Tags: Martin Hutchinson

When Boring is Best: How to Ferret out Bargain-Basement Profit Plays

By , Money Morning •

By Martin Hutchinson
Contributing Editor
Money Morning        

When stock market legends such as Warren Buffett, Jim Rogers or Sir John Templeton troll for investment plays, they hold out for bargains.

The investing masses would do well to follow suit: All too often, investors fail in the markets because they pay Neiman-Marcus prices for Wal-Mart stocks. If a stock is carrying a sky-high valuation - even if the company performs as it should - shareholders may end up sitting on losses that don't go away for many years.

So-called "value" stocks, by contrast, have less downside risk, and often also carry a hefty dividend yield, which can go a long way toward assuaging the pain of a mediocre capital performance. Buffett, the chairman of Berkshire Hathaway Inc. (BRK.A, BRK.B), and Templeton have followed this formula through the years, with famous levels of success. So has Jim Rogers, perhaps the most successful Contrarian investor of our time. [To see how you can obtain a free copy of Jim Rogers' latest bestseller, "A Bull in China: Investing Profitably in the World's Greatest Market," please click here.]

However, as with any other area of investing, there are a few pitfalls that need to be avoided.

In this bargain-hunting stock primer, we'll study some strategies that work, and will review some problems to sidestep.

When Low P/Es Translate Into High Profits

One of the best ways to determine whether a company is a bargain is to examine its Price/Earnings (P/E) ratio - which relates the current share price to one of several different measures of a company's annual earnings per share. Conservative investors look at P/E ratios on a "historic," or "trailing" basis - examining the company's earnings over the last 12 months - while more aggressive investors look at "leading" or "projected" P/Es - which are based on earnings forecast by analysts for the year in progress, or even for the fiscal year that has not yet started.

The advantage of forward or leading P/E ratios is that it generally gives you a lower number [if earnings are expected to increase], which is why many analysts, brokers and other slick salesmen prefer to use them. The advantage of historic P/E ratios is that the earnings are real, and in the books [or at least, they are if management isn't playing silly games with the accounting], which means that you are basing your analysis on a solid number.

In a deep bear market that hasn't actually blossomed into a full-fledged recession, the average P/E ratio on the stocks in the Standard and Poor's 500 Index can get down into the single digits. In 1949, for instance, the P/E on the S&P averaged a mere 7. Any time you see a P/E ratio that low for the market as a whole, it's a pretty firm "Buy" signal.

At the upper end of the P/E spectrum, the highest non-recession range for P/E ratios for the market as a whole is around 20, reached in the late 1960s - and repeated in the late 1990s. However, if a severe recession hits, earnings plummet a lot more than stock prices, so you may even have a period in which the S&P 500 as a whole makes a loss, and its P/E ratio is correspondingly infinite. We had such a year in 1981. In 2002 P/E ratios got very high, but earnings didn't fall enough to propel them to infinity.

Growth Stocks and the Not-so-Nifty 50

Proponents of so-called "growth" stocks believe that investors should invest in companies that are posting rapid earnings growth, with less of a focus on prices or valuations. The growth-stock school has been around for a long time, and growth-stock investors generally do well during economic upswings, and strong bull markets for stocks, since that's when corporate earnings increase most rapidly.  This investing discipline is often given different labels. At the top of the 1972-73 bull market, for instance, advocates said you could get rich by investing in the so-called "Nifty Fifty" - such large-cap growth stocks as Avon Products Inc. (AVP), Eastman Kodak Co. (EK), McDonald's Corp. (MCD), Polaroid, or Xerox Corp. (XRX), whose escalating P/E ratios reflected their high quality and perpetually excellent profit prospects.

Investment managers chose their stocks rather like they chose their dinner guests - only the truly superior were invited.

Well guess what? Like aristocratic dinner guests, some of those growth stocks tuned out to be ne'er-do-wells, and others turned out to be boringly plebian and stodgy. Only a few proved their elite status by continuing to provide the growth they appeared to promise. Thus, for every McDonald's, which continued to grow at double-digit rates for the next 30 years, there was a Xerox, which was overtaken by newer technologies and fell back, or a Polaroid, which went bust altogether.

Investment guru Jeremy Siegel tried to revive the case for growth stocks at the top of the bull market in 2000, and proved that the average return on the "Nifty Fifty" stocks from 1972-2000 was less than 1% below that of the market as a whole, but guess what? That simply proved that 2000 was also the top of a bubble, and that some stocks that had been overpriced in 1972 were still overpriced in 2000. The real truth was that the "growth" stocks of 1972 proved exceptionally vulnerable to the next market downturn, falling 80% to 90% over the following years, and only then did some of them prove to have long-term operational resilience and begin to climb back. The fact that, if you had waited 28 years, you could have achieved a more or less market return on a holding of growth stocks is no reason to buy them.

After all, if you had needed the money at some intermediate point during the 28 years you'd have had to sell at a thumping loss.

Definitely Dig Those Dividends!

A recent study by Yale University's Robert Shiller showed that in the 109-year stretch from 1889-1998 - including most of the biggest bull market in history there in the latter part of the 1990s - the average real return on common stocks was 7%, of which 4.7% was represented by dividends.

In addition, retained earnings form an important component of stock returns, so that around 97% of those profits can be accounted for by dividends and retained earnings - with only 3% being due to a change in their valuation.

Intuitively, this makes sense. Over a very long period of time, it is impossible for stock valuations to change sufficiently to generate an important part of the total return from holding them. Even if earnings increase rapidly for a few years, the stock can sell at an increasing multiple of its tangible book value for only a limited period of time; after that the higher earnings themselves must generate the bulk of its return.

Thus, if you buy a stock with either a low P/E ratio or a high earnings yield [which is the same thing], you may get a higher return from dividends. But even if you don't, you will certainly get a higher amount of earnings retained each year, which will build the book value of the company more rapidly and enable its stock price to rise.

That's why, in picking stocks for both Money Morning and The Money Map Report, I always pay close attention to the P/E ratio, seeking those stocks whose valuation is modest in terms of both the market they trade in and the business sector they compete in.

There's one caveat to all this. Going into a recession, cyclical stocks may have a very low P/E ratio based on past earnings, but still be very poor investments. The reason: The earnings going forward can be expected to decline sharply or even disappear altogether.

Even more important, it is foolish to treat dividend yields as an equivalent to bond yields if there is a significant chance that poor operating results will cause management to cut the dividend going forward.

When it Pays to be Bored

Right now, in the financial-services sector, commercial banks and investment banks are both being forced to take massive write-offs as a result of their foolish forays into the subprime-mortgage market, investments in asset-backed commercial paper, and sundry other related sins. While a single such write-off may not affect the dividend, if additional write-downs are required, the odds become increasingly likely that investors, lenders and the credit-rating agencies will demand a drastic reduction in dividend payouts, if not an outright elimination of the quarterly payments. Moreover, if the top management team is ousted - as has happened at Merrill Lynch & Co. Inc. (MER), Citigroup Inc. (C), and others - the new management team may believe it's best to eliminate the dividend as a means of conserving cash.

At present, for example, Merrill Lynch recently sported a P/E ratio of only 11.8, based on its 12 month trailing earnings, and a dividend yield of 3.0%.  If those trailing earnings could be dependably replicated going forward, we could project an annual investment return of about 8.5%, given the 3% dividend plus retained earnings of 5.5%  [its total earnings yield being 100/11.8 = 8.5%].

Unfortunately, Merrill has booked some huge write-offs on its subprime rubbish and given its chief executive officer the boot [with a $160 million "golden handshake!"]. It now seems likely that Merrill will need to take additional write-downs in the future. And there are widespread worries the investment banking and brokerage businesses are skidding into a cyclical downturn. For these reasons, Merrill's attractive valuation could be a trap - if you buy the shares and there are more write-offs beyond those that are already projected and theoretically therefore already factored into the share price, you run the risk of taking a loss on your investment - particularly if the dividend is reduced, or eliminated altogether.

Clearly, there are two reasons why stocks might have an attractive valuation:

  • One is that the stocks are risky, and that the market expects a downturn - in the stock itself, in the sector it plays in, or in the market as a whole. Those expectations don't always come true, and that can make the shares a bargain play. But the risk is clearly high.
  • The second is that they are boring, perhaps not followed closely by analysts, or aren't in a fashionable country or sector.

For me, it's always been true that boring is best.

[For a Money Morning Investment Research Report, "How Buying Like Warren Buffett Can Boost Your Portfolio Profits," please click here. The report is free of charge].

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