Friday, November 22, 2013

The Way of The Value Investor (Part II P/E Ratio)

After identifying a righteous sustainable dividend in quality well managed company, look at the Price Earnings Ratio (P/E). This number represents the price of a share of stock divided by the earnings per share. For example if a share of stock costs $50.00 and the earnings per share is $2.50, this stock has a P/E of 20. All things being equal (they never are equal) a lower P/E ratio indicates the possibility of better value. Historically across the market 16.0 seems to be about average. Robert J. Shiller is famous for applying P/E to the entire market. The Shiller P/E index is a pretty good indicator of the future value of an average stock purchased in the market today. Under 16 it will be relatively easy to find bargains. Currently, the Shiller P/E ratio is 19.75, high but not dangerously high. History indicates that if the Shiller P/E ratio goes over 25, the market is heading for a fall. In early 2009 the Shiller P/E index dropped below 15 at such levels a blind monkey can pick winning stocks.

The key to using the P/E ratio is to help locate sustainable high dividends. Over the last 50 years, the number one best single stock you could own has been the cigarette manufacturing company the Altria Group (MO). Because of the fear of law suits, high taxes, and government regulations these stocks have been persistently undervalued. For the same reasons cigarette companies have been generous with their investors. They would rather see their shareholders get their profits than passing the loot to governments and lawyers. History indicates that these fears were somewhat unfounded. Government really doesn’t want to stop smoking. They would lose all that tax revenue. Money lost to the lawyers can be passed on to today’s smokers. Finally, it is a big world out there and American cigarettes are still the gold standard for coughin’ nails. Today MO has a P/E ratio of 14.40. It pays a dividend of 5.17%. Try and find that kind of return on a bond or CD. It has a payout ratio of 80.0. That’s a little scary, but as I mentioned, they are generous with their investors. For the record, I do not own MO. My wife does not wish to be a merchant of death. I respect her wishes. She does own a very small amount of a cigarette company in her managed IRA. However, if you won’t tell her, I won’t tell her. Also, “ethical” investing is impossible if you have anything in mutual funds. There is no telling what you have somewhere in that stew of 200 or more companies.

Patience in investment, as in life, is a virtue. Don’t think in terms of annual or quarterly return on your investment. Look at the long term. Buy cheap and hold. Think like a catfish. Sit on the bottom and wait. Something tasty will show up.

Your brain is wired to sell when your losses are at their greatest and buy when a market is nearing its peak. Your brain is wrong. Lord Nathan Mayer Rothschild (yes, he was one of those Rothschilds) observed, "Buy to the roar of cannon, sell to the sound of trumpets.” It was sound advice during the Napoleonic Wars and it is sound advice today.

1 comment:

  1. That last bit is especially poignant. I never really thought how others invest, only how I do it. Of course, I'm young, so in my case it's generally applied to growth and not value. The higher a stock rises, the less its potential becomes, and vice versa. If I'm going to take a risk with my money, I want the biggest potential return on my investment.

    Of course, there are always so many factors that determine that potential, but as a general rule of thumb, I won't even consider a stock if I'm coming in late to the party.