A simple article on "Buy & Hold" elicited so many readers' comments. There is a hunger for genuine debate on investing techniques, obviously. In this lackluster market, I have been staying away from focusing on stocks, why not go further to refine ideas on investing.
Too many investors would hold onto low PER as the main decision making trigger. It is an important indicator but we must have a strong appreciation of its powers. Only by realising its limitations, can we use PER effectively.
The price-earnings ratio (PER) is probably the most common financial indicator used by investors. However, there are a lot of shortcomings in relying on just the PER to make financial or investing decisions.
One should also note that the earnings per share is based on net profit and not gross. Plus, it should be fully diluted, that is, it should take into account probable conversions into stock. “Trailing PER” involves taking earnings from the last four quarters, while “forward PER” uses the estimated earnings going forward 12 months.One of the simplest and safest ways to invest is to judge a stock by its absolute low PER. It is simple as you have the low figure as a buffer and cannot go wrong by very much.
If investing were that simple, there would be no need for data mining and earnings projections, or even analysts' reports. You just sort and search each sector according to historical and forward PERs, and then look at the bottom 10% in PER.
To add value, consider the sector and earnings outlooks. If these are good, then it's a safe investment. You may not get a big bang for your bucks from this investment, but it's safe and sure. If this works all the time, why bother doing anything else? That's because investing using low PER as your main yardstick will not give you market returns or better-than-market returns (alpha). If it did, all fund managers would use that exclusively and we would not need to spend billions on research.
Using low PER as a tool
You won't be the first to discover cheap PER stocks. Rule #1: There must be very good reasons why they trade at low PERs in the first place. One must fully be aware of the whys before going further. Try and locate all the negative reasons before jumping in. Reasons for low PER are aplenty. Some of the more common ones:
Steel stocks have outperformed enormously; cyclically, it still is a good time. It's the same with certain stocks in shipping services. Both are still cyclical stocks. This means their low PER may be upgraded but it won't run very far. Cyclical stocks do not have predictable growth in earnings further than three years. Get the timing correct, but also look for a time to exit. These are not for a buy-and-hold strategy.
Low PERs usually mean “capital-intensive stocks = low returns on assets” as compared to those in the services industry. Low PER stocks also usually have very high NTA (net tangible assets) per share relative to their share prices. Conversely, high PER stocks usually have low NTA per share relative to their share prices.
This is because from an investing point of view, NTA only comes into consideration upon liquidation. Certainly, you don't invest in a stock hoping for the company to be liquidated in the foreseeable future. Take Maxis Communications Bhd. Its NTA is less than a quarter of its share price. If you liquidate Maxis today, it would be hell for bondholders and shareholders.
Paying for higher PER
A stock will command a high PER if its business model is scalable without the same proportion of capital investment. If you have a cement plant, you will have to fork out a huge amount of capital to expand elsewhere. If you are N2N Connect Bhd, you can scale up your business into the Middle East bourses with relatively low capital investments.
It is highly unlikely that if you were to find a stock at 6x forward PER, you would be the first and only one to have done so. When the timing and conditions are right (like in the last few months), low PER stocks will have their day in the sun.
Hence, PER is only a minor guide and should not be given undue weighting. Many a times, when a low PER stock is moving, it is not because of the low PER, but rather, because of a confluence of other factors, such as a sector or earnings upgrade, or that cyclically, it's time has come. It just so happens that the stock has a low PER.
There are many who religiously find comfort in low PER, when in fact they have carved out a universe of stocks for their selection that are largely capital-intensive industries. You might as well say that you would only invest in capital-intensive and/or cyclical industries if you were to embrace only low PER stocks.
It's not rocket science. An 8x PER stock could still go to 4x PER in a bear market, trust me. A higher PER stock does not mean that it will fall by a higher percentage. Some will cite that artificially manipulated stocks may also have high PERs. But that should not scare people away from them. Just do your homework.
The best way to use PER in investing is by marking them to their historical PER bands. It is more meaningful to use them within the same-sector PER trading bands.
It's pretty useless and shortsighted to buy steel stocks at 7x PER and tout them as great buys compared to the market PER of 14x. On the other hand, it's okay to buy a steel stock at 7x PER when its historical PER is 10x and because you like the market sentiment, sector outlook and the stock's fundamentals.
An alternative gauge
Owing to the shortcomings of the bland PER, professional investors tend to favour using the EV/EBITDA ratio. It's very similar to PER. EV is enterprise value and EBITDA is earnings before interest, tax, depreciation and amortisation.
(Enterprise value = Common equity at equity value + debt at market value + minority interest at market value, if any – associate company at market value, if any + preferred equity at market value – cash and cash-equivalents.)
Basically, EV is one way of trying to arrive at the net present value of the company. If a company has a lot of cash, the EV can even be negative. EV looks at the company as a going concern. It indicates how much the business is worth after paying off all claims. That's why cash in bank does not count.
Hence EV/EBITDA is a cashflow measurement or a payback period measurement, while PER is an earnings multiple ratio (or payback period in terms of earnings).
The former measure is superior because it takes into account the capital structure of the company. One can better compare using EV/EBITDA as it can be adjusted for risk per capital structure of a company to get at the proper returns.
Interest and tax are external to real earnings, while depreciation and amortisation are not real cashflow items.
Hence, you would get a better gauge on real earnings minus the peripherals. Still, even though it is a more sophisticated measure, EV/EBITDA also suffers from most of the shortcomings of PER as explained above.