Fundamental Analysis

Martin Zweig does not 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. Zweig finds that 5 out of 8 of the stocks that get through his screens perform well.

When it comes to stock-picking, Martin Zweig screens many fundamental numbers. He gives greatest weight to two parameters - the earnings trend and the pe ratio (price/earnings ratio).

The Two Most
Important Fundamental Criteria

Earnings Trend

Before he will consider buying a stock, Martin Zweig needs to see the company's earnings rising consistently for the last four or five years. He also needs to reassure himself that nothing has gone wrong recently, so he checks that the most recent quarterly earnings have shown growth compared to the same quarter a year ago.

The upward earnings trend should be backed by a parallel sales trend. Zweig believes that earnings growth will not be sustainable if earnings are rising due to cost cutting rather than increased sales.

Price/Earnings Ratio

Of equal importance to increasing earnings is the price/earnings ratio. This is calculated by dividing a stock's current share price by its earnings per share. A pe ratio of 10 means it costs you $10 to buy $1's worth of annual company profit. Zweig comments:

"The data going all the way back to the 1930s show conclusively that stocks with low price/earnings ratios outperform stocks with high price/earnings ratios over the longer term".

For most big companies the pe ratio in recent years has been somewhere in the teens or low twenties. (Zweig believes that when the average pe ratio of the whole market is in the high teens or twenties, poor performance is likely to result.) There have been times when companies in Dow Jones Industrial Average have had an average pe of over 20. In these circumstances, a bull market is almost certainly nearing an end. In 1974, the average pe of the DJIA, at the end of a terrible bear market, was just six. This was a good time to buy stocks for the longer term.

Zweig is interested only in stocks whose pe ratio is not unusually high relative to the current market. He believes high pe stocks are risky. If they fail to deliver, even slightly, on the high expectations associated with their pe ratio, their prices can quickly plummet.

Zweig rules out stocks whose pe is unusually low (values of around 5 or lower) because it takes odd circumstances - usually there is something worryingly wrong with the company - to produce very low pe values.

Since he is looking for stocks with better than average growth rates, Zweig says it is unusual for him to find many stocks trading at average pe ratios. If, for example the average pe of the market was 10, he accepts he will usually find the sort of stocks that interest him trading at pe ratios of 14 or 15. This style of investing is sometimes referred to as GARP investing, where GARP stands for growth at a reasonable price.

The Law of Averages

Although some companies do prosper after achieving earnings growth through cost cutting and some stocks do rise appreciably after being marked down to very low pe ratios, Zweig is interested in probabilities. On average, companies that don't fit his criteria won't deliver the strongly rising share price he desires; therefore he avoids them.

Other Fundamental Criteria

There are several secondary fundamental factors Zweig considers when he picks stocks.

He shares Warren Buffett's wariness of highly indebted companies

He also shares Warren Buffett's wariness of poor management. He does not, however, spend time in a detailed study of a company's management the way Buffett does. Zweig simply does not buy shares in companies whose managers have overestimated future earnings.

He also does not buy the stock of companies where insiders are selling stock in any significant quantities.

Unlike Buffett, 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."

A Sample Check List of Fundamentals
For a Martin Zweig Type Stock Purchase

(This is one possible interpretation of Zweig's rules and is not stated by Zweig himself.)
  • The company should have annual earnings growth of 20 percent or more for at least four years.
  • Sales growth should be similar to earnings growth.
  • The pe ratio should not be too low. Reject companies with a pe of five or less.
  • The pe ratio should not be too high. Fast growing companies tend to have higher than average price/earnings ratios. Reduce the risk of overpaying for growth by rejecting any companies whose price/earnings ratios are more than 60 percent above average for their sector.
  • Company debt should be average or below average for the sector the company operates in.
  • Management should not have overestimated earnings during the last 3 years.
  • There should be no selling of stock by insiders. If more than one insider is selling, they should be selling fewer shares than other insiders are purchasing.
If a company passes on each of these fundamental criteria, you should check the technical criteria, if you have not already done so.

Selling According To Fundamental Criteria

Zweig watches the stocks he has purchased for deterioration in fundamentals. He believes if insiders begin to sell a stock or if its fundamentals weaken it should be sold. If there is a bull-market, it should be replaced by a stock with better fundamentals.