WS: BUY STOCKS LIKE STEAKS, IV (09 Oct 2006)

BUY STOCKS LIKE STEAKS, IV

A tried-and-true method of successful investing is to buy stocks selling at a low multiple of their earnings. Earnings are what a company has left after it has paid all its bills. Ben graham once remarked that earnings are the principal factor driving stock prices. If I accept this as truth, and I do, then the less I pay for a stock when compared with earnings, the better my future return should be. Makes sense, right? I primarily measure earnings-to-stock price by comparing the price-to-earnings (PE) ratio, to other companies and the broader stock market indices.

The PE ratio is easily determined. It is the company's stock price divided by its profits, usually reported as earnings per share (EPS). If the ABC Ice Cream Corp earned $1 million last year and had 1 million shares outstanding, the EPS would be $1. If the stock price was $10, the PE ratio would be 10. If the price of the stock was $20, the PE ratio would be 20. Some investors refer to the inverse of this as the earnings yield. It reflects the return you would receive if all the earnings were paid out in cash as a dividend rather then reinvested in the company. A stock with a PE of 20 has an earnings yield of 5%; a PE of 40 equals an earnings yield of 2.5%. Remember: the lower the PE, the higher the earnings yield.

Whether we think about our returns in terms of PE ratios or earnings yields, it is all the same. Analysts tend to look at PE ratios from two perspectives. There is the trailing PE, which is the stock price divided by the most recent fiscal year or past four quarters of earnings. Then there is the forward PE, which is the stock price divided by analysts' estimates of how much a company will earn in the next year or next four quarters. Most stocks trade based on what the market thinks the company will earn in the future. The past is the past.

When it comes to projecting earnings, however, the track record of stock analysts is spotty at best and highly inaccurate at worst. When noted investor David Dreman looked at analyst estimates from 1973 to 1993, a period containing 78,695 separate quarterly estimates, he found that there was only a 1 in 170 chance that the analyst projections would fall within plus or minus 5% of the actual number.

Corporate earnings are full of surprises; some positive, some negative. Were it possible to truly know the future, you could make a bundle. Graham's focus was to look for companies with a reasonably stable record of earnings, a degree of predictability, rather than to search vainly for the specific future earnings estimates from analysts. With that in mind, it is still better to just buy the cheapest stocks based on earnings that have already been tallied, audited, and reported to shareholder.

Over the years, numerous studies have examined the results of buying stocks at low PE ratios versus buying high PE ratio stocks. Each study-- over time periods from 1957 to the present, and measured over a period of 5 to 20 years-- confirms that buying cheaper, less popular stocks brings far greater returns. This holds true across industries and developed countries. Value investing, buying earnings cheaply, is the most reliable way I know to grow your nest egg, not because I say so, but because it's also been shown to be so-- time and again, throughout the decades in numerous academic studies.

The earnings, as reported by most major companies, are a starting point, but just a starting point. These numbers can frequently be misleading and may contain large one-time charges and credits that mask the true earnings of the company. Some finance professionals prefer to use cash flow, or operating earnings. Cash flow is the reported earnings with all noncash expenses such as depreciation and amortization added back. Free cash flow is cash flow minus the capital expenditures that are needed to maintain the assets of the company. Put another way, if I owned the business, how much money could I take out each year and still keep the doors open?

The low price relative to earnings approach has led to some of the best investment opportunities I have seen in my career. Buying low PE stocks works in both good markets and bad markets. You just have to wait a little longer for your return in a bear market. But the best part of following a low PE strategy is that it forces you to buy stocks when they are cheap while fear is running high. During these times, all the babies get thrown out with the bathwater. Such opportunities do not come on the heels of great times; they are preceded by much pain.

When stock markets are cheap in general, we are in periods of economic uncertainty. Investors have low expectations for returns going forward. Recessions, high interest rates, war threats, and other malaise rule the day. Fortunately, periods like this are the exception. Mostly, the world gets by. Economies grow at more historic rates, and there is an ebb and flow of the fortunes of individual businesses.

But just as market can go to extremes, the valuations of individual stocks also can go to extremes. Many times throughout the cycle, companies are undervalued and overvalued. Low PE stocks are usually low expectation companies. The stock market does not perceive them to have a bright future, perhaps because they got beat up during a down period, perhaps because they have simply fallen out of favor or there are shinier-looking stocks in the store.

High PE stocks, on the other hand, are usually high expectation companies. Everything is going right, and investors are convinced their run of great returns will continue for many years. As the legendary manager of the Vanguard Windsor Fund, John Neff, once said to me, "Every trend goes on forever until it ends." Things change and trends do not go on forever.

The world of investing, not unlike life in general, is filled with positive and negative surprises. It is important to understand how these surprise events affect stock prices. Study after study has shown that when a low PE, low expectation stock reports disappointing news, the effect is usually minimal. The market anticipated bad news, and there was no need to knock the price down much further. Conversely, when a low expectation stock surprises the market with good news, the price can pop. The reverse is proven to happen with high expectation stocks. You don't have to look any further than the tech bubble of the 1990s to appreciate the point (and the pain). In 2000, 2001, and 2002, I compiled lists of stocks that declined 90% or more. They were long lists.

Credits: Much of this article, with modification, is extracted from The Little Book Of Value Investing by Christopher Browne, 2007.



POSTED :09 Oct 2006