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Greetings, fellow Pro-fundity team members -
8-20-99 Page
This week's Editorial Guidepost:
- We have been discussing the Contrarian approach to investing and found their basic
strategy is to "go where the crowd isn't." That is reminiscent of professional baseball
player Wee Willie Keeler, who made it to the Hall of Fame with one key rule, "Hit 'em where
they ain't." To do this in the market, the contrarian needs some measure of where the
crowd is. The first contrarian rule moves away from the crowd by selecting only stocks
that are:
"...down in price by at least 50% from its 52-week high to be considered for purchase."
- This rule serves as a proxy for investor sentiment, since stocks in this category are
out of favor in the market. By itself this rule is not enough to single out good stock buys.
Other contrarian rules are needed to help scratch the poor investment opportunities. But
the "down-by-half rule" is the primary contrarian play.
- Other rules for the contrarian are termed confirming indicators. That is, they confirm the decision to go with stocks that are down 50% in price. The confirming indicators are used as follows:
A stock satisfies the Contrarian Buy Rules if it is:
1. Down by half
AND
2. Meets either of two Confirming Indicators:
2a. Shows major insider buying
OR
2b. Meets two of four fundamental indicators:
- Price/Earnings (P/E) ratio of less than 12
- Price/Free Cash Flow (P/FCF) ratio of less than 10
- Price/Book value (P/BV) ratio of less than 1.0
- Price/Sales (P/S) ratio of less than 1.0
- We covered insider buying last week, lets discuss the use of the second group of financial ratios as indications of value in out of favor stocks. Remember, Rule 1 is negative, Rule 2 (a & b) are positive. First find out of favor stocks, then find confirming indicators that suggest value.
- Price earnings ratio (P/E)
We have covered this important ratio in detail in the Fundamental Analysis tutorial. Basically, it is a measure of the stock price divided by its earnings per share in the most recent fiscal year. If a stock is trading at $30 per share, and the company had an earnings per share (EPS) of $2 last year, its P/E is 15 ($30/$2 = 15). In this case, the company is trading at 15 times trailing earnings. Trailing earnings are historical, leading earnings are expected or forecast. The contrarian likes to view the P/E ratio from both points of view.
When studying the P/E for a prospective buy, the difference in P/E for trailing and leading earnings is informative. For instance, if a stock is trading at 15 times trailing earnings and at 6 times leading earnings, the expected performance is favorable.
A base-line P/E ratio of less than 12 is an attractive confirming indicator for the contrarian. Low P/E portfolios beat high P/E portfolios uniformly in studies, which also showed some of the best returns came in the third, fourth, and fifth years as the portfolio was held. That fits in with the contrarian expectation that their biggest returns occur in the third year after buying a stock.
- Price/Book ratio:
A great deal of research shows that stocks trading at a low ratio of price/book value outperform the broad market while reducing portfolio risk. A P/BV ratio of less than 1.0 helps a stock qualify as a contrarian play. When a company's stock price is trading at less than its book value, the contrarian sees this as an confirming opportunity.
Value Line publishes a weekly list of companies with the lowest P/BV ratios. This is a good place for investment ideas.
- Price/Cash flow ratio (P/FCF):
On a stock that's down 50% from its 52-week high, a P/FCF ratio of less than 10 (in concert with one other of our contrarian fundamental indicators) is enough to make a stock a "buy."
Cash flow is a difficult accounting concepts to understand. Contrarians must understand the importance of cash flow, and how it is computed, in order to have confidence in using it as a confirming buy indicator.
One easy way to find companies that generate more cash flow than they need is through Value Line, the investment information service. Value Line's weekly listing of "Biggest Free Cash Flow Generators" ranks companies by the ratio of cash taken in to cash needed to pay dividends and update factories and equipment.
- Price/Sales (P/S)
When investors analyze a stock a great deal of attention is paid to company earnings. The earnings of a company can be improved by cutting costs, to a point. But unless there is fundamental growth in company sales, any increased earnings will be short-lived. The contrarian success depends, in part, on staying away from companies that are headed out of business. A great indicator of long-term company success is a low Price/Sales ratio.
Summary:
A stock that is down by half and meets two of the four fundamental indicators qualifies as a buy.
- A P/E under 12
- A P/B under 1.0
- A P/FCF under 10
- A P/S under 1.0
Next week we will review the contrarians approach to selling.
Bibliography:
"The New Contrarian Investment Strategy," David Dreman, Random House, 1982
"Contrarian Investing," Anthony M. Gallea & William Patalon III, New York Institute of Finance, 1998
Stay tuned.
Understanding:
It is our intent to help our subscribers understand market strategies well enough to
make informed decisions and understand the risks.
We provide TC-2000 tutorials to members. See the Member Login page.
Be diligent...
Take action!
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