Many investors acquire the habit of focusing on stocks that have an attractive reading on a single investment measure. The price-earnings ratio is a good case in point. But that one measure might disguise problems that could make the stock a disaster-in-waiting.
When they look for stocks to buy, investors sometimes focus on those with an attractive reading on a metric like a low per-share ratio of price-to-earnings, a low price-to-book-value ratio, or a high dividend yield. This seems like a quick, easy way of spotting an investment bargain.
However, most investment measures fall on a spectrum that ranges from suspiciously cheap to extraordinarily expensive.
The low p/e trap
For example, suppose you decide you will consider buying stocks only with a per-share price-to-earnings ratio of 10.0 or less. That way, you hope to get more earnings for each dollar you invest. But the “e,” or earnings, in the p/e ratio only covers earnings, or an earnings estimate, for a single year. The year your low p/e covers may coincide with a peak in the company’s earnings, for any number of reasons.
One key reason is that many disasters-in-waiting go through a low-p/e period prior to their eventual collapse. During this low-p/e period, people close to or involved with the company recognize that it has serious problems. They sell their own holdings and they tell their friends and relations to do the same.
Another common problem is that the company is cyclical and is at the top of its business cycle. (It’s easy to overlook the fact that tech stocks tend to be cyclical. Their growth can mask the typical peaks-and-valleys of a business cycle.)
Specific reasons why a company’s profit may slump for one or more years include the expiration of a patent, new competitors, a rise in costs, adverse legal or regulatory changes, or investigations for illegal activity.
As the saying goes, that low p/e may signal danger rather than a bargain. Note, however, that staying out of high-p/e stocks can also hurt your results.
It can be a mistake to buy “suspiciously cheap” stocks
Amazon.com Inc. (NASDAQ: AMZN), provides one of the decade’s best examples. The stock bottomed out at $36 in October 2008, six months prior to the bottom in the market indexes. Since then, it has risen more than tenfold. During that time, its p/e ratio ranged from more than 100-to-1, to well above 1,000-to-1.
The company has wisely taken advantage of a growth opportunity, as it entered new areas of online marketing. It did so by reinvesting a large part of each year’s gross earnings in the business. This pushed down the final earnings, or “e”. At the same time, the stock soared. These two factors combined to push the stock’s p/e to record heights.
Here are four key points to take away from all this:
1. Check context. To get any real value out of any investment measure, p/e’s included, you need to look at them in the context of everything else that’s going on, in the market and in individual stocks.
2. The metrics spectrum. Most investment measures fall on a spectrum that ranges from suspiciously cheap to extraordinarily expensive.
3. Resist extremes. It’s a mistake to focus on stocks in the “suspiciously cheap” end of the p/e spectrum. It’s also a mistake to reject stocks of out hand, just because their high p/e’s make them seem too expensive.
4. Look to the middle ground. Most investors, most of the time, will find their best opportunities in the middle of the spectrum, far from the extremes of suspiciously cheap to extraordinarily expensive.
This post originally appeared on TSI Network, © 2015 TSI Network.
Patrick McKeough, host of the TSINetwork.ca investment website, has been a professional investment analyst for more than three decades. He is also a portfolio manager and the editor and publisher of four investment advisories: The Successful Investor, Wall Street Stock Forecaster, Stock Pickers Digest, and Canadian Wealth Advisor. Follow Pat on Twitter and Facebook.
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