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#2 Value Investing Rule. Buy Stocks Having The Lowest Price/Earnings (P/E) Ratio.

With today's equity markets being modestly overvalued, it's quite an ordeal to find stocks of well-established large cap companies with price/earnings ratio lower than 10, needless to say about leaders in the tech industry, which are trading at stratospheric price to earnings multiples and are extremely overvalued. Though out there still exist pearls waiting to be discovered. Even good companies sometimes are trading at low P/E for many reasons. It could be some unexpected bad news, prolonged litigation, a temporary stream of bad luck in the recent past, deadbeat borrowers or a scamper manager.

Though, I wouldn't be enticed by the only fact of low P/E, because the company shares might be plunging for a reason. I would choose only a reliable company, having a good track record over at least seven years back. Another desirable factor is a growth potential of the earnings. Out of two firms with the same price to earnings I would chose the one whose earnings are expected to grow. This improves both the return on capital future perspective and partially lowers the risk of the investment (higher margin of safety). In other words, by picking up stocks with price close or lower their intrinsic value and high future growth potential you kill two birds with one stone.

Here also might belong stocks with high dividend yields or low price to cash flow, as likely winners. I would define the cash flow here in a nutshell as - earnings plus depreciation costs. The companies with above average dividend yields often retain earnings, thereafter reinvested in the business, which increases shareholders' equity capital and ultimately the market price of its shares. In best cases, shrewd managers buy back the company's shares and reduce its long-term debt.

Only an astute investor must keep an eye on this retained earnings reinvestment process, since some companies might abuse the investors money by making expensive an unprofitable acquisitions.

Stocks with low P/E are often accompanied by low price to book (P/B) ratios, as compared to other companies in the same market niche. These stocks are also often undervalued in relation to appraisal of the value of the company assets if the entire company was for sale.

The study of NYSE 500 stocks from 1957 through 1971 shows that $1,000,000 invested in stocks with lowest P/E during those 14 years would have turned into over eight million dollars.

The founder of value investing, Benjamin Graham, recommended to pick up stocks whose earnings yield was 200% of the yield on AAA bonds and hold them up to two years or until there price appreciates to at least 50%, whichever comes first. A study conducted in 1974 through 1980 on New York and AMEX stocks, selected according Graham criteria, showed an annualized return of up to 38%!

When choosing stocks with lowest P/E, it is interesting to note that small cap companies ( listed on the NYSE), according to some studies, produced much larger returns than those of large caps with the same lowest price/earnings ratio. During the seventeen year time frame, one million invested in small caps produced up to nineteen million, as compared to just eight million returned by stocks of large caps during the same period. The same money invested in the major market indexes would return only about three million dollars.

Low P/E Stocks, as time shows, proved to yield sizeable excess returns net of transaction expenses.

Needless to say, that lowest price to earnings stocks, with all other value selecting rules being complied with, add considerably to investor's margin of safety.