Stock picking
Posted 01:52 p.m., May 1, 2008
In this posting on Monday, I wrote about what I see as some shortcomings in the conventional economic wisdom, which holds that successful market-timing is impossible and that “buy and hold” is the only sensible approach for investors. In a nutshell, my view is that “buy and hold” is just a ticket to ride the roller coaster and hope you don’t have to get off when it’s in a hole.
That’s not to imply, however, that I think investing in the stock market is a pure gamble, like rolling dice; just that I think the orthodox economic theory of “random fluctuations” is wrong.
There are alternative views, some of them fairly respectable. Perhaps the best known is what’s often referred to as “value investing” or “fundamental analysis.” This approach was famously outlined in “Security Analysis” by Benjamin Graham and David Dodd. (Originally published in 1940; an updated version is available under the title “Graham and Dodd’s Security Analysis,” by Sidney Cottle, Roger F. Murray and Frank E. Block. Large sections of the 1940 edition are readable online via Google’s book search . Among many others, Warren Buffett is a notable proponent of the Graham and Dodds approach.
What this method boils down to is the idea that publicly traded companies have some level of intrinsic value that is measurable in such things as its earnings, assets and debt. If a company’s intrinsic value is greater than its current share price, it’s “undervalued” and perhaps “neglected” and so stands a fair chance of seeing its share price rise as more investors discover it. On the other hand, if the price is greater than the intrinsic value, the stock is likely to be deserted by investors as they find better values elsewhere.
One popular way of measuring the relationship of share price to underlying value is the price/earnings ratio, or P/E, also known as the earnings multiple. It’s a simple calculation: Take the current share price and divide it by the company’s annual earnings per share. You can run the calculation on the most recent “trailing 12 months” earnings (the sum of the four most recent quarterly earnings) or, if you want to try to be forward-looking, on the consensus forecast for the next 12 months.
While the calculation may be simple, its application can be a bit more complex. First, there’s no “correct” P/E ratio; rather, the existing P/E for any company represents a sort of de facto consensus about that company’s growth prospects: A stock trading for 100 times earnings is viewed as likely to post faster earnings growth than a stock trading at 10 times earnings. So P/Es have to be interpreted on a relative basis, that is, relative to other stocks (especially those of companies in the same or similar industries) and relative to the market as a whole. If a company appears generally solid based on its “fundamentals” (income, cash flow, assets, equity, etc.) but is trading at a low P/E relative to its peers, maybe that stock is undervalued.
The same kind of analysis can be applied to the market as a whole, too: If the market’s average P/E ratio appears too high or too low relative to its own historical performance or to the economic fundamentals, then a prudent investor might want to adjust her or his portfolio accordingly.
The Wall Street Journal helpfully publishes, in its “Markets Lineup” table, the average P/E ratio for the Dow Jones industrial average and Nasdaq composite index, on both a trailing and a forecast basis. The table provides both figures based on the previous day’s closing prices and as of a year before. As of the close of trading yesterday, those figures were:
DJI:
Current trailing P/E: 71.28
1 year ago: 17.39
Current forecast P/E: 14.2
1 year ago: 15.2
Nasdaq:
Current trailing P/E: 28.75
1 year ago: 44.4
Current forecast P/E: 21.91
1 year ago: 26.9
A couple of things about these figures are noteworthy. First, the current trailing P/E on the Dow is quite high considering that this index comprises 30 of the biggest companies in the world. Companies that big usually aren’t expected to post super-fast growth, but rather are viewed as steady, low-risk performers. Nasdaq-listed companies, on the other hand, generally are thought to offer bigger growth prospects (along with higher risk) and so should be accorded higher earnings multiples. Thus, the current situation is exactly the opposite of “normal,” if there is such a thing. (The forecast multiples, on the other hand, imply expectations of faster growth by the Nasdaq companies, a more typical outlook.)
One reason for this seemingly odd situation: The Dow set an all-time high last October, and the Nasdaq reached its highest point since the post-dot-com meltdown at the beginning of this decade. Since then, the Nasdaq has underperformed the Dow significantly; from those highs, the Dow is down 9 percent, the Nasdaq 16 percent.
In any case, it might be at least a little over-optimistic to believe that the 30 Dow stocks are worth an average of 71 years of their current earnings levels. What would be more realistic? Well, just for fun, if you take the Dow’s trailing 12-month earnings and give them the same multiple as the Nasdaq is getting, the result is a Dow index value today of 5,170, about 7,600 points below yesterday’s close.
On the forecast side, the market is giving both indexes a lower earnings multiple today than a year ago, suggesting that investors see greater risks now. Considering the market’s shaky performance the past five months or so, and the general economic uneasiness at the moment, that outlook is not surprising; the question is whether the current forecast P/E – and thus the current earnings forecast – is any more realistic than that of a year ago. The forecast multiple today implies a belief that the 30 Dow companies’ earnings will rise 400 percent over the next 12 months. That, too, seems rather optimistic.
Getting back for a moment to the idea of picking individual stocks based on fundamental analysis, the Nasdaq Web site has a handy tool it calls a “Guru Screener” that allows users to search for stocks that meet criteria based on the approaches of various well-known investment analysts, including Benjamin Graham.
Screening today for stocks of “strong interest” based on Graham’s methodology, I got a list of 31 companies, including a high proportion of apparel manufacturers and retailers. I won’t list them here, because I wouldn’t want anyone to interpret that as a recommendation to buy any of these stocks, or any other investment. I’m just barely qualified as an analyst, and certainly not as an adviser.
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