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October 29, 2007 - The Little Book That Makes You Rich: A Proven Market-Beating Formula for Growth Investing (Chapter-by-Chapter Review)

In his 2007 book The Little Book That Makes You Rich: A Proven Market-Beating Formula for Growth Investing, Louis Navellier, Chairman of the Board, Chief Executive Officer and Chief Investment Officer of Navellier & Associates, Inc., outlines his systematic approach to investing in timely growth stocks. This approach derives from his analysis-based belief that the market does not efficiently incorporate key indicators of growth into stock prices. Here is a chapter-by-chapter review of some of the key points in this book, along with some links to relevant research summaries:

Chapter 1 - Let's Start at the End

• "In the end, what makes for a great growth stock is the ability of the company to continually sell more of its goods and services at high levels of profitability."
• Because the game changes, "it is necessary to rank stocks on more than one fundamental variable," occasionally tweaking their weights.
• "...[T]here are eight tried-and-true fundamental factors..."
  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

In summary, historical data indicate that portfolios based on stock rankings derived from these eight fundamental variables reliably outperform.

See our blog entries of 10/4/06, 8/29/06 and 8/14/06 for analyses of the power of accounting fundamentals to predict stock prices.

Chapter 2 - Counting on Growth

• "Listening to stories...is a lousy way to pick stocks..."
• "...[A] careful study and analysis of the numbers can help...find stocks with growth potential and big gains..."

In summary, ignore stock stories and trust systematic analysis.

See Blog Synthesis: The Value Premium for research on value versus growth.

Chapter 3 - Emotional Rescue

• "When put into play in the stock market, [cognitive biases] can lead to serious loss and damage to your net worth."
• "...[R]elying only on the input from the numbers keeps me from making...emotional decisions..."

In summary, it is important to use a system to keep emotions out of investing.

See Blog Synthesis: Animal Spirits Round-up for research on the role of emotions in investing.

Chapter 4 - Revise, Revise, Revise

• Analysts tend to estimate future earnings on the low side, and they are slow to raise estimates.
• The reluctance of analysts to raise estimates, and business cycle dynamics, make it likely that additional increases in estimates will follow the first one.

In summary, increasing analysts earnings estimates are powerful indicators of growth.

See the "Biases" section of Corporate Operating Earnings Trends for research on biases in earnings forecasts.

Chapter 5 - Surprise, Surprise, Surprise

• "Stocks with positive earnings surprises are the superstars of the growth stock world."
• "...[O]nce there is a surprise, more tend to follow..."

In summary, "earnings surprise is one of the strongest factors in" Louis Navellier's fundamentals ranking system.

Chapter 6 - Sell, Sell, Sell

• "The surest and truest way to measure real growth is to identify whether the company is selling..." either more units or higher-priced units.
• Persistent sales growth trumps bad markets and bad economies.
• "Because it is such a strong variable in...stock-picking success, slowing sales is a real danger sign..."

In summary, sales growth is a very important part of Louis Navellier's fundamentals ranking system.

Chapter 7 - Expand, Expand, Expand

• Profit margin expansion with sales growth (via cost cutting) does (does not) indicate sustainable growth.
• "Rising margins usually mean that a company is dominating its business space or has a new product. Inevitably this will bring competition and margins may begin to erode.

In summary, profit "margin improvement was one of the most successful of all variables over the past few years..." in predicting outperformance.

See our blog entry of 1/12/06 on mean reversion in corporate profitability.

Chapter 8 - Let It Flow

• "Free cash flow gives a company a lot of flexibility in its decision making."
• It also creates "the opportunity to do other things... [such as dividends and stock buybacks], all of which are good for investors."

In summary, "...the very best stocks ranked by production of free cash flow outperformed...by 59 percent" during 2004-2007.

Chapter 9 - It's All Variable

• "Stocks are ultimately priced on earnings... A company with higher year-over-year earnings is automatically worth a little bit more each time it reports..."
• "There are times when [earnings momentum] is easily one of the more important variables..."
• Return on equity "is a critically important number" but it should be compared only within industry groups.
• "...[A]ny single fundamental variable might work for a period of time and then all of a sudden stop doing well."

In summary, investors should use all eight fundamental variables to hedge against the faddish failure of one or two of them.

See our blog entry of 4/3/07 on the predictive power of earnings acceleration. See our blog entry of 5/16/06 on the predictive power of return on equity.

Chapter 10 - Know Your Alpha Beta

• Minimize systematic (market) risk by mixing and matching high-beta and low-beta stocks within a portfolio.
• Minimize unsystematic (idiosyncratic) risk by diversifying a portfolio across industries.
• Alpha comes either from transient short-covering or from other, more fundamental buying pressure.

In summary, "...stick to companies with sound fundamentals that have genuine persistent buying pressure, manage...betas so market fluctuations don't have an overly large impact, and diversify away risk..."

Chapter 11 - Don't Be a Deviant

• "When a stock's price movement is too jerky and erratic - or volatile - it's clearly a sign of bad things to come..."
• The standard deviation of a stock's weekly returns divided by its alpha (over the past 52 weeks) is a good measure of reward/risk.
• Stocks with high reward/risk tend to outperform predictably.

In summary, the quantitative stock grades in Louis Navellier's ranking system come from the ratio of true, non-short covering, alpha (high is good) to 52-week price volatility (low is good).

See our blog entries of 4/23/07, 6/12/06 and 1/26/06 for research confirming that highly volatile stocks are on average poor investments.

Chapter 12 - The Zigzag Approach

• "...[T]ry to find stocks that zig when others zag" to construct a diversified portfolio that will rise smoothly.
• A typical optimized (low volatility) mix is 60% conservative, 30% moderately aggressive and 10% aggressive stocks.
• Include a few calamity-resistant "oasis" (defense, food, tobacco, high-dividend) stocks as a hedge against disasters.

In summary, a "60/30/10 mix in conservative, moderately aggressive and aggressive stocks...is a very important part of keeping performance on the smooth path to riches..."

See our blog entries of 9/21/07 and 7/16/07 for research finding that outperforming hedge funds tend to have solid gains with low volatility.

Chapter 13 - Putting It All Together

• Find stocks with strong fundamental grades.
• Check quantitative (reward/risk = alpha/volatility) grades.
• Calculate overall grades with weights of 30% on fundamental grades and 70% on quantitative grades.
• Pick the best stocks to construct a 60/30/10 conservative/moderately aggressive/aggressive portfolio mix (at least 12 stocks, equally-weighted).
• Sell stocks that fall below the Navellier system grade of "C."
• Consider tax impacts when buying and selling.
• Long-term investors should not use stop-losses.

In summary, following these steps should produce smooth market outperformance.

Chapter 14 - Quantum Leap

• Tightening the criteria on fundamental and quantitative grades can produce spectacular returns (while requiring more attention and trading).
• Tax implications argue for using an IRA account for such a strategy.
• Use limit orders to buy and mental stop-loss points.

In summary, this strategy identifies the best performance based on the strongest fundamentals, catching the sweet spot in a stock's performance cycle.

Chapter 15 - It's the Economy, Stupid

• Falling (rising) interest rates favor value (growth) stocks.
• November through April is seasonally strong for stocks.
• "...[T]he market tends to do better in the first and third years of the election cycle."
• The news media feeds market weakness in summer and strength in fall.
• Funds tend to migrate in herds from one asset class to another.

In summary, "[i]nvestors need to be aware of the trends and cycles that can affect their portfolios..."

See Blog Synthesis: Calendar Effects for stock market dependencies on calendar cycles, Blog Synthesis: The Economy and the Stock Market for stock market dependencies on economic indicators and Blog Synthesis: Politics and the Stock Market for stock market dependencies on political conditions and the election cycle.

Chapter 16 - It's a Small World After All

• The fundamental-quantitative grading system works especially well on non-U.S. stocks.
• "...[T]here is a sort of value bias among most global investors," fostering the persistence of hidden growth gems.
• U.S. regulations are keeping international investment opportunities listed elsewhere.

In summary, "...take advantage of all the growth opportunities ahead around the world."

Chapter 17 - A Watched Pot Will Boil

• Stay informed by reading Investor's Business Daily.
• Monitor the fundamental and quantitative grades of stocks weekly.
• Check portfolio mix and rebalance to 60/30/10 as needed.
• "Always be searching for new and better stocks to replace the ones you own."
• Consider the state of market trends/cycles when buying and selling.

In summary, "[k]eep an eye on the boiling pot that is your stock portfolio at all times."

Chapter 18 - Lions and Tigers and Bears, Oh My!

• "The best way to protect yourself from fraud when screening stocks is to make sure a company's operating margins, return on equity, and cash flow receive high grades."
• "Be very wary of companies that seem to book extraordinary items [or adjust reserves] as part of their normal operating earnings!"
• "One of the greatest dangers to investors is Wall Street hype."

In summary, investors should stick to rigorous and systematic analysis of fundamental and quantitative factors.

Chapter 19 - Keep Your Eyes on the Prize

• "There will always be a crisis of some kind."
• "...[Y]ou ultimately have to be an optimist."

In summary, "[w]ith all the research going on today, and all the incredible breakthroughs of just the last 10 years, how can one not be an optimist...?"

See our blog entries of 1/26/07 and 7/17/06 on doom.

In overall summary, the book is a clear and concise summary of Louis Navellier's systematic approach to constructing and maintaining a timely growth stock portfolio intended to outperform in all market conditions. The book is written such that individual investors of average sophistication can easily understand it.

Note that the book has a companion web site that offers free (with registration) access to Louis Navellier's "stock-rating system called PortfolioGrader Pro," which the book frequently cites.

For reviews of a few other books, see Blog Synthesis: Reviews of Books and Web Sites.