The Earning Per-Share (EPS) by itself does not mean much. Most investors employ the Price to Earnings (P/E) ratio to examine a company’s earnings relative to the price of its shares. The P/E ratio, often called “multiple”, divides the stock price by the last four quarters’ EPS (this is the same as dividing the market capitalization of the company by its total earnings). For instance, if ABC Corp. is currently trading at $15 a share and its last four quarters’ EPS is $1, it would have a P/E of 15. It could be a surprise for many of you, but this well-known ratio has substantial drawbacks that Wall Street analysts, who frequently use it, won’t tell you.
The P/E is used by many analysts and investors to trace bargain stocks. The underline assumption is that companies that run similar businesses (i.e. are from the same industry) should have a similar P/E. Therefore, low P/E stocks are often considered a bargain. Is it really true? Not always.
While some low P/E stocks could be cheap, many of them are not such attractive investments. For example, consider a company with a low P/E that has a large debt. In this case, the market cap of the company does not truly reflect its real value. The company’s real Enterprise Value (EV) would be the sum of its market cap and its debt (minus the company’s cash), making the numerator larger, thus the P/E will be larger than what it was initially calculated to be.
Simply stated, it means that the real price of the stock is not as cheap as it seems to be. On the other hand, if a company has a higher P/E ratio, it doesn’t necessarily mean it is not cheap. If this company is loaded with cash, then again its market cap wouldn’t reflect its true value; in this case the EV of the company would be its market cap minus its cash, thus dramatically lowering the P/E value. In order to avoid this problematic feature of the P/E, it is wise to use a different ratio, called the Earning Yield (EY), which is calculated by dividing the earnings of the company by its EV.
Another problematic feature of the P/E is its dependence on the company’s past performance. The earnings of the past 12 months are not necessarily an accurate prediction of future earnings. A company could have a uniquely profitable year for many reasons but its future earnings could be ambiguous. Therefore, looking only at the trailing 12 months’ P/E is kind of like driving while looking out the rearview mirror- it is important, but the obstacles you need to be careful of lie ahead of you. In other words, many stocks that are traded with low P/E these days often deserve to have a low P/E because of their questionable future prospects.
One of the not so commonly used ratios, which can solve this issue, is the Price to Earning Growth (PEG) ratio (The PEG is calculated by dividing the P/E ratio by the company’s predicted annual growth rate). The PEG simply takes the annualized rate of growth out to the furthest estimate and compares this with the current stock price. Since it is future growth that makes a company valuable, the PEG ratio makes a lot of sense. But this is not the end of the story, since the PEG also has a crucial problematic feature – it depends on the assumed growth of the company, a parameter which is obviously unknown by itself.
In any case, considering a low P/E ratio as an initial screening criterion for finding bargain stocks could be useful. However, this by itself does not assure a cheap stock, and additional criteria must be considered in order to find a true bargain (e.g., stocks with low Price/Book Value).
Tags: EPS, PEG, Price ot Earning
August 26th, 2008
Everyone agrees that the market is continuing to decline and some of the analysts are even considering a much longer recession period in the U.S. Does this mean that you have to close all your stock positions and divert your investments into a low yield government bonds shelter?
Over the past decade, the market has seen both bullish runs and bearish ones; dot-com irrational exuberance; corporate corruption and the resulting legislation; 9/11 and the following consequences; and now a global sub-prime credit crisis. Despite all of these, the market has been more up than down.
Since it is impossible to predict in advance when a bearish or bullish period starts or ends, the conclusion is that in the long run you have to stay in the stock market in order to benefit from its overall increment throughout the years. This is not meant to suggest that you should never sell stocks; it is just that you should continuously learn stock investing strategies, improve your investing skills, and invest with your brain, not your emotions.
You can choose to hold an Index Fund or an Exchange Traded Fund that will match the market return; but, in case you want to beat the market return and gain larger profits, there are generally two ways to consider. The first is to buy stocks and hold them for a longer period of time; this is the value investing way and it is used by great investors such as Warren Buffet, Bill Miller, and a few others. This strategy includes analyzing the fundamentals of the company, such as its financial condition, its management and other essential issues, in order to estimate the company’s intrinsic value and understand if its stock is currently undervalued, which means the price is right for buying.
The second way is to try and gain from the short term volatility of a given stock price by using Technical Analysis indicators. Technical Analysis is based on the assumption that all the information about a stock is reflected in its price; thus, by analyzing the movements of the price or the changes in the trading volume of the stock, one can predict the future short term behavior of the stock price. As in the previous strategy, this too requires self-education and practice.
No matter which path you choose, you’ll need to find the right stocks for your portfolio and know when to buy and when to sell them. The Yalicoo arena is a great place to provide these needs. Yalicoo has thousands of registered traders holding many winnings stocks. Yalicoo’s leaders have proved in the past that they can definitely beat the market at any given time by picking the right stocks and holding them for the right period of time.
In any virtual stock trading competition that you join, you will immediately see the five top leaders in the competition, including all their transactions - live. Besides the cash prizes you can win in these competitions, copying Yalicoo leaders’ stocks into your real money portfolio can increase your actual profits by hundreds and even thousands of dollars. This will dramatically simplify the process and time required to choose the right stocks for your portfolio. In any case, remember one thing: monitoring the leaders’ moves should be regular and persistent in order to achieve consistent profits.
Tags: stocks
August 24th, 2008
If you have never heard of the excellent, educational, value investing site, fool.com, I recommend that you check out their articles from time to time. Aside from their intelligent articles and varied discussion boards, they also have plenty of services aimed at helping you beat the market in the long term.
As a value investor, I was curious to check out their leading service, ‘Hidden Gem’, which focuses on small cap growth companies. Every month, Tom Gardner (the Motley Fool founder) and Bill Mann recommend two stocks with strong prospects that are predicted to beat the market in the next 5 years. Five years after the service was launched is an excellent time to test whether this service really works!
Since July 2003, 125 stocks were recommended by Tom and Bill; 67 of them have yielded a negative return since they were recommended and only 58 have a positive return. The current total return of all the picks is 28.5%, which translated to a cumulative annual return of 4.9%, compared to an annual return of less than 1% of the S&P index in the same period.
One reason for this low return is the fact that the Hidden Gems team usually seems to be much too optimistic about the future growth of the companies they pick. In other words, they choose stocks with excessively high multiples hoping that their growth will overcome their current price. The comparison to the S&P is probably non-representative since none of the stocks come from this index and many of them even relate to non-US companies. In any case, beating the S&P is obviously better than nothing, but having returns more or less equal to a simple no-risk treasury bond is definitely not great. What if you follow Yalicoo leaders instead of following the fools?
If you subscribe to our newsletters, you already know that Yalicoo players are continuously beating the market; the true market, not the constant S&P500. The winner of Yalicoo’s last monthly stock market competition had a return of 40%; in the previous monthly competition, the winner ended with a return of 17%. One month earlier – 22%, and the month before – 14%; and this goes on and on… If you followed these winners’ moves (and it’s easy, since you can see every thing they do in real time at Yalicoo) your real money portfolio could have grown dramatically.
Sites like fool.com are great and important educational places that you are more than encouraged to visit. Still, a place like Yalicoo is an excellent complementary arena for investors who aspire to maximize their returns over time.
In the last year or so since Yalicoo was launched, our investors have been beating the market almost every day, week, month and every quarter (!). These higher returns of Yalicoo’s investors definitely show a clear long-term trend. Obviously, there is no guaranty for success in the stock market; but, in light of the results shown here, even a fool that follows Yalicoo’s investors has good chances of beating the market in both short and long term periods.
August 18th, 2008
It’s Only “Monopoly Money”
Playing the stock market as a virtual trader can be fun. There’s no money at stake and one can gain experience in trading shares using actual prices under realistic market conditions. Virtual stock trading or “paper trading,” is done by the manipulation of imaginary money and investment positions that behave in a manner similar to the real markets. Before the widespread use of online trading for the general public, paper trading was considered too difficult by many new investors. With computers now doing most of the calculations, novice investors can practice making fortunes over and over again before making any financial commitment.
Stock, Options, Calls—Whatever You Choose
Virtual stock markets allow you to trade stocks, options, spreads, straddles and covered call trades. Investors with more experience use paper trading to test new and different investment strategies. For example, investors can create several different positions simultaneously to compare the performance and payoff characteristics between multiple strategies. Writing a covered call is technically the same as writing a naked put, but in practice there are subtle differences. With a paper trading account, an investor can set up a bull credit spread and a bull debit spread simultaneously and analyze the payoff for each position change as the market moves. Investors can “virtually” test advanced strategies such as leverage, short selling, forex and derivatives trading without the risk involved in real trading. Many virtual markets include stocks traded on NYSE, NASDAQ and AMEX and allow trading at any time, even when the real markets are closed. They also permit the purchase of unlimited shares of any stock at the Last Price, an action not allowed in real life where shares are limited and certain prices are not guaranteed.
Various companies and online trading simulation tools offer paper trading services, many are free, others charge. Some virtual stock markets offer research data such as integrated stock and option quote detail screens and quotes in real time. Traders can analyze their performance, have available live chats with people “in the know,” and be sent reminders on their stock positions.
Virtual Stock Games and Competitions
Virtual Stock market games and virtual stock competitions allow the trader to create public or private games with a pre-arranged cash balance or he can choose from thousands of available games. Stock market games are relied upon by investors of all levels including MBAs, financial professionals, investment clubs and college-students. Competitions can be weekly, monthly or quarterly and can start with as little as $10,000 and go as high as $500,000 per game.
August 13th, 2008
Many investors think that the current financial crisis is much more significant than previous ones. However, as you can understand from the documentary movie below, this crisis has many features that former crises such as the Enron crisis have witnessed. There might not be any accounting frauds, but there was probably inappropriate financial behavior, which received legitimization from the inspecting authorities.
Financial banks that give unlimited credit to every home buyer without considering his ability to return his loans, and rating companies that give higher rates to these banks could be the main causes for the current crisis.
The current level of government regulation is still on debate and will probably not increase in the near future. Therefore, the best way to reduce the risk involved in investing in these kinds of companies is by learning how to value stocks and knowing the right time to buy and sell. Watching and learning from other investors in a virtual stock trading community such as Yalicoo can teach you these things, and dramatically increase your chances of avoiding investing in dubious companies such as Enron.
August 13th, 2008
If you’re someone who doesn’t enjoy analyzing securities in your spare time, Exchange Traded Funds, or ETF for short, offers a terrific way to put your stock market investments on autopilot. ETF is a security that tracks an index, a commodity or a blend of assets like an index fund, but trades like a stock on an exchange. By owning an ETF, you get the diversification of an index fund but under much lower expenses than those of the average mutual fund.
These days, the variety of ETFs is so wide that there are more than 60 companies offering hundreds of ETFs in the U.S.; there are ETFs that invest in commodities, technology, health care, real estate and even in currencies. The variety is so huge that it can be confusing even for the experienced investor. However, there is one ETF that invests in one specific sector that I think has very promising long term prospects – the PHO ETF, which concentrates on the water industry.
Unlike oil, water will not run out, as it covers 70% of our planet. However, 97% of this water is saltwater and not drinkable. The tiny fraction of potable water is decreasing every day and will run out in the not too distant future. Therefore, companies are developing technologies to purify the unlimited amounts of saltwater, which can then be bottled and sold at prices much higher than the price of the tap water we drink. Drinking water won’t run out tomorrow, however, a long-sighted investor sees this supply shortage and the growing purified and bottled water industry as an interesting investment opportunity. Many investors have already identified this opportunity and the stocks of the water industry companies have risen sharply in the past few years.
Obviously, it is hard to guess which company from this sector will become the next Starbucks of the industry; thus, the PowerShares Water Resources (PHO) ETF holds a combination of leading and promising companies from the water industry, giving you the opportunity to benefit from the growing water industry, while holding a diversified non-risky portfolio of water-related companies. The PHO tracks the Palisades Water Index, which beats the S&P500 index dramatically, as can be seen in the figure below.
Economists estimate $500 billion will be spent in the next 25 years on research and infrastructure related to clean water initiatives and an additional $100 billion for researching health concerns regarding water pollution. In addition, the recent bearish market had substantially lowered the prices of most over-valued water stocks. Combining all these considerations, I feel confident saying that the current (long-term) buyer of the water PHO ETF will beat the market in the long run.
August 7th, 2008
Let’s face it, we all enjoy having money. However, most of us would prefer not having to work a nine-to-five job in order to accumulate a pile of greenbacks. Stock markets all over the world offer financial opportunities beyond our wildest dreams. Buy a few good stocks, sit back, hit the jackpot and the money will come rolling in. While it is true that some people who “play the market” have made millions, the real truth is that the great majority of “players” have lost their shirts.
Look to the Internet
For those who envision a rewarding future but have little or no experience in the stock market, the World Wide Web is the place to be. The Internet offers a variety of virtual stock market programs for self-instruction on financial markets and financial instruments and provides the trading experience necessary before moving on to the real thing.
Virtual Trading
Online financial stock games are a great way to learn the realities of a capitalist world without suffering through bankruptcy, insolvency, mortgage foreclosures and other Internet stock market games such real world hardships. There are several available Internet stock market games and stock market competitions. Virtual stock markets allow you to practice buying and selling real stocks using imaginary money for the purpose of gaining experience with stock trading. This is also known as paper trading or fantasy trading. Online stock simulation trading games provide the tools whereby “traders” can build and manage their own portfolio and compete in games against friends, classmates, colleagues or other players risk free. Online investment and trading workshops, seminars, conferences and live events abound, and they are all easily accessible. Many of them are even free! There are also virtual sites offering educational and challenging stock simulation specifically for high schools and college students, preparing them way in advance for the real world ahead.
Many virtual markets include stocks traded on NYSE, NASDAQ and AMEX and allow trading at any time, even when the real markets are closed. They also permit the purchase of unlimited shares of any stock at the Last Price, an action not allowed in real life where shares are limited and certain prices are not guaranteed.
Stock market competitions provide traders the opportunity to speculate on a variety of different financial instruments including stock, options, spreads, straddles, covered calls and even the future of popular blogs!
So put down the Wall Street Journal, warm up your PC and start trading!
August 3rd, 2008
After the market has dropped more than 20% and despite some encouraging recent earning reports, most analysts now agree that the U.S. market is already in recession. All of us have heard about the burst of the housing bubble, the banking bankruptcy crises, overextended consumer credit and more. The U.S. economy is surely slowing and is expected to grow much slower than the global rate of growth. However, if you thought that this decline is painful, think again! A 20% drop is significant, but it is only a relatively small fluctuation compared to the five (and even the ten) worst markets crashes in U.S. history.
The king of all crashes is the 1932 stock market crash. During the 810 days between April 1930 and August 1932, the market dropped 86%! Combined with the crash of 1929 (the 4th worst crash in the list), this created the greatest depression of all time. To recover from a loss like that, you need to increase your portfolio value by 615%! This was very difficult considering the fact that the market didn’t fully recover until 1954, 22 years later.
The second worst crash was the 1937-1938 crash. Five years after the end of the 1932 depression, when investors thought the market was finally on the right track, the market plunged again by 49% due to the war scare and Wall Street scandals.
The “Panic of 1907″, the stock market crash during 1906-1907, was the 3rd worst crash. Its primary cause was a retraction of loans by some banks that began in New York City and soon spread across the nation, leading to the closing of banks and businesses (sounds familiar…). To bring relief to the situation, the U.S. Treasury Department bought 36 million dollars worth of government bonds to offset the decline. However, only after J.P. Morgan stepped in and redirected money between banks and bought plummeting stocks of healthy corporations, the panic passed and the crash was over.
The next two crashes are the deadly 1929 crash, when the market declined by 48% in only two and a half months (!), and the post World War I boom crash, the 1919-1921 crash were the market dropped 46.5% (after it rose for more than 51%…). The 1929 crash was the shortest of all market crashes, but it kicked off what we now know as the Great Depression, which lasted until 1954.
Considering the large declines of these crashes can help you see the current bearish market decline in the correct perspective. Although these crashes were devastating, it is important to remember that after they bottomed the recovery was sharper and quicker than the declines. Excluding two cases in history, the patient stock market investors who held their stocks steadily and patiently came out of the crash on top.
August 1st, 2008
The first thing every investor learns is not to put all his eggs in one basket, which means – diversify your portfolio with a blend of securities or, in the case of a stock portfolio, a larger number of stocks. Diversification makes sense as long as you understand that over-diversification is as bad as under-diversification.
The main purpose of diversification is to protect you from losing money due to the risk involved in the stock market. This stock market risk is composed of two kinds of risks: the overall market risk and the individual business risk (let’s ignore inflation and currency risks in this post for simplicity). The market risk is the risk caused by the fluctuations in stock prices. Many factors can cause these fluctuations, starting from changes in individual companies, to revisions in sectors and changes in the overall economy. The fact that there is no definitive way to predict the direction of these fluctuations in advance, combined with market globalization, makes it almost impossible to reduce the market risk. In other words, unless you have a fortune teller’s skills, no matter which or how many stocks you hold, your portfolio will fluctuate in a manner similar to the market (on average). As a result, in a bearish (declining) market such as the market we are currently in, your picks will probably go down (again, on average),and vice versa - if the market trend is up, your portfolio will benefit from it.
This can be demonstrated by observing the portfolios of great market gurus; almost all their portfolios lost value due to the market drop in the past year. For example, Bill Miller and his Legg Mason Value Trust beat the S&P 500 from 1990 to 2005, but he’s down 30% a year to date. Investment expert Marty Whitman’s Third Avenue Value Fund, which returned more than 14% a year since 1990, is down about 17% so far this year. Even the all-time greatest value investor Warren Buffet’s company recently suffered major losses.
However, a wise diversification can definitely decrease the individual company risk while not reducing your chances to beat the market. The following chart presents the difference between the risks involved in a portfolio composed of a number of randomly selected stocks to the overall market. For example, if you hold only one stock, your portfolio will be 30% riskier than the market risk (risk is measured here as usual by the annual standard deviation).
Holding only a few stocks in your portfolio is obviously much riskier than holding 500 stocks. However, the additional risk rapidly decreases as the number of stocks increases; if you hold 15-20 stocks in your portfolio, even if they are randomly chosen, the risk will be only slightly higher than the market risk.
There’s no absolute best number of stocks to own. Too few and you’ve taken on too much risk. Too many and you’ve diluted the power of your holdings more than you needed to. Different numbers work for different people; it all depends on the level of confidence you have in the companies you chose.
As a rule of thumb, it is usually wise for novice investors to hold around two dozen stocks in their portfolio (but not more than that). As your level of research and margin of safety on each company rises, experienced investors can safely concentrate their portfolio on much fewer ideas, setting it to grow more quickly. In any case, remember that diversification by itself is not a magic word; it won’t do you any good if you don’t know what you’re doing. Therefore, do your homework and practice virtual stock market investing before putting your real money in the market.
July 27th, 2008
Older Posts
