Martin Zweig Winning on Wall Street

by Martin Zweig

What about trading on margin? Do you recommend it for the average investor?

  First, I’d like to explain precisely what margin is. Margin is the difference between the equity in the brokerage account and the market value of the stocks. The difference is what you borrow “on margin.” Brokers are only too happy to provide it. For example, if you have $25,000 in equity, you could put it into a margin account and, under current regulations, borrow 2-for-1. That is, you could have $50,000 worth of buying power. You would have to pay interest on whatever sum you borrowed above your $25,000 equity. The interest rate is always higher than the prime rate.

  Brokers can borrow money using your stock as collateral. They borrow at what’s called the broker loan rate, which is a little less than the prime rate. It’s a great loan for the banks because of the collateral involved. Brokers typically will add on several percentage points. If you are just a so-so customer, they may add 2 to 3 percentage points. If you’re a great customer, you may get a smaller spread. In any event, you’re paying a pretty high interest rate, which is charged to your account. Brokers do very well on margin business. In fact, many retail brokerage houses make more on interest than they do on commissions. That’s why brokers love margin accounts, but they may not be right for you.

  If you have $25,000, you probably shouldn’t buy more than $25,000 worth of stock, if that. The average guy comes in, uses margin, and suddenly has $50,000 buying power. He’s all set to hit the home run but he has no staying power. If the market dips for a few days, he worries he’s going to go broke and gets out. While he’s in, the interest keeps adding up. The interest isn’t exactly chopped liver. At current rates, you’re talking about double-digit figures. You’re paying, say 1% a month to carry the stock, which really cuts into your profits. You are extended and leveraged and tempted to take small profits, rather than letting profits run.

  Also, if you use margin, you tend to buy too much of a stock. Let me give you an example. Back in 1966, when I was trading for myself, I did a lot of research and decided I really liked Sperry Rand. I thought the stock was relatively cheap and would do very well. Believing that the more I bought, the more money I’d make, I went totally on margin. I had $20,000 in equity, borrowed another $20,000 and bought two thousand shares at $20 a share. I was right on the stock but, with almost all my money in this one stock, had almost no staying power. Within a short time, I got out of the stock, breaking even. Afterward, Sperry did pretty much what I thought it would do. The stock went up to about $70 a share in the next couple of years. Had I stayed with it, I would have made 50 points and earned $100,000 on my equity of only $20,000. But that’s only a fantasy.

  First of all, I would never have sold at the exact top. Secondly, I obviously overowned the stock. I owned so much of it that I couldn’t stand the pressure. I would have been better off buying at most five hundred shares. With more staying power, I would have captured some of that 50-point gain. I always think back to Sperry Rand when I think about margin. I just don’t feel good about using it.

  CHAPTER 16

  Concluding Words to the Intelligent Investor

  “People don’t seem to grasp easily the fundamentals of stock trading. I have often said that to buy into a rising market is the most comfortable way of buying stock.… Remember that stocks are never too high for you to begin buying or too low to begin selling. But after the initial transaction, don’t make the second unless the first shows you a profit.”

  The above words of wisdom, with which I agree completely, came from Jesse Livermore, one of my heroes in stock market lore, whom I have mentioned earlier. He was a big speculator during the first third of this century and was immortalized, so to speak, in a book called Reminiscences of a Stock Operator by Edwin Lefevre, first published in 1923 and reprinted some forty years later. I strongly suggest you read it.

  It’s remarkable how pertinent Livermore’s views are to today’s market. Here’s what he says about the importance of momentum and following the tape:

  “They say you never grow poor taking profits. No you don’t. But neither do you grow rich taking a four-point spread in a bull market.”

  In other words, as I’ve emphasized throughout this book, the idea is to let your profits run and to cut your losses. Too many people are apt to redeem their profits too quickly. In a huge bull market they wind up with piddling profits, only to watch their former holdings soar. That usually prompts them into making mistakes later when, believing the market owes them some money, they buy at the wrong time at much higher levels.

  To avoid these mistakes, use my timing models—Monetary, Four Percent, and the Super Model. They do a good job in identifying bullish and bearish trends in general. Obviously, you should do the bulk of your buying when the timing models, especially our Super Model, turn bullish

  Buying on declines can lead to big trouble. Of course, there are declines and there are declines. If the market is extremely strong and backs off for a half hour and your stock dips three-eighths of a point, there’s nothing wrong with entering then. But when the market acts poorly for days on end and the stock is down four or five points, buying could lead to trouble.

  No matter what the market conditions, you must houseclean your stocks periodically, even in an overall bullish environment. For example, if a company you are holding reports mediocre earnings, or if too many insiders begin to sell the stock, or if the stock climbs to loftier and loftier P/E’s, you will want to replace that stock and find others to round out your portfolio. Aside from the normal amount of portfolio watching, the big increases in your stock exposure—say, going from zero invested to 100% invested—will come when the models described earlier turn from bearish to bullish.

  What about the times when the market indicators are relatively neutral or mildly bullish? Such conditions may call for being less than fully invested. But even more important, they would imply that risk, while not exceptionally high—as it would be if our models were outright bearish—is high enough to warrant caution on owning aggressive-type stocks. Under such circumstances, I prefer more conservative stocks. Conversely, I gravitate toward the more aggressive stocks when our timing models are moving from a bearish to a bullish mode, as they did in, say, mid-1982, in the fall of 1984, and in early 1991.

  The conservative stocks are those such as the Midlantic Banks example, where there is a high degree of earnings stability but where P/E ratios are quite low. The more aggressive stocks are those generally regarded as growth stocks, where earnings are up sharply in the more recent past but where P/E ratios are also high. A good example is that of Emulex back in 1982. I like the aggressive growth stocks when all systems are go for the market as a whole. In the rip-roaring stages of bull markets, these stocks tend to do better than the overall market. But when the market indicators are less than outright bullish, I prefer retreating to more defensive and conservative-type stocks with lower P/E’s and greater earnings stability, even if it means a slower rate of growth.

  I’m willing to get very aggressive when overall market conditions are right. But when the indicators are mixed or only moderately bullish, I’d just as soon ease out of stocks somewhat and hold some cash equivalents. When the indicators are very negative, I would rather be mostly out of stocks and sit with cash. I’ve learned to avoid looking for that elusive needle in a haystack. If I do have a handful of stocks at such times, say 10% to 20% of my money, I still prefer to be in the conservative-type stocks.

  The average guy buys his stocks when the market is on a decline and sells in the initial phases of a rally. That’s what happened in 1973–74 when the Dow dropped almost 500 points. Data from Bob Farrell at Merrill Lynch show that cash buying by the public began in February 1973, nearly two years before the market bottomed. It’s true that by December 1974, when the market hit its lows, the public was buying heavily and it looked as though the crowd had been right. But this was the culmination of buying that had persisted for almost two years, and many people were badly hurt in the process.
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br />   Finally, when you buy stocks, you must diversify. How much diversification is proper? That depends on the size of your portfolio. The drawback with diversification, if you have a small portfolio, is that your transaction costs will increase. So, here are some rough guidelines. If you have less than $5,000, I would hesitate to buy stocks outright. Instead, I’d just as soon put that money into a no-load mutual fund, where you can get diversification.

  If you have between $5,000 and $20,000, I would try to buy 4 or 5 stocks. As you move toward about a $50,000 portfolio, I would try to purchase 8 or 9 stocks. At the $100,000 level, you can step up to about a dozen different positions. For the $250,000 range, a portfolio of roughly 20 stocks is adequate.

  Academic studies have shown that if you diversify among different industries, you’ll get roughly seven-eighths of the total benefits of diversification once you reach about eight stocks. It is important not to put all your nest eggs into one basket. If you buy only one, two, or three stocks, you might win the battle by buying when the market as a whole goes up. But you may lose the war because your particular stocks may underperform, or possibly even decline, while the market is advancing. If you diversify, you’re probably pretty sure of doing reasonably well as long as the market behaves. Moreover, if one or two stocks bomb out on you, it won’t do any major damage if you’re diversified. But if you have only one stock and it lays an egg, you’re in trouble.

  One last word about my stock-picking approach. Recall, I recommend going through every earnings report in the daily newspapers. Some of you may find this is more of a chore than you are willing to take on. Of course, you cannot expect to get something for nothing. You have to do at least a little work to achieve above-normal investment returns. However, if you want to cut down on the magnitude of the task and are willing to pass up some pretty good opportunities, you can filter out the earnings reports according to your personal preference.

  For example, you might look only at the reports on the New York Stock Exchange if you want to gravitate toward the somewhat more conservative stocks. Or, if you’re more aggressive and wish to operate in an area where there is somewhat less competition, you might concentrate only on over-the-counter stocks. Another possible screen is to pick stocks whose quarterly sales are above, say, $100 million. That way you’ll be sticking with larger companies that might be more to your taste. Conversely, if you’re more aggressive, you might want to stay with companies that are far smaller, with perhaps as little as $10 million in quarterly sales.

  Obviously, there are a number of ways to chop up the universe to reduce the number of stocks you may want to follow. I myself like to cover the entire gamut because I have found stocks to my liking both on the very small end, such as CACI or Emulex, which I mentioned earlier, right up to the bluest of the blue chips, such as General Electric and American Telephone, which I’ve recommended at various times in the past couple of years.

  Regardless of the stocks you buy, there’s no point in going to bed at night with a position that’s going against you or with a position that’s too large. If you can’t sleep, you’re doing something wrong. Remember, if you take a small loss, you can always make it back. If you wind up with a big loss, forget it. It’s a matter of simple arithmetic. Should you lose 10% on a stock, you need to make 11% to break even. If you lose 20%, you need to make 25% profit to recoup. But if you were to lose 90%, say by riding a stock down from 100 to 10, you’d need a tenfold increase to break even, and that’s almost impossible.

  On the more favorable side, I want to stress that if you have a nice profit riding in a bull market, hang in there. You may even want to buy more—it’s easy to average up. What you don’t want is to sell too soon. Imagine if, in the great bull market that started in November 1990, you had sold out in December or January, 1991. You might have made 15% to 20% on some of your positions, but you would have given up the chance to double your money by holding on for three, six, or twelve months.

  Summing up, I want to leave you with a few clear and simple rules: Buy strength, sell weakness, and stay in gear with the tape. As with any rules, I suppose there is a time to break them, but I urge you to resist the temptation. Even as astute a trader as Jesse Livermore found that when he didn’t practice what he preached, he got clobbered, going broke three or four times after making millions. I can’t guarantee that you’ll make millions in the market, but, if you heed the advice in this book, I think you’ll consistently come out ahead, have some fun, and enjoy relatively untroubled sleep at night.

  * Through 3/20/96

  * Through 3/20/96

  * The latest date when table was prepared(not a BUY).

  * The latest date when table was prepared(not a BUY).

  * Indicates change

  * The latest date when table was prepared(not a SELL).

  * The latest date when table was prepared(not a SELL).

  * Unchanged to 3/20/96

  * No change to 3/20/96.

  * Based on hard up/down volume date since 1960 and estimates of such volume in previous years.

  * Cumulative returns adjusted for overlap 6 to 12 months later.

  * a Cumulative returns adjusted for overlap 6 to 12 months later.

  * a As of 3/20/96, Value Line Index=343.82.

  * Indicates change.

  * The latest date when table was prepared(not a signal).

  * The latest date when table was prepared(not a signal).

  * The latest date when table was prepared(not a signal).

  * Dow price is third Friday following month when cash/assets data are available.

  * Total days invested the days after Thanksgiving and Chritsmas plus all days with short positions according to formula described. Direction of market refers to trend for that particular holdays period, which can vary fron one to three days.

  * 12- and 18-month returns for 1932 buy signal are cut off on 5/26/33 in order to avoid overlap with the later signal.

  * 12- and 18-month returns for 1932 buy signal are cut off on 5/26/33 in order to avoid overlap with the later signal.

  * No change at 3/20/96