Last Updated November 1999
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"Life is the art of drawing
sufficient conclusions from insufficient premises." |
| -- Samuel Butler |
 OULDN'T IT BE NICE TO
HAVE A MAGICAL formula that you could depend on to pick winning stocks? Of
course there isn't such a thing, but most of us still seek a reliable procedure…
Oddly enough, some of the some of the information you'd think would be most
informative can instead be misleading. For example, wouldn't you think insider
transactions would be a good indication of a stock's prospects? Actually they
aren't. We'll show you why in Figuring Insiders Out.
Price/Earnings ratios can also be confusing. Typically, stocks with lower
P/Es represent greater value. There are, however, certain industries where high
P/Es are better values and low P/E stocks are simply Value Traps. You didn't expect this to be easy did you?
How about you? Do you have a foolproof system? Don't keep it a secret, e-mail us.
Figuring Insiders Out
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"It's no good saying one thing
and thinking another." |
| -- Catherine Cookson |
HO WOULD BETTER
UNDERSTAND A company's prospects than its directors and officers? After all,
these are the folks calling the shots. They decide what projects to undertake,
they know potential problems before they become public, and they're also aware
of impending positive surprises as well. They should be the most highly informed
investors when they buy and sell the company's stock.
In an effort to prevent insiders from unduly benefiting from this
information, insiders must disclose their transactions with the Securities and
Exchange Commission (SEC). This information is widely available from the media
(e.g. the Wall Street Journal) and the Internet (insidertrader.com) as well as analytical
services such as Baseline.
Some investors attempt to use this information to "beat the
market". After all, if insiders are buying their company's stock, they must know something good's
about to happen. You might also think the opposite would be true if they're
selling. The trading strategy is simple -- you just do what they do when they do
it.
Unfortunately, like all rote trading strategies, this one doesn't work in the
real world. The main problem is that insiders don't just buy and sell based on
their perception of the company's prospects.
Sell When You Can
Like other investors, insiders have a number of concerns including option terms
and the taxman. These issues can lead to sales regardless of the company's
immediate prospects.
With so much executive compensation being paid in stock options, insiders
need to be aware of their specific terms. Often they can only be exercised
Example:
Microsoft Insider Transactions
Source: Baseline
Insider sales (red arrows) are
typically grouped at options expirations or other specific windows. Purchases
(green arrows) can usually occur at any time and are rarely bunched.
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at particular times during the year. Sales don't occur because insiders are down
on the company but rather because they need to raise cash or diversify their
portfolios.
Taxes are due on option exercises and stock sales so these issues also have a
hand in the timing. Like everyone else, insiders want to time transactions to
minimize taxes. An executive's personal taxes aren't really correlated with the
future prospects of his or her business.
In essence, insiders frequently sell because they can. This really
isn't much for other investors to go on in developing trading strategies.
Buy When You Want
Insider buying can be a little more illuminating, but it's not infallible
either. It can also be option related with the insider simply holding (rather
than selling) the stock upon execution. The timing of this action is still
determined by the terms of the underlying option.
But in many instances, insiders are freer to buy than sell their own company
stock. When they choose to buy (or hold stock resulting from the exercise of
options), it could be because they want to hold a greater stake in the
company, based on the belief that things are looking up.
Of course you can never be sure why an insider is buying (or selling), and
that's why their transactions just aren't that informative. Buys might be more
indicative than sales, but neither is conclusive. You might want to use it to
help confirm your fundamental analysis of a firm. but certainly don't rely on it
as your sole trading rule.
Value Traps
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"The art of being wise is the
art of knowing what to overlook." |
| -- William James |
 RICE/EARNINGS (P/E)
RATIOS ARE SOME of the basic and most widely used tools of stock valuation.
Essentially they measure the price you pay for a dollar's worth of earnings. The
lower the P/E, the less you pay, the better the bargain.
Well at least that's the way it's supposed to work. There are some instances
where low P/E stocks aren't bargains, they're value traps. To see why, you have
to start with the math behind the ratio.
Basic Concept, Basic Math
To calculate a P/E ratio, you simply divide the stock's price by its earnings.
For instance, if Stock A earns $1 and sells for $15, it has a P/E ratio of 15
($15/$1) -- you're paying $15 for each dollar of earnings. If Stock B also earns
$1 but sells for $25 a share, it has a P/E of 25 ($25/$1) -- you're paying $25
for each dollar of earnings. So far this isn't rocket science.
If the market is efficient and has an average P/E is 20, Stock A is cheap.
Investors will realize this and buy it, possibly selling Stock B which is
expensive relative to the market. Stock A's price will rise to $20 giving it a
P/E of 20, while Stock B's price will fall to $20, bringing it to the same
value.
This is why value investors often seek out stocks with low P/Es. They expect
their price to rise in order to bring them back in line with the market average.
But low P/E stocks can revert to the norm in another, less beneficial way.
Again consider Stock B with a P/E of 25. If its price remains unchanged but
its earnings increase to $1.25 a share, it will then have a P/E of 20
($25/$1.25). Similarly, if Stock A with an original P/E of 15 and price of $15
has its earnings fall to 75¢, it too will have a P/E of 20 ($15/$.75). This
time, however, it isn't a bargain, it's a value trap.
The Cyclical Illusion
As you can see, P/Es change not only because of price fluctuations, but also
from earnings increases (or decreases). A stock's a bargain if its price rises
while its earnings hold steady or increase. On the other hand, if its P/E rises
because earnings are falling, it's a value trap.
Low P/Es alone don't tell the whole story. This is especially true for
cyclical stocks. These are issues that trade up or down in tandem with the
current business climate. During economic expansions, they boom, but when the
economy slows, so do they. Typical examples of cyclical stocks are automobile
manufacturers, airlines, and retailers.
The worst time to buy a cyclical stock is when its P/E is low. That usually
means earnings are at their peak and will soon be declining. When that happens,
stock prices usually go down, too.
To illustrate this, take a look at the accompanying chart showing the price,
earnings per share, and P/E ratio for KLM Royal
Dutch Airlines. If you purchased it when the P/E was at its
KLM Royal Dutch Airlines
Cyclical Stock, Cyclical P/E
For a cyclical stock like this, a
low P/E (yellow line) often indicates earnings (green bar) have peaked and
prices (red bar) will fall. As odd as it may sound, cyclicals can offer the
greatest value when their P/Es are the highest (e.g. 1994 and 1997)
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relative low (1990 or 1995), you would have seen earnings fall in the following
years. While the P/E rose, the price didn't.
If, on the other hand you purchased the stock when the P/E was at its
relative top (1994 or 1997) the next year you would have not only enjoyed higher
earnings but a higher stock price, too.
The Lesson
So what can you learn from this? How about one size doesn't fit all.
That's right, no simple, singular trading rule (in this case low P/E) will work
in all situations. Not only do you have to know what your trading rule is, you
have to understand it in order to know when and if it's appropriate.
[It's best to] use …
basic measures and give them different emphasis based on the industry, sector,
and company being evaluated. If anyone suggests anything much simpler than that,
be very circumspect. While it would be wonderful if such a holy grail actually
existed, as you can see from the problems with low P/Es, it doesn't.
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