Investment Analysis Takes More Than One Number
While I was reading The Number (by Alex Berenson) recently, one line struck me and I realized that I’ve been doing it all wrong. Ok, I don’t need to re-do my whole investment strategy. But I’ve been looking a lot at things like the P/E ratio which is a single number that condenses a lot of information. I would love to buy a solid index with a P/E of 5 and I would stay away from one with a P/E of 30.
That’s a bit too simple though. The book points this out well since it’s all about how investors came to focus on one number, quarterly earnings, and ignore a lot of other information. Investors who see rising quarterly earnings will ignore a lot of other important information that will clearly affect future results. I’ve had a similarly limited focus by looking at the P/E ratio so much.
When a wise investor looks at an individual stock, they will look at not just the current earnings but also the likely factors that will affect future earnings. That’s harder to do at the level of an index since every stock will be affected by different factors. To some extent I have to trust the market price and hope that a slightly high P/E ratio means better prospects for future earnings unless I have reason to believe that it’s just investor euphoria.
This applies to other measures since no single number can be taken on its own. For example a lot of people point to the Shiller P/E ratio (or P/E10, using the last 10 years of earnings) which is well above average for the S&P 500 and may be indicating low returns for stocks. But those 10 years of earnings include a lot of exceptional events such as the U.S. housing bubble and the subsequent crash and recession(s). A few years of lowered earnings could easily push up the P/E10 number even if we are past the point where they will have a significant impact on future earnings.
I don’t know that for sure since I would need to analyze every stock to see how it was affected and what its future prospects are. But if other measures look good, one number that’s out of place could just be an exception rather than a warning sign. This is also a good reason to ignore predictions of doom based on some nutty theory like a 70-year market cycle. Anyone can find one measure that looks alarming. Ironically when all of them look bad and there is a real cause for concern, people are usually looking the other way and don’t notice.