Every other issue of The Validea Hot List newsletter examines in detail one of John Reese’s computerized Guru Strategies. This latest issue looks at the Martin Zweig-inspired strategy, which has produced annualized returns of 8% since its inception more than six years ago, a period in which the S&P 500 has gained just 2.1% per year. Below is an excerpt from today’s newsletter along with several top-scoring stock ideas based on the Zweig investment strategy.

Taken from the January 8, 2010 issue of The Validea Hot List

Guru Spotlight: Martin Zweig

In the dozen or so years I’ve spent researching investment strategies, one of the greatest lessons I’ve learned is that there is no one single way to beat the market — you can do so by taking numerous approaches. So while most of my strategies are either value oriented or a blend of value and growth, you can definitely make hay with a growth-oriented approach — if it’s a good one.

Martin Zweig’s approach is a great example of a good growth strategy. Zweig’s investment newsletter, the Zweig Forecast, was one of the most highly regarded investment newsletters in the country, ranking number one for risk-adjusted returns during the 15 years that Hulbert Financial Digest monitored it. It produced an impressive 15.9 percent annualized return during that time. Zweig has also managed several mutual funds, and was co-founder of Zweig Dimenna Partners, a multibillion-dollar New York-based firm that has been ranked in the top 15 of Barron’s list of the most successful hedge funds.

Before we delve into Zweig’s strategy, a few words about the man himself. While some of the gurus we’ve looked at in recent Guru Spotights — Buffett and John Neff in particular come to mind — lived modest lifestyles, Zweig put his fortune to use in some pretty fun, flashy ways. He has owned what Forbes reported was the most expensive apartment in New York City, a penthouse atop Manhattan’s Pierre Hotel that was at one time valued at more than $70 million. He’s also an avid collector of a variety of different kinds of memorabilia. The Wall Street Journal has reported that he’s owned such one-of–a-kind items as Buddy Holly’s guitar, the gun from Dirty Harry, the motorcycle from Easy Rider, and Michael Jordan’s jersey from his rookie season with the Chicago Bulls.

Zweig may spend his cash on some flashy, fun items, but the strategy he used to compile that cash was a disciplined, methodical approach. He examined earnings in a rigorous fashion, making sure growth wasn’t just strong, but also consistent, accelerating, and sustainable. His method spanned several categories:

Trend of Earnings: Earnings should be higher in the current quarter than they were a year ago in the same quarter.

Earnings Persistence: Earnings per share should have increased in each year of the past five-year period; EPS should also have grown in each of the past four quarters (vs. the respective year-ago quarters).

Long-Term Growth: EPS should be growing by at least 15 percent over the long term; a growth rate over 30 percent is exceptional.

Earnings Acceleration: EPS growth for the current quarter (vs. the same quarter last year) should be greater than the average growth for the previous three quarters (vs. the respective three quarters from a year ago). EPS growth in the current quarter also should be greater than the long-term growth rate. These criteria made sure that Zweig wasn’t getting in late on a stock that had great long-term growth numbers, but which was coming to the end of its growth run.

While Zweig’s EPS focus certainly puts him on the “growth” side of the growth/value spectrum, his approach was by no means a growth-at-all-costs strategy. Like all of the gurus I follow, he included a key value-based component in his method. He made sure that a stock’s price/earnings ratio was no greater than three times the market average, and no greater than 43, regardless of what the market average was. (He also didn’t like stocks with P/Es less than 5, because they could be indicative of an outright dog that investors were wisely avoiding.)

In addition, Zweig wanted to know that a firm’s earnings growth was sustainable over the long haul. And that meant that the growth was coming primarily from sales — not sost-cutting or other non-sales measures. My Zweig model requires a firm’s revenue growth to be at least 85 percent of EPS growth. If a stock fails that test but its revenues are growing by at least 30 percent a year, it passes, however, since that is still a very strong revenue growth rate.

Like earnings growth, Zweig believed sales growth should be increasing. My model thus requires that a stock’s sales growth for the most recent quarter (vs. the year-ago quarter) to be greater than the previous quarter’s sales growth rate (vs. the year-ago quarter).

Finally, Zweig also wanted to makes sure a firm’s growth wasn’t driven by unsustainable amounts of leverage (a key observation given all that’s happened recently). Realizing that different industries require different debt loads, he looked for stocks whose debt/equity ratios were lower than their industry average.

There’s one more thing you should know about Zweig. He relied a good amount on technical factors to adjust how much of his portfolio he put into stocks. Some of the indicators he used to move in and out of the market included the Federal Reserve’s discount rate; installment debt levels; and the prime rate. His mottos included “Don’t fight the Fed” (meaning investors should be more bullish when interest rates were low or falling) and “Don’t fight the tape” (which related to his practice of getting more bullish or bearish based on market trends).

Those rules are tough for an individual investor to put into practice; Zweig used what he called a “Super Model” that meshed all of his indicators into a system that determined how bullish or bearish he was. But over the years, I’ve found that using only the quantitative, fundamental-based criteria Zweig outlined in his book can produce very strong results. My Zweig-based portfolio has gained 64.3% since its July 2003 inception (that’s 8.0% annually), while the S&P 500 has gained just 14.1% (2.1% annually).

The model tends to choose stocks from a variety of areas, usually holding onto them for a period of a few months (though it is not averse to longer periods if the stock continues to be a prospect for more growth.) Here’s a look at the 10-stock portfolios current holdings:

Strayer Education (STRA)
National Presto Industries (NPK)
Mantech International (MANT)
Panera Bread Company (PNRA)
CVS Caremark Corporation (CVS)
ITT Educational Services (ESI)
Fuqi International (FUQI)
HCC Insurance Holdings (HCC)
Sturm, Ruger & Company (RGR)
World Acceptance Corp. (WRLD)

What I really like about the Zweig strategy is that, while it certainly would qualify as a growth approach, it doesn’t look at growth in a vacuum. As you’ve seen, it examines earnings growth from a variety of angles, making sure that it is strong, improving, and sustainable. In doing so, it allows you to find some fast-growing growth stocks that are not paper tigers, but instead solid prospects for continued long-term success.