What do Warren Buffett, Ben Graham, Seth Klarman, and Peter Lynch all have in common? Besides being wildly successful investors, they're all are adherents to value investing, a method where one attempts to buy securities that have a higher intrinsic value than their current price.
One of the most basic forms of value investing is to find stocks with low price-to-earnings (PE) ratios. The PE ratio is a simple ratio that divides the current price per share of a company by the earnings per share over the trailing 12-month period. The logic behind buying low PE stocks is simple: As an investor, you are ultimately entitled to a pro-rata portion of company earnings, so paying the lowest cost, or multiple, for those earnings is preferable than paying a higher multiple. Essentially, your dollar is buying a larger portion of company earnings than it would with a high-multiple stock.
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The risk of investing in low PE stocks
Success by investing in low PE stocks far from guaranteed. In fact, there are a few prevalent risks with using low PE ratios as your sole source of investment decision-making. First, multiple factors can determine earnings, and not all are directly related to the company's operations. Non-operational company actions like gains from sales of equipment or subsidiaries, tax benefits, or winning a lawsuit are required to be reported as earnings, which skews the earnings upward. Likewise, losses from equipment sales, restructuring, or losing a lawsuit can temporarily depress earnings. Many financial outlets report normalized earnings to account for extraordinary items and discontinued operations, but it's not guaranteed.
The second risk of investing in low PE stocks is related to operations. Investing is a forward-looking endeavor while the PE ratio is a backward-looking metric. When investors feel a company's prospects have noticeably declined due to industry changes, economic conditions, or poor operations, they will proactively sell the company, depressing the price and leading to a low PE ratio. Often, this is referred to as a value trap if the company underperforms.
For this reason, many investors use estimated earnings over the next 12 months or forward earnings. However, it's important investors understand these are earnings estimates and may not be attained by the company.
Conversely, low PE stocks that can turn things around often overperform as both increased earnings per share and multiples propel the stock higher.
Top ten cheapest companies in the S&P 100
Gilead Sciences is an example of investors dimming on the company's future prospects. In October the company's stock fell 7.5%. Year to date the stock has only gained almost 3% while the market, as defined by the S&P 500, is up more than 15%.
Shares of the company only trade at a PE ratio of 8 times earnings. In Gilead's case, this is due to investor concerns about its profitability going forward. Colleague Cory Renauer provides more detail, but a major reason is a poor sales forecast for its hepatitis C virus franchise. Often pharmaceutical manufacturers have only one or two drugs that provide the majority of their revenue and earnings. If they are underperforming or about to go off-patent, investors can sell the stock and depress PE multiples.
Altria Group's PE ratio suffers from two major factors. The first issue is that the company is operating in a business with declining users. From 1965 to 2014, the last time the CDC conducted its survey, the U.S. smoking rate for adults has decreased from 42.4% to 12%. As the parent company of Philip Morris USA, a cigarette producer, and cigarmakers John Middleton and Nat Sherman, it's logical investors are nervous about its long-term success. The second is the increase in socially responsible investing. Investors are increasingly unwilling to investing in stocks they consider traffic in harmful products or behaviors such as tobacco, alcohol, guns, and gambling establishments.
Interestingly enough, even though smoking rates have declined substantially. Altria, formerly Philip Morris is the best performing stock since 1968. This year hasn't nearly been as kind with a 3% year-to-date loss.
General Motors Company
General Motors an example of a company that suffers from extraordinary items and discontinued operations. In the recently reported third-quarter, the company reported a generally accepted accounting principles loss of $2.03/share, mostly due to selling a German subsidiary. However, the chart above uses adjusted/normalized earnings instead of GAAP-compliant earnings, as the former is more reflective of the company's operations.
General Motors operates in the highly cyclical and volatile auto industry. For the last few years, this has been a benefit because auto sales have been robust. However, in the event sales slow, it's possible for auto manufacturers to quickly swing to losses. GM, under the leadership of CEO Mary Barra, is taking measures to ensure this doesn't happen. However, for many investors memories of the company's U.S. government bailout in 2009, where shareholders were essentially wiped out, has discouraged investment and kept PE ratios low.
Verizon operates in a particularly challenging environment. Its wireless communications division now is under price pressure from competitors AT&T, T-Mobile, and Sprint. The company has a high debt load, with a debt-to-equity ratio of 4.3 times. While the company does produce significant cash from operations, it requires a lot of cash to upgrade and maintain its networks: both its wireless network and its FiOS television service.
As my colleague Evan Niu noted, Verizon did a good job in the recent quarter, continuing to add wireless subscribers in the face of strong competition, although at a lower average revenue per account. At almost 12 times earnings, investors seem unsure the company can continue to grow its bottom line.
Everybody loves a sale...
It's often said value investors are attempting to buy a stock on sale. As a shopper, it's important to understand what you are buying. Using a PE ratio is a good starting point, but it should not be the only metric one uses to evaluate stocks. If anything, be skeptical when a stock has a low PE ratio because often it's due to non-operational items or the rest of the investing community is strongly bearish on the company.
However, bearish sentiment can sometimes over discount a stock and if you have a knack for finding low PE companies that are improperly discounted, you may be able to join the ranks of the great investors mentioned at the top of this article.
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