This Value Approach Always Wins

 | Oct 30, 2012 | 11:00 AM EDT
  • Comment
  • Print Print
  • Print
Stock quotes in this article:








Consider the following fact in the most recent edition of Barron's: According to Brandes Investment Partners From 1990 to 2010, companies with high price-to-earnings ratio grew sales and profits faster than low PE ratio stocks. That's understandable; after all, the reason stocks command high PE ratios is precisely because investors pay for the fast growth. Yet there is another complimentary fact to this study. During that 20-year period, low PE-ratio stocks had the better stock returns.

It's not difficult to appreciate why low PEs outperform high PEs and to understand why is to appreciate the long-term success of a value-investing approach. Highly valued stocks are expected to generate high rates of growth and when they exceed those expectations, the market rewards the positive surprise. 

But Mr. Market gets spoiled and expectations became irrational. Just look at Chipotle (CMG), which continues to grow sales and EPS at a furious pace. So far this year, EPS growth has exceeded 20% year over year. Yet Chipotle shares are down more than 25% year to date. The reason? Chipotle shares started the year trading for 50x earnings. And because the earnings growth did not exceed expectations, the company's excellent growth was not met with a higher stock price. 

A company with a low earnings multiple, on the other hand, will tend to experience a massive appreciation in the stock price even if earnings meet or modestly beat expectations. JPMorgan Chase (JPM) is an excellent example. If someone had told me at the beginning of this year that JPMorgan would get caught in a multi-billion-dollar trading loss due to poor risk oversight and asked you to predict JPM performance for the year, many would have likely suggested a negative return. Yet here JPM sits up nearly 20% on the year. I would surmise that being valued at less than 75% of book value and less than 10x earnings at the beginning of 2012 was a nice tailwind to share price performance. Despite the tough trading loss, JPM shares were priced as if the company was facing a liquidity event. Such pessimism discounts many downside problems and rewards the value-seeking investor.

After trading for as high as $117, Caterpillar (CAT) shares have come back down to $84, valuing the company less than 10x forward earnings. A 2.5% dividend yield is now included in the price. Caterpillar management has already suggested that the Company's growth could be uncertain over the next couple of years. Yet CAT is a high-quality company with a brand known and trusted all over the world. If the price keeps coming down, then all the future growth uncertainty becomes increasingly discounted in the price. 

Advance Auto Parts (AAP) is another high-quality company that now trades for 12x earnings because new car sales are picking up, which the market sees as bad for auto parts retailers. While newer cars certainly mean less visits to your auto parts store, AAP is an inherently great business. Management continues to buy back tons of shares, an activity that will only reward shareholders immensely when the market perception of AAP improves.

A bargain stock, to me, is a quality business trading at an attractive price -- not any company with a low PE ratio. Often the perception of value is misconstrued to apply to all statistically cheap stocks. Value is assessed based on what you get for the price you pay. I would consider Chipotle attractive at 18x to 20x times earnings, but not so for JPMorgan. The key takeaway is that when you buy low, you get the dual benefit of downside protection and tremendous upside potential when the market perception changes.

Columnist Conversations

What ISN'T this company doing? Continues to dominate -- nice set of deals unveiled overnight.
The futures are up slightly this morning as traders buy yesterday's junk. As noted in last night's Strategy Se...
Equifax's (EFX) CEO is being replaced today in response to the data breach incident. Trading in the shares ...
TheStreet's Scott Gamm has Jordan Belfort on-camera today. Any questions you may have for the Wolf of Wall Str...



News Breaks

Powered by


Except as otherwise indicated, quotes are delayed. Quotes delayed at least 20 minutes for all exchanges. Market Data provided by Interactive Data. Company fundamental data provided by Morningstar. Earnings and ratings provided by Zacks. Mutual fund data provided by Valueline. ETF data provided by Lipper. Powered and implemented by Interactive Data Managed Solutions.

TheStreet Ratings updates stock ratings daily. However, if no rating change occurs, the data on this page does not update. The data does update after 90 days if no rating change occurs within that time period.

IDC calculates the Market Cap for the basic symbol to include common shares only. Year-to-date mutual fund returns are calculated on a monthly basis by Value Line and posted mid-month.