Growth Investing, Bloodlessly

Ah, the benign indifference of numbers. If only we could regard them with a cold heart. Nearly every professional money manager claims that he does, that he invests bloodlessly that is, coolly and analytically taking positions according to his scientific discipline. Of course, we all know that this is not the case for many of the actively managed funds run by real people. For retail investors, emotion

Ah, the benign indifference of numbers. If only we could regard them with a cold heart. Nearly every professional money manager claims that he does, that he invests bloodlessly — that is, coolly and analytically taking positions according to his scientific discipline. Of course, we all know that this is not the case for many of the actively managed funds run by real people.

For retail investors, emotion is truly the evil genie in the bottle. No doubt financial advisors have witnessed their greed and despair in recent years. That is why financial advisors might heed the words of growth investor and quantitative devotee Louis Navellier. “One of the chief things I have learned is that numbers do not have emotions,” he writes in his new book, (rather humbly) titled The Little Book That Makes You Rich: A Proven Market-Beating Formula For Growth Investors (John Wiley). “They don't panic; they don't get greedy. They don't have an argument with their spouse or associates and make bad decisions as a result.”

True enough — and for all investors, words to live by. Indeed, Louis Navellier has. Navellier is known for his quantitative, small-cap growth strategies, which he began advocating via his newsletter, MPT Review, in the early 1980s. The years have been kind to Louis, and his recommendations have gained over 4,800 percent in the last 22 years. His newsletters (there are four) are rated highly by The Hulbert Financial Digest, the leading newsletter that tracks investment newsletters.

Now managing $5 billion, most of it institutional money, Navellier is giving away the secrets (his quantitative tools) to his investing success. (Other professionals have already done so via Wiley's clever investing series “The Little Book That…”; Wiley has published John Bogle's The Little Book of Common Sense; Joel Greenblatt's The Little Book That Beats The Market; and Chris Browne's The Little Book of Value Investing — all slim, pithy, pocket-sized books that would make excellent gifts for some of your more-involved clients.)

We caught up with this self-professed “numbers junky” recently during the New York stop on his book publicity tour.

Registered Rep.: You and your team write the equivalent of half a book every weekend with your four newsletters. Why did you wait so long to formally pen a hardback?

Navellier: It seemed like a good time to give my investing formula away, and play the role of a teacher. Many of my funds are nearing capacity, and investors seem to have forgotten that fundamentals are important. Some on Wall Street were even mocking me as some sort of a dinosaur. They seemed to believe that [quantitative investors] don't do fundamentals. But the blowups of some structured and [arbitration] guys this summer has shown that fundamentals do matter.

RR: Far from being a dinosaur, you're adamant that your growth focus is now back in favor. How have you determined that?

Navellier: Yes, growth is definitely back in play. Growth investing and value investing used to oscillate regularly in terms of which one was the more profitable approach to picking stocks. Between 1975 and 1993, the two investing styles would switch favor every year or two. But growth beat value between 1994 and 1999 — you know, the go-go 1990s — only to go out of favor after the bubble burst in 2000. For the past seven years value has beaten growth, but the style just began shifting again in favor of growth earlier this year. It's obvious in the out-performance of growth indices versus value ones, and my performance versus that of value shops.

RR: Let's get deeper into your investing formula. It's intriguing to think that you are “giving it away” in the new book, but I'm sure there are plenty of details in the execution of your approach that investors may have trouble duplicating. Care to throw any bones to our readers so that they may better mimic you?

Navellier: I don't mind if people mimic us. We know the markets change over time, and we think we adjust our formula to the changes better than anyone else can. We also spend about $1.2 million a year on data to make sure our calculations are done with the right input. Otherwise, it's garbage in, garbage out.

But the fundamental findings relayed in the book are solid, and the eight factors of our model are tried and true for finding great stocks. They are:

  1. Positive earnings revisions;
  2. Positive earnings surprises;
  3. Increasing sales growth;
  4. Expanding operating margins;
  5. Strong cash flow;
  6. Earnings growth;
  7. Positive earnings momentum; and,
  8. High return on equity.

I've even been able to apply my formula using some of the free-screening tools on the Internet to generate a decent list of stocks. I'm sure many of the reps out there have even better tools to use if they wanted to mimic us.

RR: Of the eight factors in your formula, the last six are historic, and easy to screen for. But how can people screen for future positive earnings revisions and surprises?

Navellier: They don't have to. What we've found is that companies that have the great fundamentals identified by the last six factors tend to generate positive earnings revisions and surprises. What's more, one set of surprises tends to lead to future surprises. I should also stress that our factors work best as a group. The best stocks hit on all the factors, not just most of them.

RR: Has your investment formula changed over time?

Navellier: We test around 180 factors on a regular basis. Many factors can work for a little while, but they tend to lose their effectiveness when everyone starts using them. GARP [growth at a reasonable price] and price-to-sales ratios come to mind as two that haven't stood the test of time. That's what makes the eight factors I've identified so interesting. While I do adjust the weightings of these factors a little as the market dictates, they have stood the test of time even though they are well-known.

RR: It's interesting that you found when a company has just had positive earnings surprises and revisions, it tends to have more in the near future. Can you explain why that is?

Navellier: It comes down to the way sell-side analysts deal with their reality. If they are wrong too many times by posting estimates — which are really just educated guesses — that are too high, they can lose their jobs. But if they are wrong by estimating too low, it doesn't matter as much since the stock rises on the surprise, which makes clients happy. So analysts only raise their estimates when they have really compelling evidence that business has improved — and then they still tend to be conservative in the amount they raise estimates because of job preservation.

RR: Okay, so your system has proven good at picking stocks. A larger problem for a lot of investors, however, is getting out of a position right. Do you have a system for that as well?

Navellier: Absolutely, and it relates to the risk metrics that I mentioned before. Besides taking a stock's alpha, beta and standard deviation into account in order to decide when it has become too risky to hold, we also monitor the covariance of different stocks to make sure they combine into a portfolio that minimizes beta and residual variance, while maximizing alpha. This optimization process naturally generates selling decisions.

RR: So your selling rules are straight out of Modern Portfolio Theory. Do you ever take a stock's technicals into consideration?

Navellier: No. There's a good amount of subjectivity in technical analysis, and we don't like human judgment messing up our system.

RR: How about using other risk-management tools like raising cash, or hedging with short positions?

Navellier: I don't do either. There is an aspect of compliance that keeps me from raising cash over and above what any of my funds or managed accounts need for everyday liquidity. It's tough to justify charging fees on any large amount of cash held in either type of product. Basically, I think raising cash as a risk-management measure is something investors should do outside of any products I offer.

Not shorting is a different matter. Although our formula can obviously be made to identify the companies with the worst ratings by our eight factors, brief and violent short-covering rallies can still bite you. If I were to do any amount of shorting, it would be of ETFs that represent low-ranking industries or indices. But I'm inherently a long investor.

RR: Any input on the raging bull/bear debate regarding where the economy and stock market is heading?

Navellier: The economy is awesome. Sure housing is a drag, but the weak dollar is fuelling exports, which should more than compensate for housing. More specific to stocks, we're in the midst of the best environment for earnings since the 1950s. Earnings have averaged growth in excess of 10 percent for the last 21 quarters. Problems with the [financial sector companies] are obviously hurting overall growth numbers now, but [financial companies] tend to live in the value segment. There are lots of sectors still growing well, and guys like me have no problems finding the growth.

Another positive for stocks is the fact that dividends will remain taxed at just 15 percent until at least 2010, when Congress has the option to extend the policy. This tax law is probably the most bullish event for stocks so far in my lifetime. It has given managers great incentive to buy back their stocks in order to increase their individual ownership, and then pay themselves a dividend. The shrinking supply of stock has kept both earnings per share and the relative demand for stocks high. Some growth stocks are even paying dividends now. In the near term, as Congress debates about whether to extend this tax policy, management will only get spooked into continuing their bullish buyback behavior. If Congress refuses to extend the policy, though, look out. It could cause a stock market crash in 2010.

RR: So where is the growth now?

Navellier: We're overweighted in defense, oil services, large-cap techs and foreign telecoms. We are underweighted in financials, REITs and Japanese stocks.

RR: How can reps take advantage of your work for their clients?

Navellier: Lots of ways — which is why I make so many calls to brokerage and financial-advisor firms these days. Our money-management products are also sponsored by over 80 financial institutions, including most of the larger national and regional brokers.

But the most basic way to use me is to simply put the formula in my book to work, and make use of my free website (getrichwithgrowth.com), which will tell you how we rate the factors in our formula for any stock ticker you type in — assuming it's one of the 5,000 or so securities in our database.

Reps and advisors can also follow how I execute the strategy in one of my four newsletters. The newsletters are called Emerging Growth [which is the continuation of Navellier's original MPT Review newsletter], Blue Chip Growth, Global Growth and Quantum Growth. The letters have varying focuses on market-cap segments, risk tolerances and geographical regions. Which one a rep chooses depends on the types of assets his clients need.

RR: Which is probably why your primary business these days is money management. What are the options for reps there?

Navellier: Yes, we have about $5 billion under management in our various products at this time, and most of that money is institutional. One of our hotter products now is the Touchstone Large Cap Growth Fund. TEQAX is up more than 24 percent year-to-date. It is also very tax efficient.

Although some of my earlier funds, which focus on small- and mid-cap stocks, are closed, we can still tailor approaches via a managed account. For accredited money, we're even willing to work for 10 percent of profits while leaving any wrap fee for the rep.

Whichever of our products is being pitched, however, we are obsessed with being sold right. When it comes to a potential managed accounts client, for instance, we will offer them free Zephyr reports that mix and match various managers and/or products they are considering in order to build an efficient frontier from the list. And if our product doesn't appear on their efficient frontier, we won't be sold. Nothing personal.

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