Stock screening - the process of setting minimum criteria for shares before investing in them - has proved itself to be a successful way to choose investments. The screen based on the ideas of the hugely successful American fund manager and analyst Martin Zweig has consistently been one of the best. It looks for fast-expanding, high-growth companies with reasonably cheap and popular shares - essentially, it's about paying a reasonable price for fast-growing companies.
It was many years ago that a smart, young American trader and investment analyst called Martin Zweig picked up a copy of Reminiscences of a Stock Operator, a series of interviews between a certain Lawrence Livingstone (a pseudonym for Jesse Livermore) and the financial journalist Edwin Lefèvre. (You can buy this book at a discount in the IC bookstore).
Livermore was an immensely successful stock trader from the 1920s and 1930s who decided - rather like the equally legendary Ben Graham - to share his hard-won tips for success in the stock-picking game. Livermore had learnt the hard way, too - he'd lost all his money on more than one occasion. But he went on to be one of the most successful traders ever, before committing suicide in 1940. Livermore's greatest triumph was in 1929 when he went short just before the crash and netted a profit of at least $100m, a truly enormous sum in those days.
So, in Reminiscences of a Stock Operator, Livingstone spelled out his secrets for success. For Zweig, two particular tips must have particularly resonated. The first tip is to stick to rules. According to Livermore: "It took me five years to learn to play the game intelligently enough to make big money when I was right." Livermore absolutely believed that investors needed rules to play and win on the markets. Aimless speculating was a quick road to ruin. You needed to understand both technical and fundamental analysis. "I have been in the speculative game ever since I was fourteen. It is all I have ever done. I think I know what I am talking about. And the conclusion that I have reached after nearly thirty years of constant trading, both on a shoestring and with millions of dollars back of me, is this: A man may beat a stock or a group at a certain time, but no man living can beat the stock market!" The key for Livermore is to stick to trading rules through thick and thin - never deviate. When Livermore broke his rules, he lost everything.
The second tip concerns timing."The point is not so much to buy as cheap as possible or go short at top price, but to buy or sell at the right time... Don't become an involuntary investor by holding onto stocks whose price has fallen."
Jesse Livermore's key trading rules
• Buy rising stocks and sell falling stocks.
• Do not trade every day of every year. Trade only when the market is clearly bullish or bearish. Trade in the direction of the general market. If it's rising, you should be long, if it's falling you should be short.
• Only enter a trade after the action of the market confirms your opinion and then enter promptly.
• Continue with trades that show you a profit, end trades that show a loss.
• End trades when it is clear that the trend you are profiting from is over.
• Never meet a margin call - get out of the trade.
• Go long when stocks reach a new high. Sell short when they reach a new low.
• Don't become an involuntary investor by holding onto stocks whose price has fallen.
• A stock is never too high to buy and never too low to short.
• Markets are never wrong - opinions often are.
• The highest profits are made in trades that show a profit right from the start.
• No trading rules will deliver a profit 100 per cent of the time
For Zweig, these ideas validated one clear starting principle for all investors including himself: don't try and work against the market by taking a contrarian position. If the market's marking down a share, there's usually a good reason - always buy popular shares that are doing well and that the market likes.
But Zweig decided to take Livermore's ideas one step further. Why, he wondered, are certain shares so popular in the first place? What makes them become popular, thus driving up the share price?
The answer for Zweig was simple: accelerating profits and earnings. There's copious amounts of research that proves that the key mover in share prices over the long term is the rate of earnings growth - companies that grow fast, tend to have sharply rising share prices. So the key is to find those stocks before the whole of the market piles in, sending the share price shooting up.
Enter Zweig's own classic investing magnum opus and rival to Livermore's Reminiscences of a Stock Operator, the bestseller Winning on Wall Street. In summary, Zweig reached three simple conclusions:
1. Look for shares where earnings growth is accelerating.
2. Look for shares that are reasonably priced.
3. Don't buy stocks where the price is underperforming the market. Buy shares with some relative market strength.
In essence what Zweig outlines is a classic middle-of-the-road, higher-risk, growth screen combining elements of both technical and fundamental analysis. Crucially, though, it also seems to work.
Zweig made a fortune operating his analysis on Wall Street - he was the proud owner of the most expensive apartment in Manhattan, a trifling $70m triplex penthouse on Fifth Avenue - and other analysts who've studied his principles have also found that his relatively simple methodology can work wonders for private investors who stick with the core principles.
Evidence for this comes from a US-based association of private investors called the American Association of Individual Investors (AAII). It has been running a screen that filters through the US market using Zweig's principles for nearly 10 years. This AAII Martin Zweig screen, and the resulting portfolio, has delivered the biggest gains of any stock screen studied (more than 60 have been put through their paces) - cumulative gains have totalled 2,418 per cent and, even in 2007, the screen delivered profits of 20.7 per cent. Another highly respected American outfit has also run its own, much shorter-term test. Website Validea has run a Zweig stock screen since summer 2003 and, like the AAII's screen, it's delivered the best results with a cumulative gain of 133 per cent.
Over here in the UK, Investors Chronicle's sister publication, the Stock Screening Newsletter, has also been running a model portfolio based on Zweig's idea - and, yet again, its results have been top of the class, with consistent outperformance, even in the current rather difficult markets. In just two years of operation, a portfolio of up to 14 shares has delivered average gains of just under 15 per cent (against 10 per cent for the FTSE All-Share), even after the massive rout of recent weeks.
Understanding Zweig's strategy
Zweig doesn't study any single stock in great detail. He prefers to use what he calls a shotgun approach - he screens thousands of stocks purely on their financials, settling on a relatively short list of potential candidates. Zweig found that five out of eight of the shares that get through these basic screens perform well. So, what's in these fundamental screens? Two measures are of supreme importance - what he calls the earnings trend and the price-earnings (PE) ratio.
Both are easy to understand. The first, earnings trend, is a simple pattern that shows accelerating profit growth over time. Zweig wants to see the company's earnings rising consistently for the last four or five years, but he also wants to make sure that this pattern will hold for the future - he checks that the most recent quarterly earnings have shown considerable growth compared with the same quarter a year ago. But what constitutes a considerable growth rate? For Zweig, the minimum is between 15 and 20 per cent a year. The upward earnings trend should also ideally be backed by a parallel sales trend. Zweig believed that earnings growth is not sustainable if earnings are rising due to cost cutting rather than increased sales.
The second key measure is also easy to understand. Zweig doesn't want to overpay for a share. He wants a reasonable PE ratio. He says: "The data going all the way back to the 1930s show conclusively that stocks with low PE ratios outperform stocks with high PE ratios over the longer term".
Zweig is interested only in stocks whose PE ratio is not high relative to the current market. He believes high PE stocks are risky - that means that a PE much above 40 is much too expensive while a PE ratio of less than five is probably an anomaly and indicates a catastrophic decline in profits and sales.
Zweig doesn't like highly indebted companies, believing that company debt should be average or below average for the sector tin which it operates. And he also avoids companies where insiders are selling shares in any significant quantities. Finally, unlike Warren Buffett or Peter Lynch, Zweig does not insist on understanding what a company does or how its products work. He will consider buying any company whose fundamentals are favourable. Zweig says "If a company can show nice consistent earnings for four or five years, I don't care whether it makes broomsticks or computer parts."
Applying these principles to the UK market (with one important exception) isn't too problematic. The exception is that Zweig likes to focus on quarterly earnings figures, whereas, here in the UK, earnings are released on a six-monthly basis – so the key is to look at the most recent figures and re-assure yourself that the earnings growth acceleration is holding steady and that there aren't any hidden surprises.
Zweig investing 2008 style
Trying to apply Zweig's ideas to the choppy, bearish markets of 2008 is no easy game. Zweig himself is pretty specific about how to run a market-timing strategy: "People somehow think you must buy at the bottom and sell at the top to be successful in the market. That's nonsense. The idea is to buy when the probability is greatest that the market is going to advance".
As ideas goes, that may have sounded sensible enough a few years back. In the current markets, though, it's hard to maintain much bullish conviction using the Zweig view - markets keep on plunging and most technical analysts believe that it's going to get much, much worse before it starts to get any better. On the other hand, Zweig is also a monetary market timer - he believes that if interest rates are falling and companies are tackling their debt problems, then markets might start moving upwards.
