'I've Been Known To Fire People Who Like Stocks!' Louis Navellier

I had the opportunity to interview money manager Louis Navellier a few days ago. Louis is consistently ranked among the top money managers in the country. He has approximately $3 billion under management in a combination of hedge funds and mutual funds.  I first learned of Louis in the early 1990's and what struck me most about him was his single-minded investment focus on a company's growth, combined with his flexibility to adapt to constant market changes. This combination has allowed him to outperform the markets most years. An example is his large cap growth portfolio, which has nearly doubled the return of the Russell 1000 Index since 1991.

I hope you enjoy and profit from this interview.

Larry Connors: Hi Louis. Thanks for joining us. It's nice to talk with you again. Can you briefly tell us about your background, performance, how you got into the business, etc.?

Louis Navellier: Sure. My background’s pretty simple. When I was young and dumb, I was programming Wells Fargo’s mainframes at colleges in the mid-70s and we helped them build their first index fund. And at that time, the fund basically tried to mirror the S&P with 332 stocks. We figured how to track the S&P properly and we produced 332 stocks to track the S&P. What happened is that we messed up: It actually beat the market. Wells then went on to the fund buying all 500 stocks. And I was very perplexed why we beat the market. When I was at Berkeley, Calif., I was taught you could never beat the market. And then what happened was, I later learned that there are these things called high alpha stocks that don’t correlate to the market and move independent of the market and they are your best bet to beat the market.

Connors: Real briefly, what is a high alpha stock?

Navellier: It’s just stock that doesn’t correlate with the market. We literally work out stocks week by week over various time cycles and the return correlate to the market is explained by the data. The return not correlated to the market is explained by the alpha.

Connors: What would make a stock not correlate with the market?

Navellier: Well, I can give you lots of reasons. Sometimes, they don’t correlate because there’s a road show and hype in the stock and it’s going up… Sometimes there are short-covering rallies, and it’s rallying because the shorts are being squeezed. And those are the ones I don’t buy on. But often they rally because they under massive and relentless institutional accumulation and hopefully it’s due to good fundamentals. So I try to find out what’s the fundamental force causing the alpha. Nowadays, cash flow is a big deal. If they get rid of double taxation dividends, strong cash-flow companies will be under a lot of pressure to pay out their dividends. Historical growth is a big deal now although that wasn’t very important in 1999 when the market was all excited. Oh, my goodness, what else is going on? Historically, earnings surprises have been a cause of high alpha stocks. Positive analysts’ comments create positive alphas because that helps. After July 24 and about five weeks afterwards, there were massive corporate buy backs. That helped. So it could be a variety of fundamental forces. So the most challenging thing, I found out, is if we test what works on Wall Street fundamentally and try to lock in on those fundamental forces.

Connors: Take a step back. So you found this back in … this was in the 70s. Did you then go on to start your own fund to take advantage of this?

Navellier: No, I just started to experiment. I still had access to Wells Fargo’s computers and I basically used their computers and figured things out. Then I started publishing my research in my newsletter, "MPT Review." That was over 23 years ago. I have other newsletters now. We also have a management firm that runs about three billion dollars.

Connors: The process you use in selecting stocks is that you use a bottoms-up approach. I want to talk about that for a second. Is there a reason why you feel a bottoms-up approach is better than a tops down approach?

Navellier: We’re not afraid of a top-down approach, it’s just that sometimes you are not in a sector market. That's why I mostly look at stocks first. Last year, I would have made more money because it was a sector market. It was consumer stocks in the second quarter, health care in the third and telecom in the fourth quarter. But we’re very comfortable doing bottom up and a lot of times when we do a bottom up, you find the stock sectors anyway.

Connors: So it gets you to the same point, no matter whether you start from tops down or bottoms up. Is that correct?

Navellier: Yes, that's correct.

Connors: You have a three-step approach to investing. The first involves quantitative analysis of market and individual stock statistics.  What does that mean in a broader sense?

Navellier: We just screen and filter stocks very thoroughly. You know, this is actually on line for investors now. There is a service called portfoliograder.com. So go on it, it’s free.  You just get on there and from an entire database of 5,000+ stocks, you key in any series of stocks and it will give you an A, B, C, D, E, F ranking on it. We score them on our reward/risk quantitative criteria and we score  them on multiple fundamental criteria and you’ll find that less than 6% of stocks in the database get an A grade. And we buy A’s. We hold a lot of the B’s. We start to sell C’s and the D’s and F’s are dogs with fleas. In fact, on http://www.portfoliograder.com we also show you the database. They also show you how A, B, C, D’s and F’s have performed historically.

Connors: That's great.

Navellier: And that’s probably the best way to understand our quant system. Just get in there and start to put in stocks and see how they work. We did that because so many people asked us for custom analysis, we felt we had to automate it.

Connors: Many of our readers are professional traders or professional investors and they’ll make money on the short side as well as on the long side   Do you take your lower-ranked stocks and short them?

Navellier: We short in hedge funds but I’m not the short expert. We have separate guys that short. You’ve got to be careful of short-covering rallies. We tend to short more of the D’s than the F’s only because you can get killed on the F's, especially in a short-covering rally.

Connors: Let’s jump ahead to step number 2, which is the analysis of underlying fundamentals of stocks to identify those stocks. You’re looking at stocks with good profits, earnings growth, etc. Can you talk about that?

Navellier: One of our trademarks is profit margin expansion. When operating margins expand, earnings will grow fast. You’ll probably find my average stock has over 20% revenue growth but earnings are growing over 50% because our margins are expanding. The margins level law varies, of course, to sell it rapidly but we found that a lot of earnings surprises have come from profit margin expansion.

Connors: Profit margin expansion.  Would you key that as the most important aspect of what you’re looking for?

Navellier: I would say that and cash flow at this time.

Connors: The third step involves stock allocation utilizing the latest techniques. You’re allocating things based upon what?

Navellier: Well, we’re looking mathematically at something called covariance. Let me give you an example. Defense stocks tend to move very differently than pharmaceuticals. Retail stocks more differently than techs. To the computer, a stock is just a squiggly line. It’s going to take all these squiggly lines, which are the stocks of the prime series, and it’s going to try to figure out how to take these squiggly lines and start to blend them together to get a smooth line. And that’s what optimization does. It tells you how to mix and match stocks. It tells you whether you should have 8% in any industry, or 2% or 3%, or 1%. So what optimization does is it tells us the best stocks, like large-cap best 30, mid-cap best 40, small-cap best 50. Those are approximate numbers. And as things get more volatile, it leans us toward more diversification. It tells us precisely how to weight them. Usually about 60%+ of our portfolio is on the more conservative stocks, about 30% are in the medium risk stock and 10% in the higher-risk stock. And then it tells us precisely when to sell. Because I might buy some of these conservative stocks but over time as it moves up in price, it usually gets increasingly risky and increasingly volatile.

Connors: When do you start selling things? You buy a stock at 50 and it just starts going in the opposite direction? Does price get you out?

Navellier: Price is 65% of our model. The remaining is our quant system, which would also get us out. 

Connors: Do you use technicals in any way?

Navellier: Yes. There’s a guy named Bob Barnes who has written 12 books. He builds oscillators for us. The oscillators tend to do a lot better on liquid stocks. They are almost worthless on small-cap stocks because a small-cap stock moves like a bunny. Volume is very erratic and the news is very erratic, so small tend to move in and around the earnings season while as you get into the more liquid stocks, the technical stuff is more valuable.
 
Connors: Do you have a problem with oscillators in strongly trending markets?

Navellier: No, we love trending markets. Markets haven’t been doing that. I would say in the last few years they’ve been going through wild oscillations. But the 1998 cycle would have picked up most of the movements in the market.

Connors: So the oscillators that you are using are longer-term in nature as opposed to…

Navellier: We have 30-, 60-, 90-day short-term oscillators that give us a picture of what’s happening. But again, when I run an oscillator on a small-cap stock, it’s almost worthless, unless it’s a super-liquid one.

Connors: Very interesting.

Navellier: If they’re liquid, they work. You need it on liquidity.

Connors: We all make mistakes. Is there that one mistake that stands out for you?

Navellier: Yes, well, we don’t like stocks. That’s a mistake. In fact, I’ve been known to fire people who like stocks. Because you have to say goodbye to them -- they’re not like girlfriends or something. But I have been famous for firing traders who started to like stocks because they get slow on the trigger. I think I have a sports-team mentality. So I want to sell something good to get something better. Let’s just say your name is Joe Namath and you’re a great quaterback but maybe you aren’t as good now as you used to be.  I’ll just throw you off the team. It’s nothing personal. Or let’s say your name is Michael Jordan and we know you’re a great player but maybe you’re starting to lose your step and I’ve got to cut your minutes before I throw you off the team. So sometimes I’ll trim a stock like I would in Michael Jordan’s case. Or sometimes I’ll just get rid of you like a Joe Namath.

Connors: Got you. The smartest thing you’ve done in 23 years? Is there anything that stands out where you did it immediately right and it stayed right for you?

Navellier: We don’t like to think we’re smart because that’s not a good characteristic and Wall Street is a very humbling place.

Connors: Last question. If you were to start over today, or give advice to someone who was starting today, what would you tell them?

Navellier:  Well, I would tell them to never stop learning because the market, what happens is you’ll find something that works and then it stops working when everybody does it. So you know, several years ago, we always saw that earnings surprises worked and that positive analysis revisions worked. It’s coming back in favor, but there are times when certain things don’t work and you can go out short just some of the dogs with fleas out there and you can just get buried on short-covering rallies. Dogs can rally easily 100% or so. A short-covering rally – and there have been big ones over the last couple of years… So I just think you have to always be learning and testing and any time I meet somebody that’s cockier, I know they don’t know what they’re doing…

Connors: That’s a good way to end this. I appreciate you spending the time with us.

Navellier: Any time, Larry. Thanks for having me.