The Zweig Approach: Growth, with a Conservative Twist

When you read reports of his fun, lavish purchases -- a $70 million penthouse in Manhattan, Michael Jordan's rookie jersey, pool tables that cost more than many people's annual salaries -- you might assume that the great Martin Zweig is one to throw caution to the wind when it comes to financial affairs.

In this article, we'll show you how to add these funds to your portfolio to make it more liquid, user-friendly and profitable.

In reality, however, Zweig became one of history's greatest investors not by taking big gambles, but by using a meticulous stock-picking strategy that was far from high-risk.

For Zweig, the approach worked marvelously. In the 15 years that it was monitored, his stock recommendation newsletter returned an average of 15.9% per year, during which time it was ranked number one based on risk-adjusted returns by newsletter-tracking publication Hulbert Financial Digest. My Zweig-inspired Guru Strategy computer model -- based on his book, Winning on Wall Street -- has also fared quite well in what has been a very tough stretch for the market. Since its July 2003 inception, a 10-stock portfolio picked using the model has gained 7.3% per year -- well ahead of the S&P 500's 0.4% annualized gain.

Before we look at just how my Zweig-based model works, you should be aware that Zweig is very much a student of the broader economy. In his book, he says that stock prices are driven largely by monetary conditions. He even developed a model that assesses current monetary conditions, including interest rates and installment debt levels, and uses it to decide how invested in the market one should be.

There's an extensive amount of research involved in Zweig's use of these indicators, and he makes a compelling case for their use. I'm a believer in bottom-up fundamental analysis, however, and the fundamental parts of Zweig's stock-picking approach have worked well for me, so I focus on them.

Earnings, Earnings, and More Earnings...

In terms of his analysis of individual stocks, Zweig's approach is first and foremost concerned with earnings. It dissects a company's earnings from a variety of different angles, trying to find those that have shown steady and "reasonable" long-term growth that has been accelerating in recent quarters. Among my Zweig-based model's key earnings criteria:

  • Long-term earnings per share growth of at least 15% per year, with 30% or more the best case.
  • Earnings persistence: EPS must have increased in each year of the past five-year period.
  • Current quarter earnings and EPS growth (all quarterly EPS and sales growth figures mentioned from here on are compared to the year-ago quarter or quarters) must both be positive.
  • To find firms with accelerating growth, current quarter growth rate must be greater the long-term growth rate, and greater than the average growth rate for the most recent three quarters. The last-three-quarters criterion can be ignored if current quarter growth is 30% or more.

Beyond EPS

Strong earnings were critical to Zweig -- but he wasn't willing to pay too much for them. The Zweig method targets stocks with price/earnings ratios no more than three times the market average, and never more than 43. But to Zweig, there was also such a thing as a P/E that is too low. A very low P/E may be very low for a reason -- the company is weak and can't command higher share prices. P/Es should thus also be greater than 5.

To keep growing over the long-term, Zweig said that earnings must be accompanied by a comparable or better increase in sales; cost-cutting measures by themselves can't do the trick. And the Zweig model also wants to see sales numbers that aren't just growing, but also accelerating. Sales growth in the current quarter should thus be greater than sales growth from previous quarter.

Zweig also found that debt can skew the earnings picture. High debt means significant fixed interest payments, and if business slows, those payments can whittle away profits. The model I base on his approach thus makes sure that a company's debt/equity ratio is less than its industry average.

The Zweig model is one of my more stringent methods, but it is currently high on a handful of firms. Here's a sampling:

Strayer Education, Inc. (STRA): Virginia-based university serves 46,000 working adults on its campuses and online. Its EPS growth is a solid 20.02% over the long term, a better 27.62% over the previous three quarters, and an even better 33.33% in the most recent. It's also upped EPS every year of the past decade, has no long-term debt, and a P/E that's not too high (32.78).

Catalyst Health Solutions, Inc. (CHSI): Maryland-based pharmacy benefit management firm ($1.3 billion market cap) has solid earnings history, with a 28.31% long-term growth rate that has jumped to 32.14% in the latest quarter. It's also upped EPS in each year of the past five-year period, and has a reasonable 23.05 P/E.

Tower Group, Inc. (TWGP): Based in New York City, this small-cap ($980 million) offers specialized property and casualty insurance to businesses and individuals. It's upped EPS in seven straight years, and the gains have been dramatic; the firm's long-term growth rate is 45.12%, which jumped to 70.45% in the most recent quarter. It's selling for just 9.03 times earnings.

Check Your Ego at The Door

One final piece of Zweig advice: While everyone wants to make money on every stock pick, he makes it clear that that's not possible. "No one on this planet will ever know all there is to know about the market -- and no one can expect to be right all of the time or even most of the time," Zweig writes. "You can, however, be right more than you are wrong. In the long run, a 60 % success rate translates into huge gains, a 50 % rate into solid gains, and even a 40 % rate can beat the market." Whether you follow Zweig's approach or another proven method, that's a critical notion to keep in mind.

At the time of publication, John Reese and his private clients at Validea Capital Management were long STRA and TWGP.

John P. Reese is founder and CEO of Validea.com, an investment research firm, and Validea Capital Management, an asset management firm serving affluent investors and companies. He is also co-author of two investing books, including The Guru Investor: How to Beat the Market Using History's Best Investment Strategies