P/E ratios are easy to find. Just about every stock report publishes P/E ratios. Everybody seems to talk about them when discussing stocks. So, P/E ratios must be a great way to compare stocks.
Right? Wrong!
If you were told that Fly-By-Nite Industries had a P/E of 7, and Fantastic Plastics Inc. had a P/E of 14, would you buy Fly-By-Nite Industries instead of Fantastic Plastics Inc.? You might, but you shouldn’t be comfortable making that decision. Why? Because you need more information. You’d like to know a whole lot of things before you decided which stock to buy. One of the most important things you’d like to know is what the stock is worth, based upon its earnings, profitability and other key financial data. In other words, you’d like to have a sense of the stock’s intrinsic value. P/E ratios don’t say anything about a stock’s value!
What investors need is a Value to Price ratio. With a Value to Price ratio, investors would know immediately whether a stock was cheap, expensive or fairly priced. But this means we have to have a way of computing value. Of course there are theories and formulas for computing intrinsic value. But they are complex and some sophisticated investors even say they are unfathomable. Consequently, most investors (even the Pros), don’t begin to look at stock’s intrinsic value! They resort to trivial devices like comparing P/E ratios.
A woman recently said to me, “I’m just scared to death of stocks. I can’t afford to lose my hard earned money.” The perception of high risk in stock investing is not totally without merit. Many investors have lost 6 substantial sums of money in the market.
More recent events in the market...the Great Crash of October 19, 1987, the Bear Market of 2008, the Flash Crash of May 10, 2010, and the ills of High Frequency Trading have contributed to the casino image associated with stock investing. This is very unfortunate because stock investing is one of the best ways the average person has of accumulating substantial wealth. It just requires a few simple techniques and some discipline. In fact, it can be a lot safer than investing in real estate, collectibles or your own business. Here’s how to make good money in stocks with low risk:
1. Buy stocks with consistent, predictable earnings growth.
2. Buy stocks with earnings growth rates equal to or greater than the sum of current inflation and interest rates.
3. Do not put more than 10% of your money into any single stock.
4. Do not own more than two stocks in the same industry.
5. Do not plunge into the market. Spread your investments over time.
6. Use Stop-Sell orders to limit risk.
Stocks with consistent, predictable earnings growth are the safest stocks you can buy. They represent the best managed companies in the world. A stock portfolio with an average earnings growth rate of at least 14%/yr. has a high probability of doubling in five years. In twenty years, it will have increased by 1,500 percent.
If you bought 10 stocks, and limited your loss on any single stock to 10% by using Stop-Sell orders, your total portfolio risk is only 10%. Your risk on any single stock is only 1% of your total portfolio. How many investments can you think of that have the upside potential of stocks with such limited risk exposure?
There’s an old adage that says the way to make money in the stock market is to buy low and to sell high. That, of course, is an irrefutable truth. The only problem is that many investors confuse this bit of conventional wisdom with the assumption that if the price of a stock is going down it is low, and if it is going up it is high. Consequently, they buy stocks on the way down and sell on the way up. There’s hardly a worse thing an investor could do.
Stocks are bought on the expectation that they will go up. If a stock is going up in price, it is fulfilling that expectation. When the price is going down, it is denying that expectation. Therefore, it is logical to buy a stock when its price is going up. Moreover, one of the best times to buy a stock is when its price has broken above an old high. At this point there are no unhappy holders who are waiting to dump the stock. If the stock is fairly valued, there should be clear sailing ahead.
For many years, stockbrokers and mutual fund salesmen have been saying that stocks are a hedge against inflation. Well, they are and they aren’t. It depends on how you look at it.
A true inflation hedge is one that increases in value with higher inflation…like a house, or gold, or collectibles. But, the fact is, inflation is the stock market’s number one enemy. When inflation goes up, interest rates go up and two things happen. The first thing is that investors say, “Golly, I can make all that money on high interest rate bonds, so why should I invest in stocks?” So, they take their money out of the stock market, and stock prices go down. The second thing is that the cost of doing business goes up. So, corporate earnings go down and stock prices go down.
So why in the world would anybody say that stocks are a hedge against inflation? It’s because they can make money in stocks faster than inflation will eat it up. All they have to do is invest in stocks which have earnings growth rates higher than the sum of inflation and long-term interest rates. When they do that, the price of the stock will go up faster than inflation. And they will be whipping inflation by staying ahead of it.
Of all the myths in the market, this may be the cruelest and the most foolish. Everyone knows that the elderly are not supposed to take risks. They must be very conservative because their earnings power is limited. They can’t afford to lose their money! Well, who decided that young people could afford to lose their money?
If any group needed to watch every penny, it’s the young. They need money to start a family, buy a house, buy furniture, save for the future and on and on. Furthermore, young people usually are at the low end of the earnings scale. They have precious little disposable income.
Young people have an invaluable asset on their side, however: Time. They don’t need to take risk. They can invest in tried and true companies that make money year-in and year-out. At a growth rate of 10% per year, their investments will double every seven years. By the time their baby is off to college, that initial safe investment has increased by a factor of eight.
When you have time, you can afford patience. Patience pays off in the market.
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