Stocks with low price/earnings ratios can sometimes surprise

John Dorfman
| Tuesday, Jan. 3, 2012

I'm a strong believer in buying unpopular stocks -- those with low price/earnings ratios.

For 13 years, in an attempt to dramatize the benefit of buying stocks with a low P/E ratio, I have conducted a real-time experiment. The goal is to see what would happen if an investor robotically bought the lowest P/E stocks in the marketplace.

I restrict the field to U.S. stocks with a market value of $500 million or more and eliminate any stock with negative earnings in the most recent four quarters (because the ratio can't be calculated) and any stock with debt greater than equity (to reduce risk).

Usually about 1,000 stocks are eligible. The Low P/E Outliers Portfolio consists of the 10 eligible stocks with the lowest ratios.

During the past 13 years, these outlier stocks have averaged a 23.6 percent return per year, compared with a 3.7 percent average for the Standard & Poor's 500 Index. The lowest-P/E group has been profitable in 10 years out of 13, and has beaten the Standard & Poor's 500 Index nine times out of 13.

Why does such a simple paradigm work so well• In essence, it is because stocks advance by exceeding prevailing expectations, and low expectations are easier to exceed. Almost by definition, low P/E stocks are unpopular stocks for which investor expectations are meager.

Another question is why doesn't the concept lose its effectiveness as more people adopt it• I believe the low-P/E effect persists because it takes courage to choose unpopular stocks. For a professional manager, there is career risk, risk of losing clients if the choice turns out badly and risk of ridicule.

A few words about risks are in order. The stocks featured on this list tend to be high risk stocks. They have obvious strategic or tactical problems, their market action is volatile, and they are sometimes concentrated in very few industries.

Last year's crop of low P/E outliers posted an anemic 0.6 percent return, compared with 2.1 percent for the S&P 500 when dividends are taken into account. Seven of the 10 stocks declined.

The best gainer was Ariad Pharmaceuticals Inc. of Cambridge, Mass., up 140 percent. The worst losers were Oshkosh Corp. and Skechers USA Inc., both down 39 percent.

As we begin 2012, the lowest P/E stock in the universe of 1,222 eligible stocks is ITT Corp. (symbol ITT) of White Plains, N.Y. The once-revered conglomerate now sells for two times earnings. Some of its major products are pumps, valves and brake pads.

The P/E ratio of two is a little artificial: It is partly based on earnings from discontinued operations. (ITT recently divested its defense and water operations.) But the stock is also cheap by other measures. For example, it sells for 0.4 times book value (corporate net worth per share).

Selling for a little less than three times earnings is Career Education Corp. (CECO) of Schaumberg, Ill. It is unpopular for a reason. In a regulatory filing in November, Career Education said that it had misstated student job-placement rates and was in danger of losing accreditation at 49 of its schools.

A little over three times earnings is the multiple for Veeco Instruments Inc. (VECO). Based in Plainview, N.Y., it makes instruments for the solar, semiconductor and other industries. Its earnings history is spotty, with seven losses in eight years through 2009.

Leucadia National, a New York multi-industry company that I have recommended in recent columns, and which I own personally and for clients, is on the list, selling for less than four times earnings.

The same P/E applies to Dreamworks Animation SKG Inc. of Glendale, Calif., best known as the creator of Shrek. I own Dreamworks for clients too.

At four times earnings the outliers list includes Momenta Pharmaceuticals Inc. (MNTA) of Cambridge, Mass.; Visteon Corp. (VC) of Van Buren Township, Mich., an auto-parts manufacturer; and HollyFrontier Corp. (HFC), a refiner based in Dallas.

TRW Automotive Holdings Corp. (TRW) of Livonia, Mich., is below five times earnings. The U.S. car market has been weak since 2008, but I see glimmerings of improvement.

Rounding out the list is GT Advanced Technologies Inc. (GTAT) of Merrimack, N.H., which I own personally and for clients. The company makes furnaces that are used to make solar panels and artificial sapphires.

Growth has been good, but heavy price competition looms from Chinese competitors.

Over the past 13 years, I have found this list a fertile ground for bargain-hunting.


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