Trust Me, It Is Not Different This Time

Near-term craziness such as the GameStop , Koss Corp. and other short-squeezes almost always turn out to be fleeting. Huge run-ups in shares of companies that have never made money, such as Carvana and Uber Technologies , don't make sense, either. The folks running those companies apparently agree with me. As of Feb. 5, Carvana insiders had sold almost $177 million of shares since the start of this year. Uber insiders had made 16 straight sales against no buys dating back to June 30, 2020. Over the long term, what makes stocks go up over time is creation of value. After successfully investing for more than 42 years, I've found the four indicators listed next to be the best metrics to help gauge the true worth of individual stocks. Both absolute numbers as well as relative valuations compared to that same stock's historical metrics must suggest undervaluation for yours truly to become truly interested in owning shares. Price-to-earnings ratios, commonly called P/Es, are not just numbers. They tell us a lot about the owner earnings of those companies if they were still privately held. I wrote up this simple explanation of P/E many years ago to demystify its meaning. As noted above, P/E in its simplest form tells us how long it would take a company owner to double his firm's net value on an after-tax basis. Why after-tax? Corporate taxes had already been paid before final earnings-per-share (EPS) numbers were calculated. The example assumed flat EPS over the entire half-decade holding period. Well-run companies typically increase EPS over time, which would make results look even more favorable. Earnings yield is a less commonly heard financial term. It simply represents the inverse of a company's P/E. My explanation of how to interpret it is shown below. Buying low P/E shares means locking in high, present-day, after-tax returns even if earnings per share remain static. Paying high or incalculable (with money-losing companies) P/Es means accepting poor or negative after-tax returns now, based on the hope of earning enough in future years to offset terrible starting returns. Paying 50x or 100x earnings implies returns of 1% to 2% based on a company's present-day market capitalization. Do you really want to own risk assets that make paltry returns such as those? Low P/E companies, by definition, are adding greatly to book value and cash for expansion, share buybacks or increased dividends. Money-losing enterprises are often forced to issue ever more shares simply to continue paying the bills. That means sharing any future profits with more and more shareholders. The other three metrics on my list were dividend yield (if applicable), the stock's price to book value ratio and the stock's price to cash flow per share ratio. Once again, the key gauge is how the present-day numbers compare with that same company's historically average levels. I don't find it useful to compare those metrics to the overall market's averages. The best guide to future price action is knowledge of what any particular stock's average valuations are over all those value assessments. Popular shares often command well-above-average valuation parameters. Out-of-favor issues typically sell at nice discounts to their own normalized values. The best values are shares with below-average P/Es, price to cash flow and price to book value ratios. The converse is true when it comes to dividends. There, you'd prefer to see higher than historically normal current yield. The further from normal in either direction (overpriced or underpriced), the more likely you're going to experience regression-to-the-mean stock price action. Back in October, bank stocks were grossly cheaper than normal. Most of my picks in that industry group from last fall have already bounced back by 50% to 100%. Small-cap shares were as out-of-favor as they had been since the very top of the tech/Internet boom in late 1999 through March 2000. Those 2-3 standard deviation discounts on banks and small-caps couldn't resist the gravitational pull back toward normal. Unsurprisingly, those groups have been among the very best ones to have owned over the last four months. My daily Real Money Pro columns feature healthy stocks that meet my stringent value screens. Most of the time my picks are validated by independent third-party sources, such as GuruFocus, Yahoo Finance, FastGraphs and Morningstar MORN, which employ similar analysis techniques. Short-term trading is a sport, not an investment technique. Fixed income, at today's historically low rates, is a guaranteed loser after figuring in inflation and taxes. Everybody's true investment horizon is the same... the rest of their lives. You've got to do something with your money every single day. Why not put it to the best use?

Trust Me, It Is Not Different This Time

No matter how it looks during this red-hot market action, what makes stocks go up over time is the creation of value.

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