P/E is the most misunderstood indicator. However, it could be the most useful one.
* Better definition.
P/E should be inverted as E/P and is termed as Earning Yield. Earning Yield is easy to compare and understand. It takes care of negative earnings for screening stocks and ranking. If you sort P/Es in ascending order, your order is wrong with negative earnings but right with E/P.
It is usually compared to 10-year treasury bill yield (or 20 or 30) or a CD rate. If the stock has 5% and your one-year CD is 1%, then it beats the CD by 4% in absolute number and actually many times better. However, the CD is virtually risk free and the future earning yield is an educated guess and it may not materialize.
* Many forms of E/P.
There are many ways to predict E/P:
- Based on last 12 months. Project it to future E/P.
- Based on analysts' educated guesses. Guesses may not materialize. From AAII screens, this one usually predicts better than the previous one that is based on last 12 months.
- Based on last month or quarter. Latest information could be better for prediction. However, they are not good for seasonal businesses like retail where most sales are done in Christmas season.
* Best E/P could not be the best.
Very high E/P could be sign of troubles ahead like lawsuit pending, fraud... You can find companies E/P over 50% and it means two years' profits could equal to the entire cost of the company! I can tell you right away they smell fishy as there is no free lunch in life. However, from time to time, some bargains exist due to certain conditions or Wall Street is just wrong about the company. You need to find whether they are bargains or traps. When low E/P (sometimes even negative) but it is improving fast, it could mean big profit.
* E/P and PEG.
For value investing, E/P is usually used, the higher the better but not extraordinary high as described above. PEG measures the rate of the stock improving earning. For growth investing, PEG is usually used. Select one that favors the current market conditions whether it is value or growth. In a secular bull market, growth is usually better than value. Value (opposite to timing) is better in early recovery stage of the market cycle - the best result is selecting top stocks sorted by Value/Timing. Value and Timing could be one metric classified by some investment newsletters/subscriptions.
* Fundamental metrics.
It is one of the metrics you should use but not exclusively. If the earning yield is high but the % of debt is too, then a good bargain may not be as good as it looks like.
Some other metrics may not be easily found in the financial statements like the intangible, insider buying, pension obligation, losing market share...
* P/E variations.
There are other P/E variations like Cape. Personally I like to compare its current P/E to the average P/E for last 5 years or compare it to the average of the companies in the same sector.
P/E is more reliable for a group of stocks like SPY instead of individual stock which has too many other metrics to deal with.
Shiller P/E (from the web) is one way to track the current market valuation. It is controversial and its value is easily misinterpreted. Hence, use it as a reference only.
When you compare the earning yield of SPY and a ETF specifying in dividends, you need to add the respective dividends to ensure a fair comparison with total returns.
* Garbage in, garbage out.
I do not trust in most financial statements of emerging countries esp. the smaller ones.
* Summary.
Again, one metric should not dictate the reason to trade a stock. All metrics can be manipulated and give different prediction in different market conditions.
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Bren said:
ReplyDeleteYou do realize we hit about 11 in 2009 right?
I will also add: I think of the Shiller PE as a headwind or a tailwind. Imagine you are on a ship and you have a good tailwind, you will get further given a long amount of time. But having a tailwind is no guarantee a big storm won't hit. It's the same in the market, low PE markets are not safer (either normalized or 1 year trailing earnings), in terms of the risk for immediate loss. A big recession or liquidity crisis will cause huge immediate losses regardless of how cheap the market was at the start of the bear.
The 1942 and 1937 bear markets started from relatively low 10 year trailing PE, but they still caused losses of 30-40%. During the 70's normalized P/E was low, but that didn't stop the 1974 bear market from happening or the bear market in the mid-1910s, which started from a Schiller P/E of 15.
James thinks he can predict the market or at least only enter it when the odds are very much on his side (i.e. only buy when blood is in the streets). This strategy would have served him well in 2000-2012, whether it will do as well for 2012-2022 is an open question. During a cyclical bear market only getting in when things are very bad is a good strategy, however, once we turn the page and enter a new cyclical bull James is going to be left in the dust (as will all market timers).
Personally, I am more of a value investor. I buy undervalued companies (bought APA, CMI, CAT, TEVA, TIF and RIO during this correction - still thinking about NKE I was really hoping it would get to the low 80s). And for the last year I have been steadily outperforming the market by buying low when the opportunity presents itself (during last years correction I bought VRTX, INTC, AAPL, GOOG). I don't wait for the market to hit a certain point, I buy a company when it trades near the bottom of it's value range and my margin of safety is good. Right now, many good stocks have gone down 20-30% even though the market has only traded down 10%.
Personally, I prefer this strategy. It's lower on benchmark risk and once a stock has sold off so sharply the risk of further capital losses is slim (I mean come on how much risk is there buying GOOG for 500 or INTC for 20?). Of course if James is right and a big bear comes along I will lose money, but it all depends on how long you have to wait. The market is a pretty good discounter of widely known information. Everything James is saying is widely known, therefore, I would argue it's mostly priced in. It doesn't matter that Europe is bad, the question is do things get better ($$) or worse (-$$). I view this as a coin flip you aren't likely to come out on top trying to predict European politics. Same with the US economy. We all know it's weak, but does it get stronger ($$) or go back into recession (-$$). Again, it's a coin flip, if the ECRI can't predict the business cycle I sure as hell can't either.
Every super-successful investor is a bottom up investor. They buy undervalued companies will good potential for growth. I don't know anyone who has made a fortune timing the market...
GaltMachine said:
ReplyDeleteBren,
"You do realize we hit about 11 in 2009 right?"
I think the analysis refers to Shiller's CAPE. This did not hit 11 nor has it come close to doing so at this point in time.
John Mauldin's article last week discusses this in detail for those that are interested:
http://bit.ly/LzNbUs
Bren said:
ReplyDeleteI am tempted to write an article about how the CAPE is misused. I am tired of seeing people predict that because the CAPE is 21 and the historical average is 16.5 the market is bound to drop by 20%.
P/E has zero correlation to 1 year returns, 10 year normalized P/E has zero correlation to 1 year returns. It's only when you wait 10 years that you start to have a statistically significant edge.
The market could certainly drop by 20%, but if it does it won't have anything to do with 10 year normalized earnings. I'm still confused by James' 950 target. He has repeatedly stated he doesn't expect a US recession. How many >40% bear markets have there been in the last 100 years without a recession? I believe the answer is zero.
I can't think of any, there are: 1929, 1937, 1942, 1974, 2000 and 2008. The idea that you won't get in the market until a 1 in 16 year event occurs is foolish. In 16 years you can pick a portfolio that will pay out 50% in dividends and will give a better return than if you perfectly pick the market bottom (which you will never be able to do anyway).
Now everyone thinks a 40% bear market happens every 4 years, but historically they are quite rare.