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VectorVest is the only stock analysis and portfolio management system that analyzes, ranks, and graphs over 23,000 stocks for value, safety, and timing. VectorVest gives a buy, sell, or hold recommendation on every stock, every day and is now available for the U.S., Canada, United Kingdom... More
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  • Are P/E Ratios Leading You Away From Your Biggest Winners? 0 comments
    Mar 6, 2014 12:01 PM | about stocks: JAZZ, EXR, ATHN

    By Angel Clark

    Everyone wants a bargain, but some bargains can cost you in the end. In fact, they can dissolve away thousands of dollars in lost profits and years of your time…time spent waiting…and waiting…and waiting some more for these bargain stocks to realize their potential. Oh, and did I mention, that's only IF they realize their potential, which is by no means guaranteed.

    A classic way of finding these potentially lackluster bargains is to use P/E ratios. P/E ratios relate the stock price to the company's Earnings per Share (NYSEARCA:EPS) to express how much you, the investor, is paying for $1 of the company's earnings. They're easy to understand and readily available. As to their effectiveness? Well, I'll let you be the judge.

    I ran a few simple tests from 1/4/2006 -1/3/2014. The tests scanned and ranked the lowest 100 P/E stocks that were at least $10.00 with a 500,000 minimum average (50-day) number of shares traded. All the stocks were listed on the American, Nasdaq and New York Stock Exchanges. No ETFs were included. Another set of tests scanned and ranked for the highest 100 P/E stocks with the same parameters as previously listed.

    The scans were run the first trading day of each year to obtain the stocks and tested to the first trading day of 2014. The performance of these stocks is shown in the tables below, along with the number of winners vs. losers in each group.

     

    Jan 2006 to Jan 2014

    Jan 2007 to Jan 2014

    Jan 2008 to Jan 2014

    Jan 2009 to Jan 2014

    Lowest 100 P/E Stocks

    71.24%
    (50/50)

    45.51%
    (48/51)

    26.95%
    (44/56)

    121.62%
    (79/21)

    Highest 100 P/E Stocks

    123.58%
    (69/31)

    88.44%
    (54/46)

    49.83%
    (60/40)

    106.92%
    (69/31)

    S&P 500

    44.45%

    29.32%

    26.59%

    96.61%

     

    Jan 2010 to Jan 2014

    Jan 2011 to Jan 2014

    Jan 2012 to Jan 2014

    Jan 2013 to Jan 2014

    Lowest 100 P/E Stocks

    58.71%
    (72/28)

    27.72%
    (57/43)

    72.66%
    (77/23)

    34.81%
    (75/25)

    Highest 100 P/E Stocks

    85.05%
    (81/19)

    25.77%
    (65/35)

    38.31%
    (76/24)

    26.74%
    (69/31)

    S&P 500

    61.64%

    43.99%

    43.41%

    25.27%

    Hmmm….the highest P/E stocks significantly outperformed (>10%) the lowest P/E stocks four of the eight years tested while the lowest P/E stocks only outperformed in two of the eight years. (The remaining two test periods were negligible.)

    Using low P/E ratios as a stock picking guide would have also made you miss out on some pretty impressive winners like Athena Health (NASDAQ:ATHN), up 215% since 1/3/11 - P/E ratio 57.14 or Extra Space Storage (NYSE:EXR) up 133%, P/E 44.73

    Don't get me wrong, I'm not using this information to encourage buying the highest P/E stocks you can find, rather it's to show, or at least hint at, how little low P/E ratios correlate to long-term profitability or even a substantial increase in your number of 'winners' when used alone.

    So what's a value investor to do? Get more information of course. P/E ratios don't have to be disregarded but more information is needed to make them valuable. For example, earnings growth (NYSE:GRT) should be taken into consideration.

    How fast a company is growing current earnings is one of the factors that can have a considerable impact on future value. Using the same test parameters as above, take a look at the performance of the highest growth rate stocks:

     

    Jan 2006 to Jan 2014

    Jan 2007 to Jan 2014

    Jan 2008 to Jan 2014

    Jan 2009 to Jan 2014

    Highest 100 GRT Stocks

    96.66%
    (60/40)

    70.80%
    (51/49)

    31.52%
    (53/47)

    121.41%
    (67/33)

    S&P 500

    44.45%

    29.32%

    26.59%

    96.61%

     

    Jan 2010 to Jan 2014

    Jan 2011 to Jan 2014

    Jan 2012 to Jan 2014

    Jan 2013 to Jan 2014

    Highest 100 GRT Stocks

    68.71%
    (62.38)

    16.61%
    (59/41)

    34.28%
    (66/34)

    30.49%
    (68/32)

    S&P 500

    61.64%

    43.99%

    43.41%

    25.27%

    Not bad. Four of the eight tests resulted in a higher gain than the low P/E tests, so adding Earnings growth to our P/E analysis may hold merit. And while I'd love to proclaim my genius, the merit of Growth to P/E ratios (GPE) has been used for generations.

     

    Jan 2006 to Jan 2014

    Jan 2007 to Jan 2014

    Jan 2008 to Jan 2014

    Jan 2009 to Jan 2014

    Highest 100 GPE Stocks

    33.69%
    (53/47)

    16.94%
    (49/51)

    1.43%
    (36/64)

    113.27%
    (72/28)

    S&P 500

    44.45%

    29.32%

    26.59%

    96.61%

     

    Jan 2010 to Jan 2014

    Jan 2011 to Jan 2014

    Jan 2012 to Jan 2014

    Jan 2013 to Jan 2014

    Highest 100 GPE Stocks

    60.08%
    (62/38)

    19.57%
    (59/41)

    44.02%
    (68/32)

    35.61%
    (80/20)

    S&P 500

    61.64%

    43.99%

    43.41%

    25.27%

    Whoa! What happened there? If P/E ratios are ok and GRT is pretty good, why wouldn't GPE be great or at least better than that? One reason that the highest GPE ratios showed less than stellar performance may be that Growth and P/E ratios are not equals. As with many fundamental indicators the information they give you needs to weighted according to its importance. Another possibility, and a more important one, is that investors care about a company's past, present and future.

    Company's trading at a premium today, may be doing so for a reason. Slow but very stable earnings, price and dividend growth can attract investors who are willing to pay a premium for safety and predictability. Companies that have had a horrible history of growth and earnings but have new management or products in the pipeline lure investors like Buffet who see the turnaround potential. New startups have no history to assess but that doesn't stop their potential for generating returns that are many time higher than the current price, attracting investors like flies to honey.

    Unfortunately, investors jeopardize their entire portfolio if they rely on one single indicator to determine whether a stock is a bargain - low P/E stocks can fall just as hard and fast as high P/E stocks. Companies with higher earnings growth offer attractive prospects but those prospects need to be countered with a good hard look at the premium the stock is currently trading at as well as the company's likelihood of continuing to grow their earnings at the expected rate.

    Try taking a balanced approach - at a bare minimum, VectorVest believes the growth rate of a company should exceed the combination of interest and inflation rates. Right now that's pretty easy to do - long term interest rates for AAA corporate bonds are at 2.83% and inflation is at a low 1.6% (2.83+1.6=4.43%). Leaders should also be outperforming the S&P 500 in both price growth and earnings growth.

    Here's an historical example to show you how it would work. A year ago (1/4/13), inflation was at 1.80, AAA Bond rate was at 2.58, average EY for the companies in the S&P was 6.76 and Earnings GRT was 7 (higher than the combination of interest and inflation). The price of the S&P had risen 14.81% from the previous year. Using VectorVest to set up our basic scan from above, I added that the stocks found needed to have an earnings growth rate above 7%, an Earnings Yield above 7% and price growth over the previous year had to be more than 15%. I ran the scan on 1/4/13 and compared the results shown as of 1/2/14.

    On average, the stocks found gained 34.94% with 89 winners and 11 losers. While this was just slightly below the highest gain we managed in any of our previous 2013-2014 tests, it had the largest number of winning trades and had a returned a 40% higher gain than the S&P's 24.92%. Using VectorVest to rank these stocks a little smarter, by the most undervalued stocks according to VectorVest's value indicator, the top 10 stocks gained 40.32% with 8 winners and 2 losers. The biggest winner? Jazz Pharmaceuticals with a 127% gain.

    It's entirely possible to find bargains in any market, but the true bargains have more going for them than just low P/E ratios and if you want an easier way to find them, consider giving VectorVest a try.

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