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Lessons for Investors

The primary lesson of this chapter is that firms that have low price-earnings ratios may be neither undervalued nor good investments. If you combine that with the fact that the primary culprits for low PE ratios are low growth and high risk, it is clear that you want a portfolio of stocks with low PE ratios, high-quality earnings with potential for growth and low risk. The key then becomes coming up with the screens that will allow you to bring all of these needs into the portfolio.

  1. Low PE ratios: There are two decisions you need to make here. The first is the measure of PE that you will be using. Not only do you have to decide whether you will use current, trailing or forward PE, but you will also have to choose whether you want to use primary or diluted earnings. The second decision you have to make is on what cutoff you will use for a low PE ratio.

    In other words, will you pick all stocks with PE ratios less than 12 or only those with PE ratios less than 8? As noted earlier in the chapter, what constitutes a low PE ratio is relative. In other words, a PE ratio of 12 is low in a market in which the median PE is 25 but will be high in a market where the median PE is 7. To scale your choices to the level of the market, you can use the 10th or 20th percentile as the cutoff for a low PE ratio; which one you pick will depend upon how stringent your other screens are and how many stocks you would like to have in your final portfolio.

  2. Low risk: Here again, you have two judgments to make. The first is the measure of risk that you will use to screen firms. The standard deviation in stock prices and betas were used as screens in the last section, but there are other quantitative measures of risk that you could also consider. You could use the debt-equity ratio to measure the risk from financial leverage. In addition, there are qualitative measures of risk. Standard and Poor's, for instance, assigns stocks a letter grade that resembles the ratings they assign corporate bonds. An A-rated equity, by S&P's measure, is much safer than a BBB-rated equity. The second is the level of risk at which you will screen out stocks. With standard deviation, for instance, will you screen out all stocks that have standard deviations that exceed the median or average for the market or will you set a lower standard?

  3. Reasonable expected growth in earnings: While it is unlikely that you will find companies with low PE ratios and high expected growth rates, you can set a threshold level for growth. You could eliminate all firms, for instance, whose expected growth rate in earnings is less than 5%. How do you come up with this cutoff? You could look at the entire market and use the median or average growth rate of the market as an index.

  4. Quality of earnings: This is perhaps the toughest and most time-intensive test to meet. To do it right, you would need to examine the financial statements of each of the firms that make it through the prior screens in detail, and over several years. If you want simpler tests, you could eliminate firms for which you have doubts about earnings quality. For instance, you could remove firms that have the following:

    • Repeatedly restated earnings over the last few years: These can be a sign of underlying accounting problems at firms.

    • Grown through acquisitions rather than internal investments: Companies that grow through acquisitions are much more likely to have one-time charges (like restructuring expenses) and noncash charges (such as goodwill amortization) that make current earnings less reliable.

    • Significant option grants or profits from one-time deals: One-time profits complicate the search for “normalized earnings,” and large option grants can make forecasting per share numbers very difficult.

Taking into account these screens, stocks that passed the following screens were considered in October 2002:

  • PE ratios (current, trailing and forward) less than 12 (the 20th percentile at the time of the screening).

  • Betas that are less than 1 and standard deviations in stock prices over the last five years of less than 60% (which was the median standard deviation across all traded stocks). To control for the fact that some of these firms may have too much debt, any firms that had debt that exceeded 60% of their book capital were eliminated.

  • Expected growth in earnings per share (from analyst estimates) over the next five years greater than 5% and historical growth rates in earnings per share (over the last five years) that exceed 5%.

In addition, any firms that had restated earnings[8] over the previous five years or that had more than two large[9] restructuring charges over the previous five years were eliminated. The resulting portfolio of 27 stocks is summarized in the appendix at the end of this chapter. The portfolio is well diversified and comes from 23 different industries, as defined by Value Line.

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