Key

     In the realm of stock investment strategies, the two main schools are value and growth. Value investment strategies tend to seek out neglected or undervalued firms and growth investing looks for companies exhibiting sustainable or increasing growth in sales or earnings. But it is rare to find a purely growth-oriented or purely value-oriented stock selection strategy anymore; most screens only lean toward one style or the other.  Martin Zweig, who was named stock picker of the year two years running in the 1990s by the Hulbert Financial Digest and is chairman of the Zweig Funds, leans toward the growth methodology. In his book "Martin Zweig's Winning on Wall Street" (Warner Books, 1997), he outlines his strategy for identifying companies with strong growth in earnings and sales, a reasonable price-earnings ratio given the company's growth rate, buying by insiders (or at least an absence of heavy insider selling), and relatively strong price action. The Zweig screen is based on his approach.

Arming Yourself

     Zweig divides stock-picking into two categories-the shotgun approach and the rifle approach. The shotgun method, which Zweig advocates, entails screening publicly available data on a number of stocks using predetermined criteria. This more mechanical approach allows individuals to follow a large number of stocks at one time, spending a limited amount of time on any one company.

     In contrast, the rifle approach involves the in-depth analysis of a select number of companies. The analysis may cover accounting methods used, trends in the company and industry, and a variety of economic variables impacting the company. Zweig points out, however, that this approach is unrealistic for the average individual investor because it requires full-time analysis of the market.

Strong Growth

     One of the cornerstones of Zweig's stock-picking strategy revolves around what he terms as "reasonable gains in sales and earnings." To this end, he examines both absolute levels as well as growth from a variety of angles.

     Earnings Stability

     Zweig begins his search by examining quarterly earnings and sales. Here he requires positive growth in earnings per share between the most recent fiscal quarter and the same quarter the prior year.  Same-quarter growth is a better benchmark than sequential-quarter growth because seasonal patterns are less likely to be an influence. Zweig also examines the same-quarter growth in earnings per share going back several quarters. He warns of stocks with negative or "skimpy" growth rates on a same-quarter basis.

     The first filter specifies that the same-quarter growth rate in fully diluted earnings per share from continuing operations for each of the last four fiscal quarters is greater than zero.

Sales Growth

     Since sales drive earnings, Zweig is also interested in companies that maintain their sales as well as those that are experiencing increasing sales growth. To identify such companies, he first requires that a company have positive growth in sales as compared to the same quarter the prior year.

     Beyond positive growth in same-quarter sales, Zweig also likes companies that are able to increase this same-quarter growth rate. To capture this element, this screen compares the same-quarter growth rate in sales for the last fiscal quarter to the same-quarter growth rate in sales for the previous quarter. Those companies that have been able to increase this growth rate pass this criterion.

Earnings Persistence

     Zweig also looks for companies with persistent, rising earnings on an annual basis. Here, the screen requires that a company's earnings per share for the last four quarters (trailing 12 months) be greater than or equal to the earnings per share for the last fiscal year as well as requiring year-to-year increases in earnings per share for each of the last two fiscal years. Zweig is also impressed with stocks that exhibit "strong" longer-term growth rates. To isolate companies that meet this requirement, the screen specifies a three-year annualized growth rate in diluted earnings per share from continuing operations of at least 15%.

Sales Growth vs. Earnings Growth

     Zweig makes a point of discussing the relationship between sales growth and earnings growth. He points out that one cannot draw any negative conclusions when earnings do not grow as fast as sales without further study. He points to competition and price cutting as potential culprits, but the expenses required to introduce a new product may also serve as an explanation.

     On the other hand, he is leery of situations where earnings growth far outstrips that of sales. While it may be possible in the short term for a company to improve earnings through cost cutting, ultimately increases in sales are what drive long-term earnings growth. If you see a company with a long-term growth rate in earnings that is substantially greater than the growth rate in sales, this is a red flag warning to study the sustainable nature of the growth. In the interim, however, it is possible for a company to increase its earnings at a rate higher than that of sales due to operating efficiencies, financial leverage, etc. For this reason, a screen that would require sales growth to outpace earnings growth could punish good companies. Therefore, the screen instead implements the same sales growth requirement as for earnings-the compounded growth rate in sales for the last three-year period must be at least 15%. This way, the screen seeks out companies that are growing at a healthy clip for both earnings and sales. It is then up to you to perform further analysis to decide whether the favorable growth conditions will persist in the future.

Earnings Momentum

     The next element Zweig looks for is increasing momentum in earnings growth, both over the short term and longer term. Zweig compares the growth rate in earnings between the last fiscal quarter and the same quarter one year prior, to the growth in earnings between the sum total of the prior three fiscal quarters and the same three quarters one year ago. Zweig did make an exception here, not wanting to exclude companies that had experienced strong growth in earnings per share for the last quarter, especially if they might be able to continue that growth going forward. For that reason, he also accepts companies whose same quarter growth rate for the most recent quarter is at least 30%.

     Zweig also compares the growth in same-quarter earnings for the last fiscal quarter to the longer-term growth, hoping to find companies where the quarterly growth rate was higher. For this element, this screen required that the same quarter growth rate in earnings per share be greater than the three-year earnings per share growth rate. The criteria that make up the screen will return companies that are benefiting from the current business cycle and market environment. As economic and market conditions change over time, the industries that make up the bulk of the passing companies will probably change as well.

Price-Earnings Ratio

     The other key element of Zweig's stock selection is the price-earnings ratio. Zweig avoids living on the edge—he believes that a price-earnings ratio can be too high or too low.  On the low end, he feels that there are two types of companies-those that are experiencing financial difficulties and those companies in neglected industries. The risks of investing in financially troubled firms, in Zweig's opinion, are too great to justify the investment in them, since the risk of these firms going under overshadows any potential "value" in these stocks.

     Neglected stocks, on the other hand, are ignored by the market because of bad news surrounding the company itself or the industry in which it operates. In some cases, this overly negative view subsides and the stock goes on to enjoy above-average price appreciation. Studies have shown that these stocks tend to outperform higher price-earnings ratio stocks in the long run. However, due to the nature of the screen, it is doubtful that it will return any neglected companies in the final results. Zweig notes that if you do run across a company with a very low price-earnings ratio, given the growth requirements of the screen, you should immediately examine the balance sheet for any potential problems.

     On the other end of the spectrum, Zweig gets nervous about stocks with very high price-earnings ratios. These stocks run the risk of facing the wrath of the market should they fail to meet expectations. The higher the price-earnings ratio, the higher the expectation for that company, and the more painful the fall should it fail to meet them. Ideally, he selects stocks whose price-earnings ratios are near or slightly above the "market" average. He avoids stating an absolute ceiling, citing the fact that they rise and fall over time. The price-earnings ratios constraints for the screen consist of a minimum level of 5.0 (to avoid potentially troubled firms) and a maximum level of one and a half times the median price-earnings ratio of the entire universe of stocks.

Relative Price Strength

    In his book, Zweig spends a good amount of time discussing price action and relative price strength of individual companies. As a minimum, Zweig compares the movement of the market and that of the individual stock. He is in search of companies that have outperformed the overall market. A stock may be rising in price, but if it fails to gain at the same rate as the overall market, you are still losing out. For that reason, Zweig eliminates those companies that are underperforming the market as a whole, especially when the market is performing well. He theorizes that if a company is as good as it appears, it should perform at least as well as the overall market. The screen eliminates those companies whose price strength relative to the S&P 500 over the last 26 weeks has been below zero.

Remaining Criteria

     To round out the screen, supplemental criteria were applied to further ensure the integrity of the companies we ultimately want to examine. The first of these eliminates those companies traded as American Depositary Receipts, or ADRs-foreign listed companies that are traded on U.S. exchanges.  The screen also excludes companies categorized as part of the miscellaneous financial services and real estate operations industries, which usually consist of closed-end mutual funds and real-estate investment trusts. Lastly, the screen addresses the difficulty that can arise when attempting to invest in stocks that are lacking liquidity - they have relatively low daily trading volume. While Zweig believes that the average investor will not run into liquidity problems, it is a good idea to establish a minimum level of daily trading volume. The screen requires companies to have an average monthly trading volume (based on the last three months) that falls in the top 75%.

Qualifying Factors

     As always, the results of any stock screen are more of a starting point than a finish line. With the database winnowed down, it is time to examine each of these stocks using some other factors that Zweig feels are relevant.

Debt Levels

     Zweig makes a point of mentioning that you should not pay too much for a company that has a high level of debt. Companies that carry higher levels of debt also carry with them higher risk levels, mainly due to the higher fixed costs associated with interest expense.  Since the level of debt a company can safely carry tends to depend heavily on the industry in which it operates, it is best to compare an individual company's level of debt to that of its industry.

Price Action

     You won't find Zweig buying companies that are making new lows. He states very plainly that he is on the lookout for companies whose stock prices are on the rise, especially when those increases are spurred by an unexpected earnings announcement. Those companies that pass the screen would represent a "watch list" of companies. Zweig watches for these companies to announce their quarterly results and then follows a two-step process. First, he confirms, based on the new quarterly or annual data, that the company would still be included on the watch list. If that is the case, the second step would be to check the price performance on the announcement day. The price behavior following an earnings release can serve as a barometer that measures the market's reaction to the news. If prices fall following an earnings announcement, chances are the market's expectations were not met. Studies have shown that, in cases such as these, the negative impact on the stock's price could last for up to a year. It is for this reason that Zweig chooses not to "fight the tape." He overlooks those companies whose prices fall "significantly" on the day the latest quarterly results are announced. Likewise, an announcement that is better than what the market was expecting could have a positive impact on the stock price for a long time.

Insider Activity

     In general, Zweig is more concerned with heavy insider selling than a lack of insider buying. Zweig uses insider buying and selling activity over the last three months as potential buy and sell signals-three insider buys indicates a potential buy signal and three insider sells, a potential sell signal. He also prefers his signals to be unanimous, meaning at least three insider buys and no sells for a buy signal and at least three insider sells with no buys for a sell signal. Web sites such as MSN MoneyCentral track insider activity over the last three months (moneycentral.msn.com).

Conclusion

     When following any stock screening strategy, it is important to remember that the process is only a first step. Martin Zweig's principles help to reveal a collection of companies exhibiting strong earnings and sales growth, reasonable price-earnings ratios relative to the overall stock universe, and strong relative price strength that can prove to be an interesting starting point.