The six cheapest stocks in May
Posted on May 8, 2008 by Richard Beddard
Filed Under Naked PE, Companies, Investing |
First, here’s the May list, straight from Dr Keith Anderson’s database:
Just in case you haven’t been following the series so far, here’s a recap:
- The Naked PE is a company’s price divided by the average of its past eight years of profits, and
- It’s also adjusted for a company’s size, and sector.
By back testing concentrated portfolios of shares Dr Anderson, a lecturer at Durham University, calculated that between 1975 and 2003 a portfolio of six shares, rebalanced every year, would have returned 39% a year, suffering only two down years. Since then, the Naked PE may have performed less well - last year two Naked PE stocks went bust - and Dr Anderson is in the middle of updating his testing through to 2008. I hope to bring you the results with the August list.
There’s a lot to like about the Naked PE, apart from its name.
As any investor knows prices tend to follow earnings because we base the value of a company on our expectations of its future profits which, at the risk of oversimplifying, the company will return to the shareholder as dividends or reinvest in growing his company.
The problem is, in the short-term earnings can be an unreliable guide to future profits. Quite often, a company’s price will fall dramatically if its earnings do, or even before, but that drop in earnings is temporary. A temporary drop (or spike for that matter) in profits can’t possibly be a benchmark for the company’s future earning power.
Using the average of at least five years earnings is a more reliable, if conservative measure*1. Allowing for a company’s size and sector is something most investors do, at least intuitively.
Obviously, any company with a low price relative to its earnings is disliked by most investors. The six companies with the lowest PE ratios are most despised of all. That means our list of the six cheapest stocks contains companies investors wouldn’t normally consider. If like me, you think you can beat the market by doing something different, it seems a good place to start.
I’ve been looking at one of our last picks, Johnson Service (JSG), published in February, which tops a similar list that I keep. It shows the dilemmas an investor can face, when appraising very cheap stocks. According to my list, Johnson Service’s long-term PE ratio is just 1*2.
The company does drycleaning, rents and launders work wear (i.e. uniforms), and manages properties.
Last year amortisation and impairments turned an £18.5m pre-tax profit into a £52.4m loss. The company seems to be writing off everything including the washing room sink. It sold off its most profitable business (corporate wear) to prop up the remaining three and arranged new loans with bankers that it says will see it through to 2010, but I think this statement in April’s results:
The terms of the banking facilities incentivise the raising of equity and the Board will be considering this in consultation with Shareholders.
Means that existing shareholders may find their holdings diluted by a rights issue. Having already lost a valuable division it would be foolhardy to assume profits will return to former levels any time soon.
With both sides of the earnings per share equation so uncertain, to understand the value in Johnson Service, and the risks, you’d need to be a restructuring expert, and that’s where the story gets interesting. The interim chief executive, John Talbot, is an experienced restructuring expert.
He, along with most of his board bought shares recently, lots of them. Mr Talbot bought the most, 635,000 shares at 21.16p - an investment of £134,366. It’s difficult to imagine him laying out that much if, having reviewed Johnsons’ businesses, he didn’t think the shares were cheap at the price.
By yesterday the shares had risen to 36.5p. Other investors have probably followed Mr Talbot’s lead. Is that cheap? Dunno. But I think Johnson’s worth studying because if it does recover, I’m sure there will be opportunities to buy along the way.
Dr Anderson, who thinks the returns from the Naked PE can be improved by waiting until the downward price momentum typical of low Naked PE shares seems to have abated, cautions:
Over the ten years before the latest results, EPS according to Datastream averaged 29.1p. So it is easy to see where John Talbot’s confidence comes from. Though looking at how quickly the 200-day moving average is still descending, the latest rise could well turn out to be a dead cat bounce.
Footnotes:
- Also demonstrated by James Montier. See chapter 27 of Behavioural Investing.
It’s fallen out of Dr Anderson’s list because he requires 8 years of unbroken positive earnings and in April Johnson Service announced a loss. - I’ve also blogged and iBalled Johnston Press.
Comments
5 Responses to “The six cheapest stocks in May”
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Richard, thanks for the latest list. When looking at Barratt Developments, I’m not so sure that 8 years is long enough for measuring its naked PE because the housing market was pretty strong during the period. It would be helpful if the database can go further back to the housing downturn in the early 1990s to compute Barratt’s naked PE.
Hi John, thanks for your comment. It’s a good point. Long-term PEs are also known as ‘cyclically adjusted’ PEs - the point being they reflect earnings power over an economic cycle - although since we have to pick an arbitrary period, it’s not always going to be a perfect fit for each sector. I’m really not sure how meaningful a 15 or 20 year PE would be. Maybe Dr K will chip in!
Barratt’s average earnings over the past 10 years are 81.8p, over the past 20 years 47.5p, and over the past 40 years 26.86p. The 8-year EPS average is actually reducing their apparent earnings power compared to the traditional P/E, as they only earned 47.7p in 2001 compared to 111.7p in 2008 (both Datastream EPS figures). Even after this reduction they still come out as one of the best bargains naked PE-wise. John’s point is a fair one, especially related to how well builders have done recently, and how badly it looks like they are going to do in the next few years. On the other hand, 20 or more years ago the building sector and Barratt themselves no doubt looked very different. In the end you pay your money and take your choice.
Dr K, thank you the additional info. Another consideration with Barratt is that the company is expected to announce a rights issue that will dilute existing shareholders. To what extent is anyone’s guess.
I guess the key lesson from this is that there is no substitute for thinking in investing. Formulaic approaches such as naked PE’s, PEGs and high yields are only as good as the person using them.
Keep up the good work, Richard and Dr K.
Thanks John,
I think the Naked PE, and long-term PEs in general, are improvements on the regular PE. No measurement is going to faultlessly pick the right stocks every time though (except perhaps hindsight).
But formulaic approaches can improve returns, either mechanistically as in ‘the Dogs of the Dow’ kind of approach, or in tandem with human judgement and other indicators.