Chapter Four
Buy Earnings on the Cheap
The lower the price, the
higher the return.
A TRIED-AND-TRUE METHOD of successful investing is to buy stocks selling at a low multiple of their earnings. Earnings are what a company has left after it has paid all its bills. Ben Graham once remarked that earnings are the principal factor driving stock prices. If I accept this as truth, and I do, then the less I pay for a stock when compared with earnings, the better my future return should be. Makes sense, right? I primarily measure earnings-to-stock price by comparing the price-to-earnings (P/E) ratio, to other companies and the broader stock market indices.
The P/E ratio is easily determined. It is the company’s stock price divided by its profit, usually reported as earnings per share. If the ABC Ice Cream Corporation earned $1 million last year and had 1 million shares outstanding, the earnings per share (or EPS as it is often called) would be $1. If the stock price was $10, the P/E ratio would be 10. If the price of the stock was $20, then the ratio would be 20. Some investors refer to the inverse of this as the earnings yield. It reflects the return you would receive if all the earnings were paid out in cash as a dividend rather then reinvested in the company. The earnings yield is calculated by dividing the earnings per share by the stock price. A stock with a P/E of 20 has an earnings yield of 5 percent; a highflier with an earnings multiple of 40 would have an earnings yield of 2.5 percent. Remember: The lower the PE, the higher the earnings yield.
The concept of earnings yield is helpful when comparing investment opportunities. Graham did this. For example, a stock selling at 10 times earnings has an earnings yield of 10 percent. Compare this with a 10-year Treasury note yielding 5 percent, and you get twice the return. If you bought a 10-year Treasury note today for $1,000, it would pay you $50 per year and return your $1,000 when it matures in 10 years. Nothing is safer in terms of absolute dollars. But there is a catch. Let’s say over the next 10 years, inflation is 3 percent per year, which is close to its historic average. (Inflation was much higher in the 1970s and the 1980s, and is a bit lower than 3 percent in the first half of the current decade.) The $1,000 the U.S. Treasury returns to you in 10 years is only worth $737 in today’s money. Even with fairly modest inflation rates, the value of the purchasing power of your Treasury note investment has declined by 26.3 percent.
If you buy a stock at 10 times earnings (a 10 percent earnings yield), you are getting twice the return if the company theoretically paid out all the earnings. Few companies do. Instead, they give you a portion of the earnings in the form of a dividend, and reinvest the balance in the business to finance their growth. Corporations also have the advantage that they can often pass the cost of inflation on to their customers. With no growth in the amount of ice cream they sell, ABC Ice Cream Corporation can probably raise the price of its ice cream by at least the rate of inflation. If the $1 of earnings you bought for $10 grows at the rate of inflation, it will be $1.34 at the end of 10 years. At the same P/E ratio, the stock would be worth $13.40. Generally, corporate earnings grow at the rate of inflation and the rate of growth of the economy, historically 3 percent. Added together, inflation plus overall economic growth would mean that your original $1 of earnings would grow at 6 percent per annum. The earnings per share would then be $1.79 in 10 years; $1,000 invested in the stock at the same P/E ratio, 10 years later would be worth $1,739.
Why is this important to your financial health? Because if inflation is 3 percent, $1,000 invested today has to be worth $1,344 in 10 years just to maintain your purchasing power. The Treasury note can’t do that. Stocks can.
Whether we think about our return in terms of P/E ratios or earnings yields, it is all the same. Wall Street analysts tend to look at P/E ratios from two perspectives. There is the trailing P/E ratio, which is the stock price divided by the most recent fiscal year or past four quarters of earnings. Then there is the forward P/E ratio, which is the stock price divided by analysts’ estimates of how much a company will earn in the next year or next four quarters. Most stocks trade based on what the market thinks the company will earn in the future. The past is the past. Warren Buffett says that basing investment decisions on trailing earnings is investing by looking through the rearview mirror.
When it comes to projecting earnings, however, the track record of Wall Street analysts is spotty at best and highly inaccurate at worst. When noted investor David Dreman looked at analyst estimates from 1973 to 1993, a period containing 78,695 separate quarterly estimates, he found that there was only a 1 in 170 chance that the analyst projections would fall within plus or minus 5 percent of the actual number. Corporate earnings are full of surprises; some positive, some negative. Were it possible to truly know the future, you could make a bundle. Graham’s focus was to look for companies with a reasonably stable record of earnings, a degree of predictability, rather than to search vainly for the specific future earnings estimates that Wall Street seeks. With that in mind, it is still better to just buy the cheapest stocks based on earnings that have already been tallied, audited, and reported to the shareholders.
Over the years, numerous studies have examined the results of buying stocks at low P/E ratios versus buying high price/earnings ratio stocks (the high-growth companies and market darlings). Each study—over time periods from 1957 to virtually the present, and measured over a period of 5 years to nearly 20 years—confirms that buying cheaper, less popular stocks brings far greater returns. This holds true across industries and developed countries. But don’t just take my word for it. Take a look at the study results described in “Don’t Take My Word for It.” It will give you the courage to stay the course when the wind seems to be blowing harshly in your face. Value investing, buying earnings cheaply, is the most reliable way I know to grow your nest egg, not because I say so, but because it’s also been shown to be so—time and again, throughout the decades in numerous academic studies.
The earnings, as reported by most major companies, are a starting point, but just a starting point. These numbers can frequently be misleading and may contain large one-time charges and credits that mask the true earnings of the company. Some finance professionals prefer to use cash flow, or operating earnings. Cash flow is the reported earnings with all noncash expenses such as depreciation and amortization added back. Free cash flow is cash flow minus the capital expenditures that are needed to maintain the assets of the company. Put another way, if I owned the business, how much money could I take out each year and still keep the doors open?
I also look at low price-to-earnings opportunities in terms of what they might be worth to a potential acquirer, particularly a leveraged buyout, or LBO, firm. When companies make acquisitions of other companies, they not only look at free cash flow, they look at earnings before interest expense and income taxes. This is the best measure of how much money a company is earning. Interest expense is merely a function of how much debt a company has. An acquirer could choose to keep the debt or pay it off. The acquirer is most interested in knowing how much cash a business is producing. Professionals call this cash earnings before interest, taxes, depreciation, and amortization (EBITDA). It is sort of a top line earnings number that shows how much cash would be available to an owner of the entire business to use for paying interest or reinvesting in the business. When companies are bought by leveraged buyout firms, the LBO firm typically uses a lot of debt to finance the purchase. EBITDA is a way of measuring the cash that would be available to service that debt.
The low price relative to earnings approach has led to some of the best investment opportunities I have seen in my career. In 1999, you could buy shares in Republic New York bank at $39 based on this type of analysis; it was bought out by HSBC in three months for $72. Stocks that sold at single-digit multiples of earnings through the years include such household names as Chase Manhattan and Wells Fargo. Taking a businesslike approach to evaluating businesses when they sell at a low price-to-earnings ratio and viewing them through the lens of a rational buyer allowed valued investors to buy shares in American Express after the travel industry decline post 9/11, and Johnson & Johnson when the health care stocks were depressed because everyone thought Hillary Clinton was going to nationalize the health care industry in 1993.
Buying low P/E stocks works in both good markets and bad markets. You just may have to wait a little longer for your return in a bear market. But the best part of following a low P/E strategy is that it forces you to buy stocks when they are cheap while fear of stocks is running high. The early 1970s was a time of bursting bubbles and soaring oil prices. The early 1980s brought pain with the colossal economic mismanagement of the Carter years and the highest inflation rates in my lifetime; Federal Reserve Bank Chairman Paul Volcker had to drive interest rates into the double digits to kill inflation. Corporate CEOs were terrified their companies would be driven out of business. During these times, all the babies got thrown out with the bathwater. But these times also provided some of the best buying opportunities in history. Such opportunities do not come on the heels of great times; they are preceded by much pain.
When stock markets are cheap in general, we are in periods of economic uncertainty. Investors have low expectations for returns going forward. Recessions, high interest rates, war threats, and other malaise rule the day. Fortunately, periods like this are the exception. Mostly, the world gets by. Economies grow at more historic rates, and there is an ebb and flow of the fortunes of individual businesses. But just as markets can go to extremes, the valuations of individual stocks also can go to extremes. Many times throughout the cycle, companies are undervalued and overvalued. Low P/E stocks are usually low expectation companies. The stock market does not perceive them to have a bright future, perhaps because they got beat up during a down period, perhaps because they have simply fallen out of favor or there are shinier-looking stocks in the store. High P/E stocks, on the other hand, are usually high expectation stocks. Everything is going right, and investors are convinced their run of great returns will continue for many years. As the legendary manager of the Vanguard Windsor Fund, John Neff, once said to me, “Every trend goes on forever until it ends.” Things change and trends do not go on forever.
The world of investing, not unlike life in general, is filled with positive and negative surprises. It is important to understand how these surprise events affect stock prices. Study after study has shown that when a low P/E, low expectation stock reports disappointing news, the effect is usually minimal. The market anticipated bad news, and there was no need to knock the price down much further. Conversely, when a low expectation stock surprises the market with good news, the price can pop. The reverse is proven to happen with high expectation stocks. If they report a good quarter, the stock does not necessarily jump. It was already priced to anticipate good news. But bad news can crater a high-expectation stock. You don’t have to look any further back than the tech bubble of the 1990s to appreciate the point (and the pain). In 2000, 2001, and 2002, I compiled lists of stocks that had declined more than 90 percent. They were long lists.
