We all invest for essentially the same reason: We want to grow our savings for some future event such buying a home, retirement or passing along a legacy when we die. But how we get there sends us off in a thousand disparate directions.
For Christopher Browne, the author of “The Little Book of Value Investing,” getting there meant following Benjamin Graham’s enduring principles. Graham argued that earnings are the main drivers of stock prices, and Browne took that as his cue.
The author wanted to buy stocks selling at low multiples of their earnings because: “If I accept this as truth, and I do, then the less I pay for a stock when compared with earnings, the better my future return should be. Makes sense, right?”
The connection between stock prices and earnings is provided by the price-earnings ratio, and by its inverse, the earnings multiple. Browne got down to basics by explaining how the two metrics work.
Beginning with the price-earnings ratio, assume the ABC Ice Cream Corp. had $1 million in profits and 1 million shares outstanding; that works out to $1 in earnings per share. When the stock price is $10, you are paying that amount to buy $1 in earnings, and the price-earnings ratio would 10 (price of $10 divided by earnings of $1). Should the stock price be $20, then the price-earnings ratio would be 20 ($20 stock price divided by earnings of $1).
Next, Browne turned to the earnings yield, which, as noted, is the inverse of the price-earnings ratio. Earnings yield is calculated by dividing the earnings per share by the stock price. Returning to his ABC Ice Cream example above, we divide the $1 earnings per share by the share price of $10 and learn the earnings yield is 10%. If the stock were selling for $20, the earnings yield would be 5%. If the stock sells for $40, the earnings yield drops to 2.5%. We know from this exercise, then, that the higher the share price, the lower the earnings yield. Similarly, the lower the price-earnings ratio, the higher the earnings yield (and we always want higher earnings yields).
Every quarter, there is something of a lottery-like atmosphere as analysts and investors try to anticipate the earnings of companies and the effects those earnings will have on stock prices. Browne considers that a waste of time, referencing his favorite guru: “Graham’s focus was to look for companies with a reasonably stable record of earnings, a degree of predictability, rather than to search vainly for the specific future earnings estimates that Wall Street seeks. With that in mind, it is still better to just buy the cheapest stocks based on earnings that have already been tallied, audited, and reported to the shareholders.”
As a point of interest not covered by Browne, Warren Buffett (Trades, Portfolio) only followed this approach for a few years. Influenced by Charlie Munger (Trades, Portfolio) and others, Buffett became a believer in what he later called “wonderful companies at fair prices” rather than “fair companies at wonderful prices.”
Browne, however, remained committed to buying bargains, apparently with little concern for quality. He wrote, “Value investing, buying earnings cheaply, is the most reliable way I know to grow your nest egg, not because I say so, but because it’s also been shown to be so—time and again, throughout the decades in numerous academic studies.”
The earnings lottery results should be taken with a grain of salt. He wrote that the earnings number can be misleading because it can include one-time charges or credits that mask the true earnings. Some analysts and investors get around that by using cash flow or operating earnings, rather than just earnings.
Cash flow shows the earnings as reported, plus noncash expenses including depreciation and amortization. There is a variation called “free cash flow,” which starts with regular cash flow and takes out the capital spending needed to keep the company operating.
A company’s attractiveness also can be assessed by using the approach that might be used in a leveraged buyout or by another company interested in buying the whole enterprise. They want to know how much cash a company is bringing in before its interest expenses and income taxes; its true earning power, so to speak. Thus, they start with earnings, then adjust to determine earnings before interest, taxes, depreciation and amortization, which is also known as Ebitda.
Browne argued the practice of buying low price-earnings stocks is effective in both good and bad markets. The “best part” of this strategy is that investors are forced to buy stocks when they are cheap. Of course, the best markets for buying value are those in which fears are deep and widespread. He wrote:
“When stock markets are cheap in general, we are in periods of economic uncertainty. Investors have low expectations for returns going forward. Recessions, high interest rates, war threats, and other malaise rule the day. Fortunately, periods like this are the exception. Mostly, the world gets by.”
Many of the low price-earnings stocks Browne bought were from low-expectation companies, meaning the market didn’t expect them to do very well in the future, they had been beaten up at some point or they were eclipsed by something shiny and new. They looked drab and discouraging in comparison to high-expectation stocks.
Into this world of expectations come surprises, both positive and negative. In his words:
“Study after study has shown that when a low P/E, low expectation stock reports disappointing news, the effect is usually minimal. The market anticipated bad news, and there was no need to knock the price down much further. Conversely, when a low expectation stock surprises the market with good news, the price can pop.”
On the other hand, nothing much happens when a high-expectation stock announces good news; it was already expected or even priced in. When high-expectation stocks announce bad news, however, the stock price can take a very big tumble.
Buying low-price-earnings, low-expectation stocks, then, is a more viable strategy than stocks at the higher end of the spectrum because they have less downside risk and much more upside opportunity.
Read more here:
- Christopher Browne: Enduring Principles of Value Investing
- Christopher Browne: 'Think Like a Banker'
- Christopher Browne: 'Buy Stocks Like Steaks...on Sale'
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