Wednesday, May 22, 2013

Not all P/E ratios are created equal

My favorite companies to invest in are those that have strong competitive advantages, which allow them to have an easily distinguishable product or service. This allows companies to have pricing power. This pricing power comes from the strong brand name associated with the product, and it allows the business to earn high returns on equity, and pass on cost increases to customers. This translates into solid profitability, which enables the business to increase dividends to shareholders over time.

I try to buy stock in great businesses only at attractive valuations. For me this entails a P/E that is lower than 20, an adequate dividend yield, a history of consistent dividend growth and an adequately covered dividend. In the current market environment, most stable businesses are trading at the higher end of what I am willing to pay for. I am planning on holding on to these cash machines, as I expect them to pay much higher distributions and earn much more ten, twenty or thirty years down the road.

However, I am also considering selling a few of those businesses if they trade above 30 times earnings. Brown-Forman (BF-B), Kimberly-Clark (KMB) and Colgate-Palmolive (CL) are a few businesses that would be overvalued at 30 times earnings. Currently these businesses trade at 26.90, 22.60 and 25.50 times earnings. All of these companies have strong brand names, and solid and dependable cash flows, that will only be increasing for the next 20 – 30 years. However, as I like being prepared in deploying cash from stocks I have sold, I have been researching attractive candidates for reinvestment.

I have been able to find plenty of companies with low P/E ratios, which could be fine investments for new capital. However, I am not so certain whether many of these investments have the same characteristics as the ones I am considering selling.

Many of these companies are cyclicals. Their fortunes rise and fall with the economy. Examples include companies such as BHP Billiton (BBL), Caterpillar (CAT), Exxon Mobil (XOM). BHP Billiton trades at 16.50 times earnings, Caterpillar trades at 12.10 times earnings, while Exxon Mobil trades at 9.30 times earnings. If the economy goes through another recession like the one we experienced in 2008 – 2009, commodity prices will plummet, which would depress earnings for commodity producers. It could also negatively affect the three companies mentioned above. Another sector that is somewhat cyclical is the financial one, as recessions could lead to losses in loan portfolios, when borrowers lose their jobs during the downturn.

As a result, one cannot compare the low P/E ratio of a cyclical company such as BHP Biliton to the high P/E ratio to a consumer staple such as Procter & Gamble (PG) or Colgate-Palmolive (CL). The earnings per share of a cyclical company might fall by 50% during the next recession, whereas the earnings per share of a company like Procter & Gamble might stay flat or even increase.

For example, between 2008 and 2009, EPS for Exxon Mobil fell from $8.69/share to $3.98/share, before recovering to $9.70 by 2012. EPS for BHP Billiton fell from $5.50 to $2.11 during the same period, until reaching out $5.77 in 2012. At the same time, Procter & Gamble’s (PG) earnings went from $3.64/share to $4.26/share. From there on they decreased to $3.66 by 2012, although this could be due to one-time items.

Investors should also avoid purchasing shares in companies whose P/E ratios are low today, but which might have issues in maintaining profitability ten years down the road. For example, many technology companies such as Intel (INTC) and Microsoft (MSFT) appear cheap today at 12.10 and 16.70 times earnings. However, if Intel fails to grow earnings over the next decade, the only returns for enterprising income investors might be derived from a flat dividend. If these companies fail to adapt to the ever changing world of technology, where paradigm shifts are the norm every five years or so, their earnings stream might be much lower over time. This could even pose problems for the future stability in dividend payments.

The purpose of this exercise is not to show that Exxon Mobil, Intel and BHP Billiton are bad investments today. The purpose is to show that investors cannot compare P/E ratios in vacuum between sectors. Purchasing a stock at a low P/E ratio is a winning proposition if earnings do not fall during the lifespan of your investment, but increase over time. If earnings fall by 50%, a company that looked cheap at a P/E of 15 might become overvalued all of a sudden.

It is also important to understand the company one is purchasing, how they generate their money, do they have any advantages, and analyze the trends in earnings per share, dividends per share, revenues and Returns on Equity over the past 10 years. I am considering to slowly start accumulating cash in my portfolios as the market continues going higher. However, I might consider adding to some cyclical names such as the oil majors if markets behave like they did in 1995.

That is why selling overvalued companies like Brown-Forman (BF-B) is so tough, and i have been dragging my feet doing it. I see Brown-Forman as a company capable of earning at least $6/share in 2023, and worth $120/share then. I also believe that I would earn close to $20 - $25/share in dividends from the company over the next decade.

Full Disclosure: Long BF-B, CL, KMB,

Relevant Articles:

Strong Brands Grow Dividends
Replacing appreciated investments with higher yielding stocks
Attractively valued dividend stocks to consider today
Why would I not sell dividend stocks even after a 1000%. gain?
Seven wide-moat dividends stocks to consider

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