Martin Zweig Winning on Wall Street

by Martin Zweig

  I have been doing the computer ratings for about twenty years, following the same methodology during that span. My associate, David Katzen, now does the computer programming. I want to show the results of that procedure, not to motivate you to use a computer, but rather to demonstrate that by applying the same approach by hand, you can produce superior results. The computer rates stocks on a scale from 1, the best, to 9, the worst. There is not an equal number of stocks in each group. Rather, only the top 5% of all stocks rated are in the No. 1 group. The next 8% are rated 2s, the following 12% are given 3s, and the next 15% are 4s. The middle 20% of all stocks get a neutral rating of 5; then 15% are rated 6, and 12% are rated 7. The next-to-worst 8% of all stocks get an 8 rating, and the bottom 5% of the universe are rated a lowly 9.

  Table 38 shows the results for the 239-month period since I first began to do these ratings in May 1976. Stocks are rated monthly, so this methodology assumes (perhaps unrealistically) that you would switch your portfolio each month so as to stay only in stocks rated 1, 2, etc. Obviously, if you did that in the real world you would encounter transactions costs that would tend to get significant. A more realistic approach would be to buy the stocks rated 1, 2, or 3 and hold them either for an arbitrary six months or until they fall to below rank 5. The results won’t be as good as shown here, but they would still outperform the market and would hold down transaction costs.

  TABLE 38

  RESULTS OF ZWEIG PERFORMANCE RATINGS: MAY 1976 TO MAY 1996

  Performance-Ratings Group

  % of Stocks in Group

  % Return in 239 Months

  1 (best) 5

  +10432.1%

  2 8

  +6313.4%

  3 12

  +2486.5%

  4 15

  +1976.7%

  5 (average) 20

  +1099.5%

  6 15

  +682.3%

  7 12

  +415.2%

  8 8

  +225.6%

  9 (worst) 5

  +39.4%

  All Stocks:

  +1156.5%

  Source: The Zweig Performance Ratings Report, P.O. Box 360. Belmore, NY 11710

  Note that the top-rated group appreciated a cumulative 10432.1% in just 20 years. That’s more than nine times the average appreciation of all stocks monitored, which was 1156.5%. Conversely, had you held a portfolio only on stocks rated 9 that entire time, you would have made only 39.4%, a dismal return compared to the achievement of all stocks, and an amount that would have had a hard time even keeping up with inflation over that span. Note that the returns of each group are in exactly the order projected. That is, group 1 did the best, group 2 did next to best, and so on right down to group 9, which came in in last place. Remember, these results were achieved by using a method very similar to the one I have outlined here. The only major difference is that this was done strictly with a computer rather than by hand, plus some thinking on the part of the investor.

  CHAPTER 12

  My Own Stock Selections—Why It’s Sometimes Right to Sell “Too Soon”

  Real-life examples are probably the best way to familiarize you with precisely how my stock-picking method works. So let’s look at the case histories of five representative stocks I’ve recommended in The Zweig Forecast. Again, these illustrations are from the previous edition of this book, but they still reflect my stock selection procedures.

  DURR-FILLAUER MEDICAL

  Durr-Fillauer is a Montgomery, Alabama-based distributor of medical, surgical, hospital, and laboratory supplies in the southeastern part of the United States. I first recommended the stock in my advisory service on May 19, 1980, at a price of 7½ adjusted for subsequent stock splits. I liked the company’s stable business and excellent long-term growth rate, but, most of all, it looked dirt cheap at a P/E of only 8. That spring I was also in the process of turning more and more bullish on the market. By the end of May 1980 I had become fully invested in my advisory newsletter for the first time in several years.

  My judgment on the stock proved correct, and in mid-1981 I sold Durr-Fillauer in pieces, netting 115% profit on half the position in July 1981 and 95% on the other half in September 1981, for a net gain of 105% at the average selling price of 15%. By contrast, the Dow Industrials had gained less than 8% over that span. This is only a forerunner of the buying example I’ll describe in more detail, which took place in mid-1982, the second time I bought Durr-Fillauer.

  Obviously, because of my good experience on the first purchase, I had a warm spot in my heart for the stock. I kept my eye closely on it as the price dropped by roughly 40% in the bear market of 1981, after I had gotten out of the position. By the summer of 1982 I was ready to do some buying in general, and since Durr-Fillauer’s business-and-profit patterns were the types I prefer, I reexamined the stock. I decided to buy it on July 12, 1982, at a price of 8¼, again adjusted for subsequent stock splits. At that point the most recent quarter reported was its first, or March, quarter of 1982, in which earnings had risen 27% while sales were up 36%. Those were not only solid gains, but they were well above the longer-run growth rate for the previous 5¼ years, which showed sales and earnings per share up an annualized 17% over that span. The earnings had risen every year since 1974.

  Even at its somewhat depressed price—the stock was still off close to 20% from its previous high—the P/E was 13. That was quite a bit above the 8 level at which I had purchased the stock a couple of years earlier, but it still seemed reasonable in the 1982 market environment. Moreover, I knew that the June quarterly report would be released within days, and I was expecting a decent gain. In fact, when that report appeared, earnings had jumped 38% for the quarter on a 41% increase in sales. That brought the twelve-month total earnings to 70¢a share, for a P/E ratio of 12 on my $8.25 purchase price. A further check showed no insider activity in Durr-Fillauer in the previous six months.

  So, I had found a stock with solid and stable growth, a reasonable P/E, and no insider negatives. Since I was beginning to like the overall stock market, the only remaining question was the price action of the stock itself. Durr-Fillauer had bottomed at around the area in the 1981 bear market, down from a high of almost 10 (again, these prices are adjusted for the subsequent split in 1982).

  In the summer of 1981 the Dow Industrials had dropped about 200 points, temporarily bottoming in late September at 824. After a rally in the fall, the market as a whole drifted down in the first half of 1982, making newer lows. The Dow was flirting with the 800 level in July and would eventually bottom in August at 777. But Durr-Fillauer, at 8¼, was more than 30% above its fall 1981 low. The stock was acting much better than the market as a whole. I decided to recommend it.

  A month later the stock market bottomed and Durr-Fillauer began to rise. I held the stock throughout the 1982-83 bull advance, during which Durr-Fillauer rose to more than $20 a share. I kept raising my trailing stop (a method described in chapter 13). I probably should have tightened the stop more than I did, but since I liked the company so much, and because I had done so well in my original purchase, I tried to give it all the room possible. Finally, in August 1983 the stock fell back to 15 and it was stopped out for an 81.8% long-term capital gain. During that thirteen- month holding period the Dow Industrials had gained 44.7%, not much over one-half the gain experienced by Durr-Fillauer.

  At the time Durr-Fillauer was sold the P/E ratio was up to 20, and it had actually been above that figure when the stock was at its highs. It had become overvalued, but I tried to hold on as long as I could because the stock market’s overall momentum was still positive. But in the summer of ’83 the market as a whole began to waver a bit and higher P/E stocks started to give back some of their gains, which led to the sale of Durr-Fillauer.

  CACI, INC.

  On the same day in July 1982 that I recommended Durr-Fillauer, I also recommended CACI, Inc. CACI provides analytical and computer software techniques to solve managerial and operational problems, primarily for the g
overnment. I had had the stock on my potential-purchase list for several months, having spotted CACI’s fourth-quarter 1981 earnings report in which net had increased by 135%. In the latest available quarter before my purchase, first quarter 1981, earnings were 98¢ a share versus 45¢ a year earlier, an 118% increase on a sales gain of 71 %. That extremely rapid growth was even faster than in a five-year stretch in which annualized earnings increases were a hefty 64%.

  Once again I had found a stock where earnings had grown steadily—in this case even spectacularly—and where the recent quarter found growth accelerating above that of the longer-term trend. Once more, I was expecting another good earnings report within a few days after I had picked the stock, and such proved to be the case. Net for the second quarter of 1982 was $1.67 versus 95¢ the previous year, a jump of 76% with sales rising 53%. That was still above the long-term growth rate and brought the previous twelve-month earnings total to $4.26.

  Incredibly, CACI’s price at the time I purchased it was only 41 1/8; (prior to two 3-for-l splits in the coming year or so). Thus, the P/E ratio was a very moderate 10 despite the enormous growth in earnings. I could find no meaningful insider activity at that time, so once more the final question was that of price action. Here, if anything, the price action was splendid. From its 1981 low, CACI had roughly tripled by this point even though the P/E was still modest. The stock market was drifting lower and CACI was advancing strongly. The only stumbling block to purchase was having the guts to buy a stock that had roughly tripled in the previous year. Many investors refuse to pay up for such stocks, but I actually prefer doing it as long as the earnings growth is there and the P/E is reasonable. It proved to be a good choice.

  By September 30 CACI had surged to 61¼ and I decided to take partial profits by selling half the stock for a 46.3% gain. In that span the Dow Industrials had risen by only 8.6%. In retrospect, selling was a mistake, but at the time I wanted to lighten some positions to use the money elsewhere. I also wanted to sell off just enough so that what was left would not be such a temptation to sell. I was determined to let the profits ride on the rest.

  The stock then split 3-for-l, reducing my effective original purchase price to $13.96. The new stock moved up spectacularly, and on December 15, 1982, I sold the remaining holdings at $42 on the new stock, equivalent to $126 on the original purchase price only six months earlier. This netted a profit of 200.9% versus an increase of only 20.3%on the Dow.

  Once again, in retrospect, I had sold too soon. But the P/E ratio was already up to 24, and I had a few second thoughts on the market as a whole for the short run (there was a small dip before the market took off again in January). The stock I had sold at 42 reached 78 by mid-1983, although, adjusted for a second 3-for-l split, the final high was about 26. Earnings then went downhill rapidly, and the postsplit CACI stock plunged all the way to $2 a share in 1984. That was the equivalent of $6 on the stock that I had sold “too soon” at $42. I’d like to make a “mistake” like that anytime.

  EMULEX CORP.

  The bear market bottomed on Thursday, August 12, 1982, at 777 on the Dow. On Friday, August 13, the Dow was up about 11 points in quiet trading, but the advance did not look impressive. That night the Federal Reserve cut the discount rate for the third time in about five weeks, a bullish move, as we’ve already seen. However, the market had rallied only for a day or so on the previous two cuts and each time had fallen to lower lows. On Monday, August 16, the Dow was up about 11 points in the morning but then reversed and drifted back to close with only a 4-point gain. The action was not that impressive, and it looked as if for the third time in a row that the market would fail to respond for more than a few hours to a discount-rate cut.

  However, most of the signs were in place for a bull market. Monetary conditions were bullish, and the Monetary Model we constructed in an earlier chapter was in a maximum bullish position. Sentiment indicators were in truly excellent shape because pessimism was extreme at that point. The only missing link was tape action.

  Suddenly, everything turned around. On Tuesday morning, August 17, Henry Kaufman, chief economist of Salomon Brothers, forecast that interest rates would fall. No matter that Kaufman had been wrong for months on end, having expected rates to go higher. Wall Street chose to accept this latest prediction. Interest rates had already collapsed about five full percentage points in a handful of weeks, yet investors still weren’t convinced that the trend was downward. Kaufman’s change of stance was the catalyst to getting Wall Street in general to change its mind about the direction of rates, and that gave folks the courage to buy stocks.

  The market put on one of its greatest all-time shows on that day, with the Dow zooming some 38 points and up-to-down volume jumping to a record 42 to 1 ratio. That one day’s action was enough to convince me that the tape—the missing link—had turned convincingly upward. That evening on my telephone hotline, which is part of my Zweig Forecast service, I moved aggressively to buy stocks, including the golds and utilities I mentioned earlier. There was also a growth stock that I recommended that night, Emulex Corp. It was purchased at the next day’s average price of $15 (later adjusted to $7.50 for a 2-for-l split in early 1983).

  Emulex designs and manufactures peripheral products for mini and micro computers. Its second-quarter report, out shortly before I recommended the stock, showed earnings up 50%for the quarter, with sales soaring 95%. The prior quarter had also seen a 50% jump in earnings. Emulex had gone public just a year or so earlier and had a brief financial record going back only two years. However, in that span earnings had grown at a 48% annualized rate. True, the firm did not have a long-run track record, but that’s often the story with high-tech stocks.

  High-tech stocks are riskier than most because competitive conditions change rapidly and today’s growth stock can become tomorrow’s bankruptcy case. But when it’s all systems go for the stock market—and I’ve rarely seen better overall market conditions than in August of 1982—it’s worth getting more aggressive with stock purchases. The fact that Emulex had only a brief corporate life was merely a minor flaw in an otherwise excellent opportunity.

  When I recommended it for The Zweig Forecast, Emulex’s twelve-month earnings were 96¢(on the basis of shares outstanding prior to two 2-for-l splits over the next couple of years—which actually made my effective purchase price $3.75 in terms of graph S). At the then price of $15 per share on the original stock, Emulex carried a P/E of 16, a higher P/E than the general market. But for a company growing at roughly 50% in a very bullish stock market environment, it seemed that there was considerable room for earnings to keep growing and for the P/E to expand further. Once again, I detected no significant insider trading in the stock.

  As for price action, Emulex had bottomed in the fall of 1981 at 8½. It rallied a bit at year’s end, then fell in the spring of 1982 to the same 8½ figure, holding steady at the previous year’s low. By the summer, when the Dow and the other major averages were making new lows, Emulex was rising. It had nearly doubled from its low when I bought it, although the overall market was only a few percentage points above its own lows. Obviously, the relative tape action of Emulex was excellent.

  By mid-November, three months later, Emulex had more than doubled. I sold half the position at 33 5/8, nabbing a 124.2% profit, during which time the Dow had gained only 23.1%, Once again, my strategy was to sell down to the point where I was comfortable in holding the rest.than doubled. I sold half the position at 33 5/8, nabbing a 124.2% profit, during which time the Dow had gained only 23.1%, Once again, my strategy was to sell down to the point where I was comfortable in holding the rest.than doubled. I sold half the position at 33 5/8, nabbing a 124.2% profit, during which time the Dow had gained only 23.1%, Once again, my strategy was to sell down to the point where I was comfortable in holding the rest.than doubled. I sold half the position at 33 5/8, nabbing a 124.2% profit, during which time the Dow had gained only 23.1%, Once again, my strategy was to sell down to the point where I was co
mfortable in holding the rest.

  Reprinted Courtesy of Long Term Values, P.O. Box 24933, Los Angeles. CA 90024

  If you hold too much of a position, you ’re apt to worry about it excessively and often wind up selling it too soon. By taking partial profits, I found it a heck of a lot more comfortable to keep holding the stock. Remember that the market then was very volatile and a stock like Emulex was bouncing around quite a bit, and I didn’t need to be forced to sell out on a small dip. However, I needed the gumption to sit with it for the major move, and, by selling a piece of my position, I was able to do that. Then too, Emulex’s P/E ratio had already doubled to more than 31, which was not exactly prudent nor for the faint of heart.

  Nonetheless, in bull markets, when such a stock gets a head of steam, it can climb to prices that are ridiculously overvalued. I wouldn’t risk an entire stake on such a selection, but I had already had a double or more in it. Having then sold half, I had taken out all of the original investment plus some, and was therefore in position to ride a hot stock, even though it was overvalued. I maintained additional protection through the use of trailing stops, which will be described in the next chapter.