The Little Book That Makes You Rich

In spite of a horrendous title for any serious investment book, I enjoyed reading "The Little Book That Makes You Rich" by Louis Navellier. I have a bias against anything that claims to "makes you rich" so, if you're like me, don't hold the title against this little gem.

Although many of the concepts Navellier covers is already well-known by more savvy and experienced growth investors (and especially those who use stock screening in their strategy), this small book is worthwhile and has offered up some ideas and an online tool I think you may want to become more familiar with.

Navellier starts out his book out by outlining what makes for a great stock. In his view "the plain fact is at the end of the day what makes for a great growth stock one that can grow to 20 times your original investment is the fundamentals of the company." (page 2) The problem is, as Navellier talks about (and which I completely agree) is that fundamental variables have a short life span before they stop working and the edge is gone. For example, there will be periods of time the market "favors stocks with earnings momentum while there will be other periods that cash flow will reign supreme." (page 3) I've seen the same thing in the screens I monitor and this is a very important point to consider.

When people ask me what my favorite fundamental criteria is that I use in my favorite stock screens or why I utilize so many stock screens instead of just one, I realize they've yet to understand something very important - the market is always evolving and, like all of us, the market's preferences to what it rewards the most also do change over time. For example, you may hate eating sushi as a child, but later grow to love it when you get older and your tastes mature. The market is the same way. The challenge all of us have is to develop a strategy that takes that into consideration and to fit our strategy to the market's preferences. That's why any strategy or system that is built on the principle that "Do A, B, or C and you'll get rich" is ultimately doomed for failure. Nothing is that easy even though all of us wish differently.

In the bulk of the book, Navellier then goes on to make the case (and a compelling one at that) for 8 "tried and true" key fundamental factors to incorporate when screening your 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

8. High return on equity

If you don't know what these are or how important they are in the screens you use, then I think you'll find this book to be very worthwhile. I especially liked his perspective on why earnings estimates are typically a lot lower now (i.e. why most companies are beating their estimates) and why analyst revisions are so important to watch for. For example, Navellier talks about how herd mentality forces analysts to follow each other and stay too conservative because their most important goal is to avoid getting fired for being wrong by being too optimistic about a specific stock. (Surprise - their top priority is not to make you money!) In his view, analysts can miss as long as others miss along with them and they are too conservative because analysts don't get fired for being too conservative anymore. Therefore, when you do see analysts raising their estimates, it is a clear indicator that good things are happening in that stock.

While I don't want to give too much of the book away, if you're looking to understand what is currently working in modern stock screening now, Navellier does a great overview by explaining why each of these eight fundamental factors are important for stock selection. My only qualm is that I would have also like to read about how these factors have changed in his career and more importantly, what caused them to change. In addition, he provides little insight to how he modifies his screening system to provide greater weight toward certain fundamentals rather than others and how he adjusts them over time. I suspect this is a relatively large part of his proprietary strategy, but he provided little insight along these lines. While we both agree that things do change and you have to modify your criteria to suit the market, it would have been nice for him to offer a more complete review of how and why they have changed and how to recognize when and how to make routine adjustments based on market conditions. Doing so would have made his book more useful for experienced investors who utilize stock screens. But, I suppose I'm asking for too much from a book that is only 185 pages long and can be read in a couple of hours.

After covering the different fundamental factors, Navellier then goes into strategy of evaluating risk versus reward - in other words how to formulate portfolios that do well utilizing screens that lead toward selecting certain stocks. It is in this section that I personally found the most interesting. This is also a topic that I don't cover as much as I should something I would like to focus more attention on. The reason is simple - I provide a lot of very good stock screens that will serve members well, but if you don't know how to build a portfolio out of stocks those screens highlight, then chances are fairly good you're not using the screens the way you should and your results won't achieve the level you desire.

Navellier's approach is fairly simple. In essence, he calls it his Zig Zag approach. To do well in the market, Navellier recommends to create a portfolio that is 1) diversified across different industries & sectors, and 2) with individual stocks that have very different levels of risk. While most of us understand the importance of the first, it is the second point that I found the most interesting.

According to Navellier's research, a good starting portfolio will be comprised of a 60/30/10 mix. (page 106) In other words, 60% of your stocks should be rated "conservative," 30% of your stocks will be rated "moderately aggressive," and 10% will be rated "aggressive." In his research, this mix provided for "smoother, steadier returns." In essence, Navellier doesn't believe in using market-timing, but creating a portfolio that will do well no matter what happens in the market. In addition, the mix provides for a group of stocks that "tend to zig and zag against each other, thus helping to achieve higher and smoother returns." The bottom line is that by both diversifying your positions across a number of industries AND by varying your risk levels your portfolio is built do well without any market-timing. That kind of system should appeal to many of you who don't like timing the market or simply suck at it (in fact, most do including me at times).

So, how do you find out the level of risk of a particular stock or how a stock stands up to the 8 key fundamental factors that Navellier favors? Well, here's the nice part. As a free compliment to the book, Navellier's has created a website Get Rich With Growth which allows you to filter your favorite stocks so you can see how they rank both in terms of the 8 fundamental factors, but also in terms of risk, and also what he calls his "Quant Grade."

Although Navellier doesn't reveal how he creates his quant grade, he says on page 97 that high quant scores are typically indicative of "institutional buying pressure." This sounds like a fancy way of saying "money flow" or "accumulation" in an aloof way, but clearly he does utilize that in his strategies as I do as well and which I've also previously discussed in prior posts. For example, the MoneyStream filter I've shared I suspect is another way of doing this same thing although I'm sure Navellier's approach has been modified/perfected to suit his own strategies. Without more extensive evaluation and cross comparison of his quant scores with my own strategies, it is difficult for me to know exactly how he does it, but I intend to try to figure it out.

Near the end of the book, Navellier then talks about how to utilize his PortfolioGrader tool. For example, on page 123 he makes the claim that stocks that scored a fundamental A and that have A or B scores in all fundamental categories were true superstars even though "A" grade stocks remain A's for an average of four to five months. That list, he says, returned more than 50% per year from 1998 to 2003 and his website offers the following compelling graphic:

As you know, in the past I've found it fun and interesting to filter my screens' results against other systems. (See this previous post). So while we are at it, I thought it would be useful to go ahead and filter my stock screen machine stocks through Navellier's filtering system.

What I found was no surprise - the vast majority of stocks found within my stock screen machine rank very high in Navellier's system. For example, only 7 stocks out of 170 were tagged with low ratings while the rest scored at the top end of his ratings system. In fact, 15 stocks received Navellier's highest marks - with a score of A in total, quant, and fundamental grades. To view the excel file scores, take a look at this excel file I created (please also note my notes near the bottom of the excel file as I separate the top 15 stocks by risk):

As the excel file shows, within the top 15 highest rated stocks, the risk levels are close to Navellier's target allocations with 50% of them being conservative, 40% moderately aggressive, and 10% aggressive. (These are not precise percentages - I have to make some generalizations since I'm only dealing with 15 stocks in this small sample). The problem is that as you can see, the most of the top stocks represent only two sectors: information technology and industrials (according to Navellier's very own sector designations). And, there presents the challenge. Most of these ratings systems will target really good stocks in well-performing sectors, but diversification throughout sectors becomes the key challenge. Ideally, you would then want to fill in the gaps by looking for stocks in other sectors that are also highly ranked.

In addition, I'd also like to make the point that Navellier avoids (since he's advocating a stock-only focused strategy) is that you can also utilize ETFs to provide for some of this risk and sector distributions. For example, take my 80% passive/20% active lazy portfolio strategy I've recommended. In the 80% lazy portfolio section, if you do a good job of both separating your risk and sector allocations, you can afford then to add stocks to the portfolio that are more sector-concentrated and which present greater levels of risk. This is part of the nice thing about combining ETF and stock strategies now is that portfolio allocation becomes a whole lot easier to manage. For example, a portfolio that is structured so that 80% will match the performance of the overall market with 20% in well-selected individual stocks even with high levels or risk and sector concentration will serve you well.

For tracking purposes, I will create a model portfolio out of the highest ranked 15 stocks in the stock screen machine (again see excel file) and report back after some time has passed. Like with other systems I've profiled, I also like to evaluate how a system performs by what it doesn't rate well. Since the vast majority of stocks in my screen machine don't fit that category, I will use Navellier's built-in filter of the top 20 stocks to sell which he also makes available at his website. I know many of you are looking for short-sell screens, so I'm interested as well to see how this filter of the worst of the worst fares, especially in comparison to my own screen of junk stocks. If you intend to track these as well (and I suggest you do) in all fairness to Navellier's system, I will utilize Monday's closing prices for tracking purposes since these grades are based on Monday's update (he updates his ranking system every weekend). The top 20 stocks to sell have also been added to the excel file above in case you don't want to visit his website right now.

Bottom line - you'll want to check out his tool when you have time, if not add it to your toolbox. The fact that my stock screen machine stocks rank so highly in his system is a good sign of its utility. For now it is free, but keep in mind that after you provide an email address in registration, Navellier will begin to send you emails to inspire you to sign up for his expensive newsletters ($999 per year). A truly excellent marketing approach, if you ask me. By opening his system this way, he's making a bet that people would rather have him do the screening and provide his favorite picks instead of people doing the work on their own. From what I know of the investment public, that's a very low risk/high reward bet to make.

Notwithstanding this issue along with lots of boastful commentary about how smart he has been (a common element among newsletter gurus), Navellier did a good job with the book and offers a nice introduction to screening and the fundamental elements that are working in today's market. He also offers some perspectives in terms of risk management that make sense for most investors and so I do recommend it. In addition, he should be given full credit for freely opening up his system to everyone, especially for those of us looking to tweak, upgrade, and compare and contrast their own investment strategies to his approach. Without a doubt, I know I'll enjoy playing with his PortfolioGrader!