f you have heard fund
managers talk about the way Now, if these low P/E stocks had
they invest, you know a very unstable earnings or carried
great many employ a top down a great deal of debt, the spread
approach. First, they decide how between the long bond yield and
much of their portfolio to the earnings yield of these
allocate to stocks and how much stocks might be justified.
to allocate to bonds. At this However, many low P/E stocks
point, they may also decide upon actually have more stable
the relative mix of foreign and earnings than their high multiple
domestic securities. Next, they kin. Some do employ a great deal
decide upon the industries to of debt. Still, within recent
invest in. It is not until all memory, one could find a stock
these decisions have been made with an earnings yield of 8 -
that they actually get down to 12%, a dividend yield of 3- 5%,
analyzing any particular and literally no debt, despite
securities. If you think some of the lowest bond yields in
logically about this approach for half a century. This situation
but a moment, you will recognize could only come about if
how truly foolish it is. investors shopped for their bonds
without also considering stocks.
A stock's earnings yield is the This makes about as much sense as
inverse of its P/E ratio. So, a shopping for a van without also
stock with a P/E ratio of 25 has considering a car or truck.
an earnings yield of 4%, while a
stock with a P/E ratio of 8 has All investments are ultimately
an earnings yield of 12.5%. In cash to cash operations. As such,
this way, a low P/E stock is they should be judged by a single
comparable to a high - yield measure: the discounted value of
bond. their future cash flows. For this
reason, a top down approach to than it is for a general manager
investing is nonsensical. to prefer all lefties over all
Starting your search by first righties. You needn't determine
deciding upon the form of whether stocks or bonds are
security or the industry is like attractive; you need only
a general manager deciding upon a determine whether a particular
left handed or right handed stock or bond is attractive.
pitcher before evaluating each Likewise, you needn't determine
individual player. In both cases, whether "the market" is
the choice is not merely hasty; undervalued or overvalued; you
it's false. Even if pitching left need only determine that a
handed is inherently more particular stock is undervalued.
effective, the general manager is If you're convinced it is, buy it
not comparing apples and oranges; - the market be damned!
he's comparing pitchers. Whatever
inherent advantage or Clearly, the most prudent
disadvantage exists in a approach to investing is to
pitcher's handedness can be evaluate each individual security
reduced to an ultimate value in relation to all others, and
(e.g., run value). For this only to consider the form of
reason, a pitcher's handedness is security insofar as it affects
merely one factor (among many) to each individual evaluation. A top
be considered, not a binding down approach to investing is an
choice to be made. The same is unnecessary hindrance. Some very
true of the form of security. It smart investors have imposed it
is neither more necessary nor upon themselves and overcome it;
more logical for an investor to but, there is no need for you to
prefer all bonds over all stocks do the same.
(or all retailers over all banks)
About the Author:
Geoff Gannon writes a daily value investing blog and produces a twice weekly (half hour) value investing podcast at Gannon on Investing.
Source: www.isnare.com
