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INTERVIEWS


An Interview With Fund Manager Louis Navellier

10/25/00 12:51:27 PM PST
by Jason K. Hutson

With more than 15 years of experience behind him, Louis Navellier, founder and president of Navellier & Associates, Navellier Management, and editor of MPT Review is a well-known figure in the investment world. He makes frequent appearances on Wall $treet Week, The Nightly Business Report, and CNBC and is frequently quoted in financial journals and periodicals such as Investor's Business Daily, Barron's, Forbes, and The Wall Street Journal.

Navellier offers highly regarded investment letters such as Mutual Funds, Blue Chip Growth Letter, and MPT Review. Most of his mutual funds have been rated four to five stars by Morningstar, Inc., and he has never had a down year since he got into the money management business in 1985.

His success can be credited to his ability to follow a disciplined, quantitative, and bottom-up stockpicking approach. Following it has helped him reach his objective of seeking optimal returns while minimizing risk for long-term investors. In a late August telephone interview with Jason Hutson and Jayanthi Gopalakrishnan of Working Money, Navellier discussed the techniques he utilizes for selecting stocks.




What inspired you to start your own fund? Basically, I started by publishing my research in 1980 and then moved on to publishing MPT Review before I managed money. It was a logical step. After managing money, I wanted to be in the mutual fund business. I got in the business five years ago and now I have lots of funds. In fact, my biggest client is one of my mutual funds. I also run money for the Pilgrim Fund family. I run a fund for them as well as an annuity; I run $1 billion for them.

Our sister publication, Technical Analysis of STOCKS & COMMODITIES, interviewed you in 1994. How have your analysis methods changed since then? We have gotten a lot more sophisticated. Basically, we take our universe of stocks and test what fundamental variables work. Once we figure that out, we run them through an optimization model, which tells us how to weight the individual stocks.

What's your first step for stock selection? The first step is to take our universe of more than 9,000 stocks and pare it down to a universe of approximately 450 with great reward-risk characteristics based on alpha and standard deviation (see below).

 
Which is, for our readers? Alpha is a measure of stock performance, the premium that a portfolio earns above a certain point. And the standard deviation measures how risky the stock is. We calculate these numbers against the most relevant benchmarks such as the Standard & Poor's 500, Russell 2000, and Nasdaq -- which one really depends on the fund. We also use statistical benchmarks, like R-squared. We use about six different benchmarks that continue to work well.

And using alpha can be tricky; we have to be careful about the high-alpha stocks. Unfortunately, alpha could also be created by something like a rumor on the Internet, so we want to make sure we have something we can sink our teeth into. We want to identify the fundamental force creating the high alpha.

How do you identify the fundamental force? That's where the backtesting comes in. We retest things that work on a one- and three-year basis and only use those that work. Right now, for instance, our small- to mid-cap funds are based on earnings momentum, stocks with strong earnings to price histories, stocks with positive analyst earnings and positive earnings upgrades, and stocks with strong operating growth. Operating growth is important because lots of companies manufacture their earnings through acquisitions. Finally, those companies on which the funds are based have to have strong revenue growth and high liquidation value. A lot of them get acquired frequently.

So by measuring alpha and standard deviation, we get the reward-risk ratio. We only pick those in the top 5% -- those stocks that meet our objective of generating the highest reward with minimal risk. The stocks that make it on this list are published in MPT Review under "Buy List." Once we rank the stocks under those criteria, it's time to score the stocks on a model we use with a number of fundamental factors. Not surprisingly, the stocks that score the highest perform the best.

Which takes us to your second step, selecting fundamentally superior stocks. How do you select those? I score stocks to see which ones are fundamentally superior. I study 36 criteria such as strong sales, strong earnings, profit margin, profit expansion, analyst upgrades, earnings momentum, and so on. We then backtest these variables and weight them over their one- and three-year performances. Based on what works, we build a stock selection model, which varies from fund to fund. For example, currently in our small- to mid-cap growth model, we look at six factors. The first is the IBES 1 month, which makes up about 21% of the model. The other criteria include liquidation value to price, which is 11%; sales change, which is 8%; EPS change, which is 24%; earnings momentum is about 22%; and standardized unexpected analysis, which is 14%.

How often do you change these weightings? We change them every quarter, just because they correspond with corporate quarterly earnings. If any criterion doesn't seem to be working well, at the end of each quarterly earnings cycle, we throw it out and substitute something that does.

What happens then? The next step is optimization, which is basically for allocating stocks that complement each other to create the best portfolio we can. The model is set up so we can reduce risk as much as possible.

How often do you run these tests? Essentially, we score the stocks every week based on fundamentals -- kind of like you would score a basketball player on assists per game, rebounds, free throws, whatever. Just as you can score that athlete on his or her skills, you can score a stock on its fundamentals. The main difference is our computer calculates what the optimal weight is, unlike when you were in school and all your grades carried the same weight in your GPA. So we score the stocks every weekend and backtest how that model works. That seems to work pretty well.


What programs do you use for backtesting? We are one of the biggest users of a service called FactSet. Factset Research Systems caters to institutional managers, and they have been kind enough to let us test their software on occasion. They give us a quantitative system and we manipulate it and essentially figure out how to blow it up. That's what we do -- we pride ourselves on that!

Does your system tell you when to sell stocks? Oh, yes. Every weekend, we sit and crunch all the numbers. If we see a stock has increased in risk, we cut back on our positions. Basically, if a stock goes out of favor based on the variables of our model, we'll sell the stock.

Not only that, I also call the companies on a quarterly basis and talk with the chief financial officer and the treasurer. If I get any hint the operating margins could come under pressure, I sell the stock.

Most of your analysis involves selecting individual stocks. Do you do any analysis to determine which industry sector is the hottest? No. We are entirely bottom-up. We use what we see on our computer screens to select stocks. We usually end up in the best industries, but the truth is we back into that. Sector selection is really a byproduct. You will find us in 15% of some groups like semiconductors. Oil services are really hot right now, so we have some of those in our funds.

How often do you check the outcome of your models? We retest the models quarterly when we get fresh financial data. But we also run the system every weekend using last quarter's model.

How often do the stocks change in your different funds? It depends on the risk. Large-cap growth and value tend to have 45-60% turnover. Mid-cap growth is about 90% turnover. Get to the smaller micro-caps and you can push 110-140% turnover. The more volatile the vehicle, the more turnover is required.

From a tax standpoint, given this turnover, how do you keep distributions low for the benefit of your shareholders? Glad you asked. My most successful management program, one that I've had for more than 15 years, is our small- to mid-cap fund program called the floater. It floats between those two categories. If someone had given me a dollar 15 or so years ago, it would have been worth more than $35 by the end of June 2000. We have been growing 26% a year. We are in our 16th year and have never had a down year. With that floater program last year, we had a 70% turnover. Normal turnover may be 90-110% in some years, but last year, even though we had 70%, the shareholders only had to pay 15% in taxes.

How did you manage that? The key to tax efficiency is to keep losses short term and harvest as many long-term gains as possible. If a loss goes long term, you lose 80% of your writeoff. So you want to keep all your losses short term and harvest as many long-term gains as possible. Normally, I like to keep my investors in the best 30 stocks in their respective categories -- best 30 micro-caps, 30 small-caps, mid-caps, large-caps, and so on. It's not unusual to see 34, 36, 38 stocks in the portfolio, because I have earmarked four to eight stocks that are 12 months and one day old. So if the system says to sell after the 10th or 11th month, don't be surprised if I wait four to eight weeks to sell to book the long-term capital gain.

What would be the first thing you tell someone just getting started in investing? I think he or she should get started investing in mutual funds. I'm not saying that just because I'm a mutual fund manager; it's just a safer place for investors to start out. There's less volatility with a group of stocks than with any one stock. If an investor can handle the volatility with a mutual fund, then he might want to try stocks next. But I really think people should start with funds first.

What's the first step someone should take to select a mutual fund? I would try to do four- and five-star funds. I would try to go with funds that are growing. I would make sure the manager has been around for two to three years -- that's a big problem in the fund business. For aggressive investors, I would suggest 40% in large-cap, 40% in mid-cap, and 20% in small- or micro-cap. If those investors were conservative, I would do 60% large-cap and 40% mid-cap. This is not really my expertise. We show our clients graphs that suggest these various allocations.

What factors do you base these allocation models on? There's nothing analytical about them. They are there to make people think. One of my professor friends, Arnold Langsen, writes a newsletter called Prudence and Performance. He talks about a couple of optimization models to mix and match funds and he is also an expert in sector funds. Take the software he has -- he used to sell it; I'm not sure if he still does. Hook it up to funds to mix and match. Say you have an 8% pain threshold. It will give you the best mix based on the last three to five years.

One of our goals at Working Money is to encourage young people to save as much money as they can early on. Do you have a personal example you could share? It's the miracle of compounding. The earlier you start, the better off you are. The government gives us certain tax incentives to save, and you want to take advantage of those. If you can save and let it compound, you'll have a nice profit. That's what I try to do. I manage a lot of pension funds, more than $6 billion overall, plus CDs. Counties, municipalities, hostels, foundations, unions, and insurance companies are my largest clients. I am my own biggest client. And I am obsessed with what I do.

What are some of your plans? At Navellier, our main goal is to do things our major clients and distributors want. I'm not big on load funds; I'm more into no-loads, but I play both markets. I have both no-load and load annuities. We have seven good no-load funds. But the broker-dealer community says, "Just give us something that produces." So we started a top-20 fund. That's the kind of thing we'll continue to develop. And we currently have an all-capitalization fund in the works and an international American Depository Receipt (ADR) fund in the works.

We try to do what the distributors want us to do. Right now, they're clamoring for a tech fund, which I'm not crazy about. I like to mix things up; that way, the risk goes down. But everyone wants tech funds. I am from the West, but I have more business in Mississippi than I do in California! Out West, people favor a race-car driver philosophy -- if there's a turn coming up, they don't slow down; they hit the gas. They're a little more aggressive than I'm used to.

So what's your outlook for the rest of the year? Unbelievably positive. Interest rates are stable, volume is firm, and earnings are expected to continue growing. I think we'll see a rally into the election. I am very bullish.

What do you think will outperform over the next couple years? I think oil services. Oil drillers are in the early stages of a long-term rally. I also think independent power producers are taking advantage of high utility costs in certain parts of the country. They just sell power at surplus rates.

What else? There are tons of special semiconductor companies that make chips for high-definition TV, global positioning navigation systems, all these things people don't know they need but are going to get when they buy a TV or a car now. I also like high-margin companies that dominate their business. In our small- to mid-cap funds, the average stock right now shows more than 80% revenue growth over the past few years. Earnings are still growing over 600%. They're growing faster than revenue, and this creates tremendous profit margin expansion.

Any favorites? I especially like independent power producers like Calpine Corp. [CPN] and Dynegy, Inc. [DYN]. I also like oil services such as BJ Services Company [BJS] and Lone Star Technologies, Inc. [LSS]. Another area I like are the semiconductors such as Applied Micro Circuits Corp. [AMCC].

Thanks for your time, Louis.



Jason K. Hutson

Traders.com Staffwriter. Enjoys trendlines, support and resistance, moving averages, rsi, macd, adx, bollinger bands, parabolic sar, chart formations, volume analysis.




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