trend, you can profit. Of course, too many people recognize a trend much too late, long after it has been discounted in Wall Street. Later in this chapter, when I go through several examples of stocks I picked in the past, I will demonstrate how one selection—the Dreyfus Corp.—was a play on my feeling that disinflation and the return of the individual investor to the financial markets were long-term trends from which that company would gain.

  Whether you are right or wrong about the long-term economic trend, it is important to reject picking any stock that violates your perception of the trend. For example, if you felt that the price of oil would continue to sink, it would be psychologically difficult for you to buy oil stocks, even if the outlook for an individual company looked favorable. In that case, you’d be better off ignoring the group, even if you miss out on a rising stock. That’s because if you purchase a stock greatly at odds with your own feelings, you’re going to be very uncomfortable with it, and you’ll probably sell it on the first tiny reaction, or be tempted to get out with a very small profit if it rises a bit. This would defeat the whole purpose in buying stocks, namely, looking for those that may make a big move and letting your profits ride—but cutting your losses short.

  Don’t buy stocks if you are going to be satisfied with 5% or 10% gains. It’s not worth the risk, nor is it worth losing any sleep in buying a stock. So you have to stick with those areas that make you more comfortable. From time to time I have totally rejected various industries because of my perception of long-run economic trends. Fortunately, back in late 1981 and early ’82 I began to believe in the disinflation theme very early in its process. For the most part, that kept me away from a lot of natural resource stocks and caused me to drift more and more toward defensive-type stocks.

  Even so, in August of 1982 I recommended several gold stocks, because I thought that gold was about to embark on a significant bear market rally, which indeed occurred. It’s normally a game I wouldn’t play, but I also hedged myself by buying numerous utility stocks at the time. Ironically, over the next couple of months, the gold group was the best performer in the entire stock market, while utilities were among the worst. Nonetheless, the combination of the two still beat the market. A few months later I sold the golds because I knew that they were a bet against the long-term trend.

  INSIDER TRADING

  The last major variable I use in picking stocks is the degree of insider trading. Insiders are officers and directors or very large stockholders of corporations. My philosophy
is that where there is smoke, there is a much greater chance of fire. If insiders are heavily selling stock, no matter what their alleged reasons, I generally take a dim view. It may not matter if one insider is selling stock because he needs some money to pay for his children’s tuition. But if seven or eight of them are doing the same thing, it just doesn’t have a good aroma. Conversely, if numerous insiders are buying stock at or about the same time, it’s usually an excellent sign.

  Several academicians have done studies on insider trading and all have found that stocks insiders buy heavily outperform the market. Years ago I wrote an article in Barron’s (June 21, 1976) that summarized the results of several of these academic studies. The results are shown in table 36, along with the returns I unearthed in my own study at that time. Those first four studies covered the period from 1958 to 1965. The first column after the date shows the market’s overall annualized return during the time frames of those various studies. The next column shows the performance of stocks in which there was heavy insider buying as defined by each of the various researchers. Next you’ll see the difference between the insider-buy stocks and the market’s return, which in each case was considerable. Finally, in the far right column you’ll see that the insider-buy stocks did anywhere from 1.67 times as well as the overall market up to 3.98 times as well.

  The brief results of my own studies are on the bottom line of the table, covering a twenty-two-month period from 1974 to 1976. In that span the overall market rose at an annualized rate of 15.3%. But stocks that had insider-buy signals returned just about three times that amount, gaining 45.8% per year. I define an insider-buy signal as a case when three or more insiders buy stock within the latest three-month period but when none sells. Conversely, I would define an insider-sell signal as a case when three or more insiders sell within the latest three months and none buys. I prefer unanimity for a signal.

  TABLE 36

  PERFORMANCE OF INSIDER BUY SIGNALS BASED ON VARIOUS STUDIES

  Annualized Rates of Return

  Study

  Dates

  Market

  Insider Buy Signals

  Difference vs. Market

  Insider Gain Compared With Market Gain

  Rogoff 1958 +29.7% +49.6% +19.9% 1.67X

  Glass 1961–65 +9.5% +21.2% +11.7% 2.23X

  Devere 1960–65 +6.1% +24.3% +18.2% 3.98X

  Jaffe 1962–65 +7.3% +14.7% +7.4% 2.01X

  Zweig

  1974–76

  +15.3%

  +45.8%

  +30.5%

  2.99X

  In my 1974 to 1976 study, 104 stocks gave insider-buy signals and I arbitrarily held each for the following six months. Sixty-two and a half percent of them did better than the market, and the cumulative overall gain for these stocks was 99.5%. During that span the Dow Industrials gained only 24.3% and my Zweig Unweighted Price Index was up 29.8%. Conversely, 275 stocks gave insider-sell signals during that time. Only 37.1% did better than the market. In other words, about five-eighths of the insider-buy-signal stocks beat the market, whereas only about three-eighths of the insider-sell-signal stocks did. Those 275 stocks with insider sells rose a meager 3.6% during the nearly two-year study period, grossly underperforming the market averages. A few academic studies in more recent years have confirmed the results of earlier studies.

  It can get even more interesting when one combines insiders’ trading with P/E ratios, particularly when heavy insider selling is coupled with very high P/E’s. Such signs would surely be indicative of stocks to avoid. In a much earlier Barron’s article (December 17, 1973) I first wrote about insider trading. I listed a table of twenty-three stocks to avoid. This is reproduced here as table 37.

  TABLE 37

  INSIDER SALES IN HIGH-P/E GLAMOUR STOCKS

  Stock

  No. of Insiders Selling During 1973

  P/E Ratio(11/30/73)

  American Home Products 5

  33x

  Automatic Data Processing 18

  36

  Avon Products 42

  35

  Becton, Dickenson 10

  26

  Burroughs 11

  40

  Coca-Cola 11

  36

  Disney Productions 17

  26

  First National City Corp. 5

  21

  Gannett Co. 6

  24

  Hewlett-Packard 10

  44

  IBM 10

  26

  Int’l Flavors & Fragrances 7

  55

  Kerr-McGee 14

  39

  McDonald’s 13

  41

  Merck 6

  36

  Minnesota Mining & Mfg. 13

  30

  Motorola 16

  19

  Penney, J.C. 14

  21

  Perkin-Elmer 10

  35

  Philip Morris 9

  20

  Procter & Gamble 8

  26

  Simplicity Pattern 6

  37

  Xerox 5

  34

  Total 266

  Average

  11.6

  32.2x

  Note: In all cases at least 3 insiders sold stock since July, while in no case did any insider buy stock during the past year.

  During the previous year, a total of 266 corporate insiders had sold these various stocks and not one single insider bought any. That worked out to an astounding 11.6 sellers on average per stock. Even more incredible, as fast as the insiders were selling these issues, institutional investors were buying them. They drove the price/earnings ratios on this group up to an average of 32. This is based on prices of late November 1973, which reflected a general market decline for most of that year. In other words, these twenty-three stocks had incredibly high P/E ratios even though they had already been drifting lower in price throughout the preceding months.

  All of these stocks were part of what was then known as the “nifty fifty” glamour stocks. This was a group of “growth” stocks that the institutions loved to the nth degree. Indeed, there was a greater fool theory in those days that these stocks were “one-decision stocks.” The only decision you ever had to make was to buy them. It was assumed that growth would continue ad infinitum and therefore these stocks could only go higher.

  This theory was as dumb as any going back to the one that prevailed in 1929 and was promulgated by Professor Irving Fisher. He advocated buying common stocks because company earnings would always go higher and therefore the stocks would go ever upward. That theory was blamed in part for causing the massive speculation in the late twenties that eventually led to the crash. Some people never learn.

  The stocks in the table, and a few dozen others, were driven to incredibly absurd P/E ratios. Imagine International Flavors & Fragrances at 55 times earnings, Burroughs at 40 times earnings, or Coca-Cola at 36 times earnings. Some of these stocks continued to exhibit earnings growth in the years that followed, but many of them couldn’t even stay on a growth track. Xerox and International Flavors were only two of the issues that soon became former growth stocks. The point, though, as stated earlier, is that when the P/E ratios get too high, the risk becomes unbearable. There is no room for disappointment.

  In the year that followed my article, 1974, the stock market as a whole caved in. It was the worst bear market in decades. That alone chilled the speculative enthusiasm for high-P/E stocks. Then, too, there were many earnings disappointments in this group. Even to this day I still can’t imagine how institutional investors were willing to pay 32 times or more for the earnings of these stocks when the insiders were simultaneously bailing out en masse.

  One year after I listed the stocks in Barron’s the Dow had fallen by 27%. However, the twenty-three stocks with multiple insider sales and extraordinary P/E ratios plunged some 41.5% on average, or 14.5 percentage points worse than the Dow Industrials.

  In sum, it’s just as important—perhaps even more
important—to screen out the negatives as it is to screen for the positives. If you could just eliminate, say, the worst 10% of all stocks and choose even randomly from the rest, you would beat the market. A good defense will actually serve to help your offense.

  If you want to continue that analogy with football, imagine a team with an excellent defense and just an average offense playing a team that is average in both areas. It’s probable that the strong defensive team would score more points than usual, for the simple reason that it would keep turning the ball over to its offense in better field position. In addition, the defense, by preventing the other team from scoring frequently, would make it easier for the offensive squad to run their best plays rather than forcing them into catch-up-type offense. So, good defense will help an offense in football. It’s the same in the stock market. Just by avoiding the losers, or at least a good chunk of the biggest disasters, it will help you increase your rate of return vis-à-vis the market.

  So, as the studies show, you’ve got about a five-to-three edge by following the insiders. The question then is, where do you get insider trading data? Corporate insiders are required to file their trades with the appropriate stock exchange and with the SEC. The government then publishes a monthly report on insider transactions, but there are much faster ways to get these same data. Vickers Stock Research (226 New York Avenue, Huntington, New York 11743; 516-423-7710) is a service that monitors the insider trading by sending representatives directly to the exchanges to examine the filings as soon as they occur. Each week Vickers publishes a list of all significant insider trades.

  Using computer screens for both positive and negative factors for approximately 3,000 stocks, my previously mentioned Zweig Performance Ratings Report siphons through much of the same data that I have described in this chapter. By using the computer, we can cull through an enormous amount of data in a mechanical fashion, screening for earnings and sales growth, stability of earnings, price-earnings ratios, the relative price action of the stock, and a few other variables that are outside the scope of this book. Even though I have the computer ratings at my fingertips, I still think it worthwhile to start the stock-picking procedure by going through the daily earnings reports as I’ve shown here. It’s somewhat more laborious but worth the effort.