Investing in Up or Down Markets

cropped-bob-shapiro.jpg   By Bob Shapiro

Stock prices can be analyzed in a number of ways, to determine whether they are high, low, or fairly priced.

The Price to Earnings Ratio (PE) takes the most recent price of the shares and divides it by the most recent earnings, usually for the last 12 months. This Trailing PE allows you to compare a company’s price today with its price last year or 5 years ago, on an apples to apples basis.

It also allows you to compare to other companies in its industry (or the industry average) or to the stock market as a whole. You also can compare to stock markets around the world.

The PE is imperfect at best, as company managements have some ability to manipulate the earnings part of the PE. They may draw a small amount of earnings forward, or they may defer earnings. And, as I have mentioned previously, they may inflate per share earnings by buying back company stock.

For example, if a company’s shares sell for $10 and they have $1 of earnings, then the PE would be 10. What they do with the $1 of earnings – reinvest it or return it to shareholders – shouldn’t affect the PE. However, if they use the whole $1 to buy back company shares, then the earnings divided by the reduced number of shares might appear to be 11+.

Clearly, the shareholders didn’t gain anything. In fact they have lost the future earnings if the money had been reinvested in their company.

A variation on the trailing PE is the Cyclically Adjusted PE (CAPE), which essentially is a 10 Year PE Ratio. This smooths out the finagling and other variations in the way earnings are calculated.

CAPE

Above is a CAPE comparison of stocks in different world markets (courtesy of Peter Schiff at Euro Pacific Capital). Using the CAPE shows that US stocks are quite high by world standards, while stocks in Norway are on the low side.

Another analysis tool is the Dividend Yield. Investors buy stocks expecting a return on their investments in a future dividend stream. On the above chart, you can see that US stocks currently pay a low dividend yield, while Norway companies are somewhat more generous.

Yet another valuable metric is the expected growth rate, sometimes measured as earnings or sales growth and sometimes compared to the stock PE ratio (PEG).

I’ve used an online stock screener (Yahoo!) looking for stocks (Market Cap $1-10 Billion, any Dividend, any PEG, and any estimated earnings growth).

There were 9 stocks with a PEG of 0.25 or less (expected growth at least 4 times the current PE). Of these, three are paying a dividend between 8.5% and 9.5%!

At the other valuation extreme on the same screen, there are 13 stocks with a PEG of 6 or higher (PE is 6 times the expected growth rate), and three which pay 0%, 0%, and 1.7% in dividend yield. It may be reasonable to expect that these last three stocks will do less well than the first three, over the next year, whether both groups rise, both groups fall, or there is a split result.

I mention this because there are different ways to invest your money. While I am comfortable with my money mainly in Precious Metals and their company stocks, you may not be. You may prefer to buy only the best from a screen such as I have described, you may prefer to “sell short” the worst, or you may prefer a combination – buy the best and short the worst.

I AM NOT recommending anything (I do own PDLI), but here is a listing of the six stocks from the above screen:

Buy-Short Stocks

My point is not to ask for you to plunk down your hard earned money on my say so – on PM Stocks, the screened stocks above, or a stock in relatively low priced Norway – but rather to show you that there are various possibilities. You don’t have to settle for just as (more?) risky Treasuries or bank accounts which pay less than CPI returns.

Good luck and good investing!

2 thoughts on “Investing in Up or Down Markets

  1. Interesting stuff, Bob. Thanks for sharing. I generally invest only in technology stocks because I worked in the industry and have a pretty good understanding what the companies I follow do and how they stack up against their peers. But if it’s a choice between two companies that look like they’re at a good price (or, often, an RSI suggesting they’re oversold), I’ll usually choose the one with a lower PE ratio. Of course, in tech, there are also several companies that haven’t made money yet, so they don’t have a positive PE at all. That can make things trickier.

    The thing that has really fascinated me lately is the degree to which all the companies I follow are institutionally owned. This used to mean they were in the portfolios of pension funds or big bank trust departments, but lately it means owned by mutual funds. according to data compiled by Gerald Davis of UMich, “75 percent of the largest 1,000 corporations’ shares were held by institutions, not individuals.” A single company, BlackRock, “owned at least 5 percent of the shares of more than 1,800 US corporations…with more than $3.5 trillion in assets under management, BlackRock was the single largest shareholder of one in five corporations in the United States.”

    Given this type of concentration, I question the cyclical oscillation of many of these stocks. I profit from it, but I still question it…

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  2. Yes, these metrics don’t work all that well for young companies with no earnings as yet. However, the NASDAQ PE can be helpful. In 2000, the company I was working for (ChannelWave in Cambridge) was rushing to go public before the market crashed. It didn’t make it.
    BTW, mutual funds have several logistical restrictions. First, they don’t invest in small or micro cap companies since their purchases will move the market and there wouldn’t be sufficient liquidity when they decide to sell. Second, an asset manager follows the herd most times since there’s nothing extra if they win with an unusual call, but they personally can lose big-time if they lose on a contrarian pick. Third, these days, there is a lot of money in Index Funds, which by definition all buy the stocks in the respective indices.
    I offered this idea as an alternative which is little used today. If it gains a lot of popularity, it too will stop being effective. BTW, I charted the Value Line results of #1 and #5 picks using Long/Short, and it did quite well up until around 2005. Value Line has gained quite a following, so I suppose that their popularity alone is moving the market.
    Bob

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