Explaining the Historical PE Mentality
I've now been asked on numerous occasions as to why examining the Historical PE of a stock makes sense. The criticisms have actually been quite good.
- "This sounds like reversion to the mean to me. Statistical mumbo jumbo"
- "Just because a stock is at a low for its historical PE doesn't mean buy it"
- "The stock market isn't that easy"
These are great quotes and really speak to the heart of value investing. I am not a pure value investor, but I can't help but pick up stocks that have been beaten down for no reason or are cheap beyond belief.
The key to the Historical PE mantra is finding companies that are rock solid. To start, it doesn't even make sense for companies that aren't profitable. That eliminates quite a few. So if your going to use this methodology, start with bellweather stocks that grow earnings consistently over time and have a strong, no, unflappable record of growth. They are out there - MMM, GE, KO, BA, etc. They don't have to be a DOW stock, but that's a good place to start. Here, it really is reversion to the mean. Given that the company is totally solid and will continue to drive profits, why not buy when its cheap? But how do you define cheap? Its not the stock price - that's irrelevant - its the price as compared to earnings. Earnings drive the market and if you don't think so, you are not an investor, you are a gambler.
Get it? If the earnings keep climbing at a steady pace, then PE ratio is the perfect metric. Right, but earnings don't grow steadily. They can bounce around. Sometimes, the PE ratio is low because the earnings estimates are in the toilet. Pure Technical analysis is like staring at your feet during a marathon. It works for a little bit, but not a good long term methodology. The company you are investing in absolutely must have rock solid growth. Fact is, it won't work for many companies. Homebuilders are a great example. Historically low PE, that's for sure! Rock solid growth? Not really.
So what stocks satisfy this criteria? Where should I put my money? Well its not that easy, but we can take a look at some possible candidates.
Here are two examples - MMM (which is currently at an all time low) and Citigroup (another sitting pretty). Do you really think that these companies will be unable to drive future growth opportunities? Is there a sudden shift in the markets that has totally redifined these businesses for years to come? No. Both will have growth spurts and lackluster years. But you can take advantage by realizing that the historical PE is at a low. One day it will be higher - history proves that - with earnings much higher as well. Nope, not a 10 bagger, just stocks that will beat the market over time.
Go to www.bigcharts.com and use the lower indicators. They have historical EPS and PE ratio. Look for the stairstep growth in EPS and the fluctuation in PE.
While you might not agree with the methodology, at least you learned something. Fool on....