How to avoid this classic investment mistake
There’s one classic mistake that a lot of investors make. And if you’re making this same mistake, it could end up costing you a lot of money.
A lot of money.
I’m going to show you why - and how you can avoid it.
You see, many investors - including some so-called experts - are slaves to what is called the P/E, or price-earnings, ratio.
This valuation metric is a vital weapon in the investor’s arsenal. It’s a great way of telling - at a glance - if a company is overvalued... undervalued... or about right.
But useful though the P/E ratio is, it can also lead you badly astray. And cost you a fortune in the process...
In a moment I’ll show you how, over the last year, this classic mistake has led some investors to make a whopping 93% loss. First, though, let’s take a quick look at what the P/E ratio actually is.
The P/E ratio tells you how many years’ worth of company earnings it would take to pay back your investment if company earnings were to remain constant. So, for example, it would take 7 years to recover an investment in a company with a P/E of 7, 8 years if the P/E were 8, and so on.
It is the ratio between the price of a single share and the earnings per share. To work it out, you simply divide the former by the latter.
Whether or not a given ratio suggests good value depends on the sector. But as a general rule, a P/E of less than 10 suggests a company is worth a look.
So you can imagine our excitement at this morning’s meeting when colleague Andrew Vaughan piped up:
"There’s a share trading today at a P/E ratio of less than one!"
A P/E ratio of less than one?! Surely, we all thought, there must be a catch...
Indeed there was. Andrew revealed that the share in question is Barratt Developments, the home builder.
"Ah," we all said.
Ah indeed.
Tell Bloomberg to list all the stocks on the FTSE 350 by P/E ratio and Barratt comes top of the league. By P/E alone, then, it is the best value medium or large company share there is.
But does that mean you should rush out and buy it?
Absolutely not!
Barratt offers an excellent case study in why P/E ratio can be misleading. It shows us why ignoring the Big Picture - something so many investors are prone to do - can end up being extremely costly indeed.
You see, this time last year, Barratt was trading at around 1,000p. Its full year results for 2006 (the most recent available at that time) showed earnings per share of 115.3p.
So... we do the maths, and what comes out is a nice, juicy P/E ratio of 8.7.
Looks like good value - and people will always need homes, right?
But if you’d bought Barratt a year ago - based on an attractive P/E and a vague idea that the business was solid - you were in for a nasty surprise.
Here’s what happened next:
No wonder the Investor Relations page of Barratt’s website features blokes wearing hard hats! Can you imagine the shareholder flak they’ve taken? From 1,000p, the shares are now down to less than 73p. That’s a 93% hit!
Of course, this time last year the credit crunch was yet to get into full swing. No one knew the mortgage market would dry up to quite the extent it has. But there were warning signs - and smart investors heeded them.
And the factors that conspired to produce the chart above are still around today. This morning I read that mortgage approvals last month hit an all-time low - slumping 20%.
Lenders continue to raise rates. The Chancellor is threatening to take action to make lenders more sympathetic to borrowers. But we’ve been here before, and it’s doubtful that central government can actually do anything to help.
All of which means investors believe house prices will continue to fall. Michael Saunders, chief UK economist at Citigroup, had this to say:
"Our base case - base case, not worst case - is for house prices to fall 20%. It may turn out even worse." For a developer like Barratt, this is terrible news. The prices of houses - the very thing it sells - are going through the floor.
Contrarian investors have throughout the crunch been calling a bottom in home building. So far it’s lost them a lot of money.
The story of Barratt over the last 12 months shows us why taking a holistic, Big Picture view is so important.
Now Barratt’s P/E ratio is 0.72. Of course, this P/E is based on last year’s earnings. Next year’s could be better. But the economic climate suggests otherwise.
Keeping a watchful eye on the prevailing trends - as well as the potential pitfalls - is a key part of the investment philosophy here at Fleet Street. We believe it can help you avoid the sort of losses incurred by those who are blinded by attractive-looking P/E ratios.
In the case of home builders like Barratt, the current climate is dead against them. It’ll take a lot to turn investor sentiment around.
There will be a time when home builders represent good value. But it isn’t here yet.
The recession results are flying in...
Yesterday I posed the following question:
Within the next two years, do you believe the British economy will have a recession?
The replies are coming thick and fast! And I’m enjoying reading them.
I’ll be reporting on the results on Monday - which gives a few more days for replies to come in (quite understandably a lot of you are keen to explain your view. And, I’m sure you’ll agree, there is A LOT to say on the subject!)
If you haven’t already, simply email your reply to fleetstreetdaily@fspinvest.co.uk
Why Manraaj is cursing a Canadian analyst... as well as our own legal department!
Manraaj Singh could barely sit still at this morning’s editorial meeting.
"It’s just so bloody frustrating!" says our emerging markets man.
What’s got Manraaj so hot and bothered is this: he’s sitting on a dynamite share recommendation, but he can’t get it out to his readers just yet.
And now it looks like one Canadian analyst could beat him to the punch...
"It’s not too late," he says. "But I’m in a real race against time!"
Find out why Manraaj is risking a major bust-up with the powers that be just to get this recommendation to the public!
Until tomorrow,
Ben Traynor
Today’s Daily Reckoning - The most boneheaded miscalculation of all time...
"Terrorism will be reduced...weapons of mass murder will be limited, people will be safer around the world, human rights and democracy will be unleashed in the Middle East, and the fragile outlook for world prosperity will be improved... The uncertainty tax on world growth will be lowered too, as will the energy tax from temporarily spiking oil prices."
This was Larry Kudlow writing in March, 2003.
The spike in oil prices he described took place on March 12th, 2003, pushing the price of a barrel of crude all the way up to $37.83 and the price of a gallon of gasoline to $1.72. Yesterday, oil closed at $137 and gas sells for $4.06.
But Kudlow was hardly alone in his hallucinations. Laurence Lindsey, then George Bush’s senior economic advisor, looked into his own crystal ball and saw nothing he didn’t like.
"Under every plausible scenario, the negative effect will be quite small relative to the economic benefits... The key issue is oil, and a regime change in Iraq would facilitate an increase in world oil," thereby driving down oil prices.
You can read today’s Daily Reckoning in full HERE
P.S. If you enjoyed this article then we encourage you to sign up for the free Fleet Street Daily eletter. Learn what you can expect from today's markets -- and how to prosper in the face of uncertainty. You won't find more thought provoking writing anywhere on the Internet.
