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Buying stocks with low P/E ratios is one of the oldest strategies used by professionals and retail investors alike. Perhaps at its core is the idea that stock prices tend to "revert to the mean" in the long-run and companies that are in the dog house today should outperform over a 3 to 5 year time period. Financials and homebuilders stocks with low P/E ratio today fall in this category.

P/E's have certainly gone down in the past two months courtesy of the ongoing market correction. So is it time for investors to go back to the market and start buying stocks with low P/E's?

The answer depends on one's view of the economy and whether one is buying stocks of companies with cyclical earnings versus companies with steady earnings growth. Mechanically, a stock trades at a low P/E because of a disconnect between market price and earnings. Let us consider two very different scenarios:

Case 1: Steady Earnings Growth

Consider the case of a company whose earnings are growing at a steady rate but the Street's interest in the stock remains limited; perhaps reflecting investors' concerns about the future prospects of the company. Multiples contract and the stock trades at a low P/E as a consequence of growing earnings but flat stock price.

Big pharma stock Abbott Labs (ABT) is a case in point. Earnings-per-share for Abbott Labs have grown from $2.50 in 2006 to $4.50 2011. Yet the stock has barely moved, reflecting concerns about the coming patent cliff. Abbott traded at $48 in July 2006 versus $52 currently. As a result, the P/E has declined from 19.2 in 2006 to 11.5 currently.

Figure 1: ABT's Earnings-per-share
ABT Earnings-per-share

Another example of a company with growing earnings but stalling stock price is Microsoft (MSFT). Earnings-per-share for Microsoft more than doubled in the last five years from $1.27 in 2006 to $2.58 2011. Yet the stock has barely moved, reflecting concerns about the obsolescence of Windows. Microsoft traded around $25 in July 2006 versus $25 currently. As a result, the P/E has declined from 19.6 in 2006 to 9.8 currently.



Figure 2: MSFT's Earnings-per-share

Stocks of companies with steady earnings growth rates should be bought if investors believe that concerns will eventually abate. In this case, multiples will expand to catch up with earnings and the stock valuation is headed higher. To paraphrase Larry Kudlow, the great CNBC commentator: "Profits are the mother's milk of stocks!!"

Case 2: Cyclical Earnings
Investors have to be more careful, however, when buying stocks of companies with cyclical earnings and low P/E ratios. Depressed multiples might reflect the fact that earnings have peaked and will decline in the future if the economy weakens. Cyclicals companies with low P/E ratio should only be bought if investors believe that the economy will remain strong in the near future and earnings will keep expanding. On the other hand, if investors believe that a double dip or a new recession will come at the end of 2011 or in 2012, they should stay away from buying cyclicals like Freeport McMoran (FCX) or Ford (F) even though the stocks trade at depressed P/E's.

Projected earnings for Freeport McMoran in 2011 are equal to $6 and the stock trades at a multiple of 8. However, the record level of earnings comes from high copper and gold prices. If the economy weakens, it is entirely possible that the company will miss earnings and multiple expands even if the market price declines.

Figure 3: FCX's Earnings-per-share



In summary, not all P/E stocks are created equal. Investors can buy low P/E stocks whose earnings grow at a steady pace, under the value investing proposition that stocks revert to the mean. For these stocks, something ought to give as the stock valuation cannot remain depressed forever in light of growing earnings.

Investors should only buy stock of companies with cyclical earnings that trade at low P/E's if they believe that the economy will remain strong and earnings improve in the near future. If their view is that a double dip or a new recession is coming, they should steer clear of cyclical companies like miners (FCX, ANR), the automobile sector (F, GM), and consumer discretionary (GPS, M, ARO).

Disclosure: I am long ANR, MSFT, ABT.

Source: When to Buy Stocks With Low P/E Ratios