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May, 2005


In the August, 2004, larvalbug bytes I presented an essay on computer screening to find good stocks. To illustrate, three low price to earnings ratio assets were suggested.

Since the selection date (8/18/04) and through the close of business on 5/13/05, the mean appreciation of the three securities has been 24.8%. In the same period, the S&P 500 Index has appreciated 5.4% (roughly a 6.4% total return if dividends are included).

While I cannot guarantee stocks chosen in this manner will always perform close to four times as well as the major averages, per Janet Lowe in her 1994 book, Benjamin Graham on Value Investing: Lessons from the Dean of Wall Street, a low price to earnings strategy in the past provided an average of 15% or better compound annual performance (before dividends, taxes, and commissions) for every five year period through Graham's more than half-century of investing.

Here is his approach, as described in Janet Lowe's cited work and further discussed in John Train's books, The Money Masters (1980) and The Midas Touch (1987):

  1. Take the average AAA (or Aaa) corporate bond yield and multiply by 2;

  2. Assure that the earnings yield (the reciprocal of the P/E) of the candidate stock is greater than the result from #1;

  3. A company with a P/E of 10 will have an earnings yield of 10, one with a P/E of 5, will have an earnings yield of 20. If the AAA corporate bond yield is 10, the earnings yield of 10 (P/E of 10) will not do, as it must be twice the AAA corporate bond yield. But if it is 20 (P/E of 5), that works perfectly. A P/E of 4 equates to an earnings yield of 25, more than adequate when the AAA corporate bond yield is 10. Today the AAA corporate bond yield is around 5.5. Double that, and the earnings yield must be at least 11. Thus, the P/Es considered must be no greater than 9.09. (If my arithmetic is correct, to obtain the maximum allowable price to earnings ratio under this strategy, divide 100 by twice the AAA corporate bond yield.) Note: even if the formula from the AAA corporate bond yield would permit it, never invest in stocks with a P/E above 10.

  4. Considering only stocks with P/Es of 10 or below and such that the earnings yield is at least twice the AAA corporate bond yield, check the ratio of shareholders' equity to total assets. All acceptable candidate stocks must have shareholders' equity to total assets of 50% (.50) or greater.

  5. Create a portfolio of at least 30 such stocks.

  6. Hold each asset until it has appreciated 50% or more or until it has been held to the end of the second calendar year from date of purchase, whichever first (i.e. if bought May 13, 2003, sell by the end of December, 2005, at the latest).

In addition to the above rules, I have added four more, to better assure the portfolio's safety and total return potential:

  1. A stock at the time of purchase must have some dividend;

  2. The dividend payout ratio must be no more than 0.5;

  3. The company must have positive free cash flow;

  4. The debt to equity ratio must be .33 or below.

Here then is an updated low P/E selection, the best 5 out of 9 stocks I found that meet these minimum buy criteria (and remember, an investor utilizing this method should gradually add new assets, as others qualify, until she or he has a portfolio of 30 or more, then replace any sold with new low P/E stocks that also meet the initial purchase criteria):

P/EDividendDebt to
Chevron Corp.CVX$
Outlook Group Corp.OUTL$7.758.53.1%0.11
Phelps DodgePD$79.916.51.2%0.22
Radian Group, Inc.RDN$45.508.70.2%0.21
Schnitzer Steel Ind.SCHN$22.324.40.3%0.09

(All table data is effective with the close of trading 5/13/05.)


Larry is not a professional. Don't take him seriously!

Actually, the investment article provided here is for general information only and should not be considered as professional advice, a solicitation to buy or sell any security, or the Word of God. Investors are encouraged to do their own research while considering their personal goals and circumstances, or consult their own professional financial advisors, before making investment decisions. Neither Larry nor LARVALBUG will be liable for any losses sustained by any visitor to this site.

(Disclosure statement: Larry and Val have holdings in some of the suggested assets but do not "make a market" in any of them and do not derive any direct benefit from recommending them, except perhaps for a bit of smug self-satisfaction.)

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