Martin Zweig Winning on Wall Street

by Martin Zweig

  Early in 1983 Emulex split 2-for-l, so my adjusted purchase price became 7½ . It didn’t take long before the split stock was right back to where the presplit stock had been, above $30 a share. On April 4, 1983, I had had enough and sold the split stock at 33¼(equivalent to 16 5/8; on the chart because of still another split later). That sale netted a whopping 343.3% gain in eight months, during which span the Dow Industrials had risen only 35.9%. At the time of the sale, Emulex’s P/E was up to an absurd 43. Even in a rip-roaring bull market, that was more than I could tolerate.

  Once again, I had sold “too soon.” Within three months after I had sold it, Emulex climbed to its all-time high of 27¾, equal to 55½ on the presplit shares I had sold at 33¼. However, by the spring of 1984 Emulex had dipped back to below my sales point. Then, in the second half of 1984, the stock collapsed, dropping to below 7 dollars before a sharp rally in early 1985. Later, in ’85, Emulex slipped to another new low at 5¾, down more than 65% from my sales price two years earlier. Thus, as in the case of CACI, I wound up having been right in letting the other guy grab the last few points. Unless he sold soon thereafter, that other guy was left holding the bag.

  DREYFUS

  I have given you four trades involving three stocks, all of which made a lot of money. But I’m not always right. On July 21, 1983, I recommended the Dreyfus Corp., the big money management firm that runs billions of dollars of mutual funds. For the previous eight consecutive years Dreyfus’s earnings had risen. In the latest available quarter, that ending March 31, 1983, Dreyfus had reported a net of 89¢ versus 65¢, a nice gain of 37%. Sales had also been rising in commensurate fashion. Total earnings for the prior twelve months were $6.98. The purchase price for Dreyfus was 68¼, so the P/E ratio was a very reasonable 10, clearly in line with the market’s at that time. Yet, Dreyfus had shown superior long-term growth.

  However, I made two mistakes in picking Dreyfus at that point—plus I ran into a buzz saw. First, Dreyfus had had three insider sellers in the previous three months. It wasn’t a lot, but it was enough to flash a warning sign. My second mistake had nothing to do with Dreyfus. Rather, the market’s overall action was starting to get choppy and over the next several months would prove to be no better than flat for most of the blue chips and down for most of the smaller secondary stocks. The third problem was that a few days after I recommended its purchase, Dreyfus reported its second-quarter earnings of only 70¢ versus 75¢ a year ago. I obviously had not expected that drop, and I don’t think Wall Street had either. The stock immediately fell several points, and I was stopped out at 61½ for a modest 9.9% loss. In that time the Dow had lost 2.4%.

  Despite that bad quarter and three more weaker comparisons that followed, I continued to like Dreyfus. The company’s business consists of managing short-term money market funds and longer-term stock and bond funds. I felt that the disinflation, which had begun in 1981 and was well entrenched by 1984, would make financial assets, such as stocks and bonds, the best available long-run investments, far better than real estate, gold, oil, or collectibles, which had been the kings during the late 1970s when inflation ran sky-high. Dreyfus controlled billions of dollars of assets that I felt would appreciate in the long run, plus the kicker that the public would pour in additional assets for Dreyfus to manage as disinflation continued to reign.

  In the September quarter of 1984, Dreyfus’s earnings got back on track with a net of 85¢ versus 70¢ the prior year, a 21 % increase and the first quarterly gain in five attempts. In the fall of 1984 interest rates were starting to come down, and I felt that would increase the profitability of Dreyfus’s stock and bond holdings. In addition, changes in pension laws had created individual retirement accounts (IRAs) a vast pool of cash flow in which Dreyfus was gaining a goodly market share. I thought this would help increase long-run results for the firm.

  Encouraged by the third-quarter 1984 report on Dreyfus, and much more sanguine about the outlook for the market as a whole, on November 2, 1984, I once again recommended Dreyfus for purchase, at a price of 37 3/8;. The stock had been split in late 1983 after my first trade, so that its newest recommended price was actually above my previous purchase in 1983, the one that had lost more than 9%. Thus, I had made a mistake once in Dreyfus, and yet here I was coming back in to buy it again at even a slightly higher price. The market, though, little knew nor cared that more than a year earlier I had made a poor trade in stock. All that mattered now were current conditions. Unlike the previous year, market action was considerably better and Dreyfus did not have any meaningful number of insider trades. Moreover, I felt that future quarters would compare very favorably with the more-or-less depressed net results of late 1983 and early 1984.

  At my purchase point in November 1984 (by the way, just as the Fed had cut the discount rate), Dreyfus had shown earnings of $3.15 for the prior twelve months. Its P/E ratio was a reasonable 12, especially since earnings were slightly depressed, having declined 7% in 1983, the first such dip in nine years. One small break in the growth rate is clearly forgivable when the company is beginning to show signs of getting back on track—and especially when the outlook for its industry is improving and the P/E remains modest.

  Price action for Dreyfus was no problem at that time as the stock was already at its highest price of the year, clearly way outperforming the market as a whole. In mid-1985 the stock was up to about 68, a new high, or some 82% ahead of its purchase price. I had also raised my protective stop several times, so that by now I was guaranteed a nice profit even if the stock began to retreat. I sold the stock in January 1986 at 85. The stop was last raised to 67½ and the profit was 127%.

  MIDLANTIC BANKS

  The last example is one of buying a stock that looked extremely cheap. For several years the entire banking group sold at very low P/E ratios, primarily because some of the larger international banks had dubious foreign loans on their books. The middle-sized and smaller regional banks had few such loans and were not vulnerable to them, but they suffered by association anyhow. Also, some of these regional banks had their own problems, particularly in the Southwest, where many banks had loaned heavily to the oil industry, which was coming upon hard times. But in other areas of the country, particularly in the East and Southeast, there were numerous regional banks with excellent earnings trends, small risks of bad loans, and very low P/E ratios. One such example was Midlantic Banks, which I recommended for purchase in The Zweig Forecast on August 10, 1984, at 24¼.

  On a fully diluted basis (earnings that allow for conversion into stock of all warrants, convertibles, and any outstanding options), Midlantic had reported net for the second quarter of 1984 of 99¢ versus 83¢ a year earlier, a 19% gain. Sales, by the way, are not reported for bank stocks. For the prior four quarters, Midlantic had shown earnings of $3.72, so its P/E was only 6½ Looking backward, I saw Midlantic had shown earnings increases every single year beginning in 1975, when net was 76¢ a share. Thus, in the previous 8½ years, Midlantic’s earnings had grown at a very laudable 20% per year. Had Midlantic been a high-tech stock, its P/E ratio would have been three or four times as great, given that long-run 20% growth rate. Because it was a bank, it was generally ignored.

  Over the couple of dozen years in which I’ve been in the stock market, I’ve seen virtually every industry at one time or another have its day in the sun. Back in the late fifties and early sixties, the glamour groups included steels, aluminums, chemicals, and public utilities. Can you imagine those stocks today selling at 20 to 30 times earnings? Well, they did back then. I’ve seen the bowling stocks run wild, mobile homes do the same, and other groups move into the glamour category, such as gambling, gold, restaurants, and aerospace stocks. Each group eventually had its bubble pierced and came back to earth.

  In most cases, long before these groups had their big runs, they were regarded as wallflowers. In other words, today’s wallflowers have a chance of becoming tomorrow’s glamour stocks, no matter how farfetched it may seem. My point is that it doesn
’t matter whether Midlantic is in the banking business or something else. What does matter is that it was able to achieve a 20% annualized growth rate for the better part of the decade, with no down years and with only moderate business risk. When I can buy a stock like that at 6½ times earnings in a fairly decent overall stock market environment, it seems like a very good bet.

  At the purchase time Midlantic had had one insider buy stock in the previous three months, with no one selling. That, at the least, was not a negative. As for price action, Midlantic had made a new all-time high, above 24, in early 1984 and then had sold down to 21 and change at midyear. As the market improved that summer, Midlantic moved up to challenge that all-time high when the market as a whole was still below its own former peak. The stock was acting well on both a relative and an absolute basis.

  Shortly after I recommended it, Midlantic broke out to another all-time high, above the 26 area. It then consolidated for a couple of months and then ran up above 29 by year’s end 1984.

  Midlantic kept moving higher and reached 39½ in mid-1985, showing a profit of 63%, while the Dow had risen only 7% in that same time frame. In the interim I had raised the protective stop several times to lock in a very nice profit if the price began to slide. I sold Midlantic in December 1986 when it was stopped at 41¼ for a 70% profit.

  Setting and using stops is an integral part of my market strategy—and you’ll find complete details on this risk-limiting method in the following chapter.

  CHAPTER 13

  Stop! How to Manage Your Investments to Minimize Risks and Maximize Profits

  As I said before, I’m proud of my record in the stock market. Since the Hulbert Financial Digest began to rate most of the investment advisory services in mid-1980,1 have not had a down year—and only one other stock advisory out of the one hundred and forty-five now rated can make the same claim. But I also make my share of mistakes, and it’s certain that I’ll make more mistakes in the future.

  Suppose I make a wrong call on the market as a whole. Or, at the least, let’s say out of the dozens of stocks I recommend, some of them head south. What then? The ver is simple: I use stop points on every single recommendation I make.

  WHAT IS A STOP?

  A stop order can be placed directly with a specialist of the New York Stock Exchange through your broker. It tells the specialist to sell your stock “at the market” the moment it hits your stop point, or “trigger price.” On over-the-counter stocks, where there is no specialist, you cannot use a stop as such. The same is true on the AMEX, where the stop rules are a bit different and, in my opinion, normally not workable. So, for OTC and AMEX stocks, I suggest using a “mental stop.” This means that you or your broker will have to follow the stock in question and, when it hits your mental stop, the broker will have to sell it right away.

  Getting back to the NYSE, the stop is automatically triggered when the stock falls to your stop point. You don’t have a chance to second-guess yourself, cancel the stop, and then ride the price down because you have gotten stubborn—an often-fatal error. There are some people who don’t want the specialist to see their stop order on the assumption that he will let the price slide just enough to trip their stop. That has not been my experience. I don’t blame the specialist when my stop is hit, only to see the stock rebound. If you have the discipline to follow through with a mental stop, then go ahead and use it. But in most cases, at least for issues on the NYSE, you would be better off giving your stop to the broker. But whatever you do, don’t back out of your original plan when prices fall. If so, the whole idea of the stop is ruined.

  You’ll recall my earlier reference to Jesse Livermore, sometimes regarded as the greatest speculator ever. His words of more than sixty years ago say it all: “A loss never bothers me after I take it. I forget it overnight. But being wrong—not taking the loss—that is what does damage to the pocketbook and to the soul. Of all the speculative blunders there are few greater than trying to average a losing game. Always sell what shows you a loss and keep what shows you a profit.”

  The purpose of a stop is to stay consistent with Jesse Liver-more’s rules—to let your profits run but to cut your losses short. If you buy a stock at 20 you won’t be too badly hurt if you stop yourself out at 17 for a 15% loss. You’ll still have the bulk of your capital left. A 20% drop is about as much as I would be willing to take, because that needs a rebound of 25% to hit the break-even point. That is, if a stock drops from 20 to 16, it’s down 20%. On a return trip from 16 back to 20, it works out to a 25% increase. That’s not necessarily so difficult to achieve.

  However, if a stock is slammed for a 50% loss, say from 20 down to 10, you’ll need a double to break even. Or, if you allow the situation to get totally out of hand, and you ride a stock down 90% from 20 to 2, you’ll need a tenfold increase, or a gain of 900%, before you can get your money back. Such gains are hard to come by. So, it is sheer folly to let losses run wild. Remember: Your first loss is your best loss!

  Generally I set my stops 10% to 20% below my purchase price. The exact level depends on my own analysis of the stock’s trading pattern and the “feel” I’ve gained from two dozen years of experience in the market. Usually, I will give more room to more volatile stocks, such as high-tech issues, and less room to more conservative stocks, such as utilities. A 10% margin is generally too little for an extremely volatile stock. It’s no big deal for a $30 high-tech stock to drop quickly to $27 on a normal correction and then turn and go back up again. A stodgier utility stock, though, doesn’t usually do that unless it’s about to reverse its major course.

  Chart Courtesy of Trendline, a division of Standard & Poor’s Corporation

  I often try to set a stop point just below a previous low that a stock has made recently. Or perhaps I’ll draw a trendline on a chart and set my stop just below the upward-sloping trendline, on the assumption that if that uptrend were to break, it might lead to a downward reversal in the price. Admittedly, setting stops is an art and not a science. Sometimes I wind up getting stopped right at the bottom eighth on a correction and wishing mightily that I had given myself a bit more room. But other times I’m stopped out as a stock is breaking down from a trading range and, after I take my reasonable loss, I watch as a bystander while the stock plummets.

  Graph T (p. 237), on MCI, shows how unlucky one can get at times using stops. I had recommended MCI in late July 1982, just three weeks before the brand-new bull market boomed. My recommended price was 42 7/8 and I set a fairly tight stop at 39 7/8. I should have given myself a bit more room. As you can see on the graph, MCI backed off for a few weeks, hitting $9, which was made after a couple of 2-for-l splits. That price was equal to $36 back in 1982. In other words, I was stopped out of MCI in two weeks for a 3-point loss, and the stock backed down about another 4 points. It then turned around and soared to more than $28 on the split stock, which was equal to over 112 on the shares that I had recommended at 42 7/8.

  What went wrong? Well, my timing on the market was pretty good, since my recommendation was made just a couple of weeks before the August 1982 bottom. And my stock selection was excellent; MCI nearly tripled over the next several months. But I ran into a bad combination of a short-term decline and a stop that was a bit too tight. Consequently, I was taken out just before its spectacular surge. Had I set the stop 17% below my purchase price, I would have enjoyed a very profitable run. However, at that time I felt that would give the stock too much room because I was not so certain about the market’s direction.

  I could easily find more MCIs among the hundreds of recommendations I have made in the past. However, I can find far more cases where my stops greatly protected my subscribers. For example, when the bull market began to explode in mid-August 1982, I recommended the gold stock ASA at 32¾ (see graph U). Two months later I recommended the sale of ASA at 51½ nabbing a healthy 57.3% profit. In July 1983, near the top of the market, I decided to recommend ASA once again (unwisely going against the disinflation trend described
earlier). By this time the stock was 70 5/8, and I placed a stop at 64¾. In September 1983, less than two months after I recommended it, ASA hit its stop and I was taken out for an 8.3% loss. By November ASA had nose-dived to 50. Later, after a rally, it worked its way irregularly downward, reaching the 44–45 area several times from 1984 to 1985. Finally, in mid-1985, ASA plunged to 35. Clearly the sale at 64¾ prevented much greater damage.

  In September 1983 I recommended an electronics firm, Sanders Associates, at 55 5/8 (see graph V, p. 240). Sanders quickly moved up to over 60, and I raised my original stop a couple of points to 53½ (more about trailing stops later). Sanders quickly reversed and fell through my stop point, generating a small 4.3% loss. By March 1984 Sanders had fallen to $35, some 35% below my stop point. Even on a good rally in 1984, Sanders failed to reach my stop level. From there it was downhill again to $31 in early 1985. Clearly the stop proved useful in this case.

  Chart Courtesy of Trendlirte, a division of Standard & Poor’s Corporation

  Chart Courtesy of Trendline, a division of Standard & Poor’s Corporation

  In November 1983 I recommended the purchase of an OTC company called St. Jude Medical at 17 5/8 (see graph W). I placed a stop at 14 7/8. St. Jude managed a weak rally to a bit over 19 and then fell apart, triggering my stop in February 1984 for a 15.6% loss. By early 1985 the stock was below 7½, down 50% from my stop point. Had I held it that long, 1 would have needed a double to break even.