Topic: How To Invest

Investor Toolkit: Why the quick and easy way to buy stocks could be the wrong way

Buy Stocks

Every Wednesday, we publish our “Investor Toolkit” series on TSI Network. Whether you’re a beginning or experienced investor, these weekly updates are designed to give you stock market advice and tips on the most effective ways to buy stocks.

Today’s tip: “Many investors acquire the habit of focusing on stocks that have an attractive reading on a single investment measure, but that one measure may disguise problems that could make the stock a disaster-in-waiting.”

When they look for stocks to buy, investors sometimes fall into a habit of focusing on those with a particularly attractive reading on a single investment measure. These readings include a low per-share ratio of price-to-earnings, a low price-to-book-value ratio, or a high dividend yield. This seems like a quick, easy way of spotting an investment bargain.

However, most investment measures fall on a spectrum that ranges from suspiciously cheap to extraordinarily expensive.

For example, suppose you decide you will only consider buying stocks with a per-share price-to-earnings ratio of 10.0 or less. That way, you hope to get more earnings for each dollar you invest. But the “e” or earnings in the p/e only covers earnings, or an earnings estimate, for a single year. The year your low p/e covers may coincide with a peak in the company’s earnings, for any number of reasons.

One key reason is that many disasters-in-waiting go through a low-p/e period prior to their eventual collapse. During this low-p/e period, people close to or involved with the company recognize that it has serious problems. They sell their own holdings and they tell their friends and relations to do the same.

Another common problem is that the company is cyclical and is at the top of its business cycle. (It’s easy to overlook the fact that tech stocks tend to be cyclical. Their growth can mask the typical peaks-and-valleys of a business cycle.)

Specific reasons why a company’s profit may slump for one or more years include the expiration of a patent, new competitors, a rise in costs, adverse legal or regulatory changes, or investigations for illegal activity.

As the saying goes, that low p/e may signal danger rather than a bargain. Note, however, that staying out of high-p/e stocks can also hurt your results.  

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It can be a mistake to buy stocks that are “suspiciously cheap.” Inc., $421.71, symbol AMZN on Nasdaq (Shares outstanding: 465.6 million; Market cap: $198.1 billion;, provides one of the decade’s best examples. The stock bottomed out at $36 in October 2008, six months prior to the bottom in the market indexes. Since then, it has risen more than 10-fold. During that time, its p/e ratio ranged from more than 100.0-to-1.0, to well above 1,000-to-1.0.

The company has wisely taken advantage of a growth opportunity, as it entered new areas of online marketing. It did so by re-investing a large part of each year’s gross earnings in the business. This pushed down the final earnings or “e”. At the same time, the stock soared. These two factors combined to push the stock’s p/e to record heights.

Amazon is a hold for long-term growth.

Here are four key points to take away from all this:

  1. To get any real value out of any investment measure, p/e’s included, you need to look at them in the context of everything else that’s going on, in the market and in individual stocks.
  2. Most investment measures fall on a spectrum that ranges from suspiciously cheap to extraordinarily expensive.
  3. It’s a mistake to focus on stocks in the “suspiciously cheap” end of the p/e spectrum. It’s also a mistake to reject stocks of out hand, just because their high p/e’s make them seem too expensive.
  4. Most investors, most of the time, will find their best opportunities in the middle of the spectrum, far from the extremes of suspiciously cheap to extraordinarily expensive.


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