Chasing 39% profit a year
Posted on May 14, 2007 by Richard Beddard
Filed Under Companies, Investing, Naked PE |
In February, I reported on Dr Keith Anderson’s research. Keith is a lecturer at the University of Durham who says he’s improved the predictive power of the price earnings (PE) ratio. That’s a bit like a medical doctor claiming he’s found the elexir of youth. Now Keith’s sent me new data, revealing how the six shares with the lowest Naked PE ratios, the “six cheapest shares in the market“, he selected in February have done, and which shares have the lowest Naked PE ratios now*1.
Low PE shares (where the price is low relative to the company’s earnings) are, on the face of it, cheap and investing in them ought to deliver superior returns. That’s why you see PE ratios quoted in the financial press and on websites like ours. Sadly matters are rarely that simple in the financial markets. The price of a share is dictated by supply and demand, so if the price is low relative to earnings that’s because, despite the apparent profitability of a company, investors don’t rate its prospects. They may be right, and as a predictor of future performance the venerable PE ratio is disappointing.
Keith’s Naked PE ratio, described in more detail on his website, is adjusted to take account of a company’s long-term profit record, its size, and its industry. It sounds simple enough, but the statistical techniques and long runs of data necessary to calculate it are beyond the capabilities of most private investors. Keith’s testing shows that investing in the companies with the six lowest Naked PE ratios in 1975, and rebalancing the portfolio every year so it always contains the lowest Naked PE shares, produced an average annual return of 39% to 2004 including dividends, enough to turn £100 into nearly £1.5m.
In the investing world, I believe such returns over long periods are unknown. Warren Buffett, regarded as a master buyer of good companies on the cheap, increased the book value of his investment company, Berkshire Hathaway, by 21.6% between 1965 and 2006. In that period the US stockmarket rose 10.4% annually including dividends. Fidelity’s Anthony Bolton is perhaps Britain’s most celebrated fund manager. £100 invested in Fidelity Special Situations at the beginning of 1980 would have been worth £7,500 in 2003, a return of almost 20%.
It’s not fair to compare these records with a portfolio of six shares reconstructed after the event. As the amount invested grows, the pool of appropriate investments (companies that are big enough) shrinks. And Mr Buffett and Mr Bolton really made those returns. So, in the spirit of scientific curiosity, Keith is testing his Naked PE ratio in today’s markets. And he’s taking his own medicine; he owns shares in Invensys, Vodafone and Autologic, three of the companies that appear in the lists that follow.
| Company name | Return |
| SMG | -1.5% |
| Watermark | -4.0% |
| Vodafone | -5.2% |
| Invensys | 12.5% |
| Autologic | 10.6% |
| Bionostics (was Ferraris) | 19.0% |
| Average | 5.2% |
| FTSE All Share | 4.2% |
The six shares with the lowest Naked PE ratios in February (above) have just about beaten the market mid price to mid price; not including the charges that would be payable if the shares had actually been bought. It’s far too soon to be drawing any conclusions about the efficacy of the Naked PE ratio from this test, so here are the six stocks with the lowest Naked PE ratios now:
| Company name | Price | Cap (£m) | PE | 8y PE | Naked PE | |
| MICE | 10.0 | 17.7 | 2.0 | 1.7 | 1.7 | |
| Vodafone | 141.5 | 74,785.6 | 12.9 | 19.6 | 3.4 | |
| Autologic | 117.5 | 71.4 | 11.0 | 4.2 | 3.4 | |
| Watermark | 24.3 | 10.8 | 7.1 | 3.0 | 3.5 | |
| Invensys | 337.0 | 2,683.3 | 20.6 | 5.6 | 4.0 | |
| Inter Link Foods | 131.0 | 15.3 | 4.5 | 4.3 | 4.9 | |
| Bionostics (was Ferraris) | 23.5 | 11.7 | 8.7 | 2.7 | 2.4 |
SMG has dropped out of the top six, to number 20. Keith uses eight years of earnings data to calculate the earnings component of the Naked PE, and SMG’s latest earnings of 3p per share are much lower than the 12p SMG earned nine years ago, now pushed out of the sequence. With its lower eight year earnings record it looks less attractive than it did in February.
Ferraris, which has changed its name to Bionostics, also goes because it’s earnings in 2000 were zero or negative (also recorded as zero in the earnings data). Keith’s research shows that three or more years of negative earnings in the eight year sequence increases the probability of poorer returns and he excludes stocks with negative earnings. Ignoring that year, Bionostics still has the second most attractive Naked PE ratio.
Replacing SMG and Ferraris are Inter Link Foods and Mice. The prices of both companies have crashed recently, but they have been profitable in the past. A plunging share price can make a company look cheap and lull investors into ‘catching a falling knife‘ or buying when the price has further to fall. When he trades, Keith tries to avoid such impatience:
I (entirely unscientifically) try to wait two years after a heavy drop before buying, or wait for a rise of 15% of my calculated fair value.
Although a company may have suffered a temporary dip in its earnings, the expectation of low Naked PE companies is that earnings will recover, and so will the price. Calculating ‘fair value’ means assuming earnings will return to the eight year average and working out the corresponding price at a typical PE. For example, Autologic has:
…a nine-year average EPS of 29.55p, multiplied by a representative PE of 12, so a fair value of 355p. Fifteen per cent of this is 53p. Its low was 65p, so I started buying recently when they went up through 65p+53p=118p.
But Keith admits his trading strategy has less-secure foundations than the Naked PE:
This is from my personal observation of how share prices of out-of-favour companies move over the years, and it could probably be improved considerably by a proper scientific study.
In August I’ll catch up on the performance of Keith’s February selections, and update you on the cheapest six shares in the market.
Footnotes
- Prices are closing prices for Wednesday 9 May
- Edmond Jackson, who writes the Stock to Watch column on our mothership, Interactive Investor, has picked up on a number of these shares too: Autologic, Watermark, and Vodafone (today!).
Comments
4 Responses to “Chasing 39% profit a year”
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Companies like Invensys, Vodaphone and SMG have bought and sold so many companies it must be difficult to to follow normal earngs trend. Buying a company is its early days that has a a product with a glabal product or service surely is annother way. Vodaphone at 1p inthe early 1990’s was wonderful return. Now it might double in 7 years. Not great surely and not 30%+
The trouble with using this is that you would have to run with it for about 3 years, and there is no assurance that the data would be available that long. It does look interesting though.
Hi Poulterlooser and Ronnie, thanks for your comments. A couple of observations:
Ronnie: This method can’t pick out early stage companies because eight years of earnings are required as a starting point (though obviously if you can do that successfully you are on to a winner!). It tends to pick up recovery situations in their early stages. Those can be quite dramatic too, which may explain the results of the backtesting. The likes of Vodaphone, Invensys and SMG are disregarded by the market. To me it’s interesting that a portfolio of ‘has-beens’ has outperformed so dramatically in the past (remember to test the Naked PE Keith rebalanced the portfolio every year).
I think Keith’s study adds intellectual rigour to the notion that companies shunned by investors can be very profitable investments. As many of my most successful investments have been recovery situations that gives me strength, which you need when you are backing a horse most other people think will fall. One of the comparisons I make routinely when judging a company is the current PE ratio against the company’s long-term average PE ratio. Keiths work appears to validate that approach too.
Poulterlooser - absolutely right, you’d need to run with it even longer I’d guess. I wouldn’t follow the portfolio slavishly, though, as I’m a firm believer people should make their own minds up about investments. The reason I publish Keith’s results is because I think we can learn lessons from them that can improve our own investing techniques. The reason Keith lets me publish them is he can reach more investors that way. Let’s hope things stay that way!
Ouch look at ITF !
I guess just too much debt huh ?