Price / Earnings Hybrid Strategy
It is appreciated that Trade2Win is first and foremost a "technical analysis" site. Those that know of me from T2W may be aware that my methodology is one of "fundamental analysis". From this rather black and white perspective, what do I have to offer the committed technical analyst? I offer you the price/earnings ratio.
The P/E ratio, as it is more commonly referred to, lends itself well to the non-financial analyst for a number of reasons. I shall suggest a methodology that is hybrid in nature, combining the P/E ratio (exclusive of any knowledge, or reference to, the financial statements) with a technical chart that acts as a filter for the P/E ratio, imbuing the P/E’s calculation with a factor of safety. We shall end up with a methodology that has been statistically tested through 60 years of varied market conditions, returning on aggregate 24% actualised returns. Still interested?
- "TTM", or trailing twelve months, i.e. the last four quarters’ earnings.
- "Current", from the last "year’s" earnings as per the "Annual Report".
- "Forward", on projected earnings for the next financial year.
Which format to use? Traditionally, analysts would use "current" earnings. This is probably less true today, as the emphasis has shifted to "forward" and "TTM". I recommend, of course, referring to "current" earnings. The reasons are quite technical, and it is beyond the scope of this article to explore them in detail. It is however relevant to provide an explanation, as we are putting into operation a “contrarian” strategy, and therefore wish to avoid the crowd.
Embedded within a low P/E ratio are some powerful psychological truisms that can benefit the conservative trader. The market has made, and is making, some very definite statements within a low P/E ratio. Let us examine them in some detail. The market has passed judgment upon this common stock thus:
- Poor growth prospects and poor earnings expected in the future
- The industry has poor growth prospects and poor earnings expected in the future
- There is a decreasing trend of earnings; this company, and industry, may be finished.
- This stock and industry are boring
- No analysts follow this stock and it’s not worth paying attention to.
- Neglect, generally, as a second tier stock.
Low P/E stocks have some pitfalls and traps that you must be aware of. The dependability of the earnings cannot be relied upon. Accounting tricks and artifices can seriously distort earnings, upwards, or downwards. Without a thorough and penetrating analysis, aberrations will slip through undetected and even with said analysis, mistakes can still be made by the analyst. Again, due to the limited space available in the article, a detailed explanation of the methods used to detect these distortions is inappropriate.
However, all is not lost. An effective filter exists: the price chart. The specific pattern that will be employed will in most, if not all, cases eliminate the need ever to look at a financial report; this combined with adequate diversification provides excellent risk management. By taking this approach (chart analysis combined with adequate diversification), we can therefore dispense with the requirement of reading the annual report, or performing ratio and commonality analysis. The effect is to avoid jumping onto the issue on the basis of good news, and eliminating the risk of too much money in one stock.