You'd think I'd rather review a book like Harry Potter and the Deathly Hollows instead of a somber investing book. Well, I would -- especially because that would match the amuse part of the Fool's motto. But doing so wouldn't accomplish much toward the educate or enrich parts, now would it? And that's at least as important as amusing you. So, onward with a review of a book more educational than Harry Potter facing You-Know-Who, though probably less exciting.
It can't miss
You'll often find people promising you big profits from particular strategies, such as buying immediately after a big drop, following stocks with strong upward momentum, or buying companies with great management teams. Often, the article or advertisement touting the strategy absolutely guarantees market-beating returns. But before rushing out, inspired to try the story that most resonates with you, stop and ask yourself -- does this method really work?
In Investment Fables, Professor Aswath Damodaran of the Stern School of Business of New York University asks that very question for a dozen investing stories. He concludes, perhaps unsurprisingly, that some of them work after a fashion, and some of them don't.
Taking a deeper look
He devotes a chapter to each strategy, such as low P/E, stable earnings, and momentum. For each strategy, he outlines what the strategy is about, takes the reader through the theoretical underpinnings of each, follows with an analysis of what would affect the results of each, and ends by analyzing what would make the strategy work if it was applied intelligently. In some cases, such as the chapter devoted to stable earnings, that last section doesn't have a lot.
Let me take you through part of what he had to say about one strategy: buying low P/E stocks.
Not all P/Es are equal
Damodaran starts off by pointing out that value investors often invest in stocks with low P/E ratios. In fact, the first screen described by Benjamin Graham in "Security Analysis" requires a low P/E in order to pass. He then discusses where the P/E comes from and what can affect the earnings part of the ratio. This includes flexibility in revenue recognition, operating versus capital expenses, and depreciation. Changes can be made in each of these to increase or decrease earnings while still staying within GAAP guidelines. Damodaran even points out that it is important to know which P/E is being discussed: trailing, current, or forward.
Later, he points out that P/E ratios vary across the market, industry sectors, and time. For instance, at the time Damodaran wrote the book, the market included companies with a current P/E ranging from 0 to 7,103, while over the previous 40 years, the average P/E of the market ranged from eight to 30. So, using a rule of thumb of "buy stocks with a P/E below eight" can be good or bad, depending on several things.
Can it work?
Low P/E stocks can outperform the market, but you can't just buy based on P/E alone. There are several other things to consider as well. These include company risk, price volatility, quality of earnings, and growth prospects. Not every low P/E company would make a good investment -- many companies are cheap for a reason. Trying to avoid such companies can help build a better portfolio than just buying low P/E stocks.
At the end of the chapter, Damodaran provides a list of 27 companies that passed his screen in October 2002, taking into account risk, quality of earnings, and the other considerations. The list includes such well-known names as insurance provider Loews (NYSE: LTR ) and cigarette king Altria Group (NYSE: MO ) , along with not-so-well-known names such as footwear producer Brown Shoe (NYSE: BWS ) and plastic-film maker Tredegar (NYSE: TG ) . A portfolio equally weighted in those 27 companies would have returned 17.6% annually since then (not including three that were bought out in corporate takeovers in the interim), compared to 11.1% for the S&P 500 index.
Wrapping it up
Damodaran ends the book with a review of 10 lessons that apply to many of the strategies he investigated -- common themes, if you will. Among these are know yourself and your investing style, remember the fundamentals, and don't forget that luck plays a role, too. Finally, remember that all of these strategies have been around a long time, even when dressed in pretty new clothes.
Overall, this is an excellent addition to any investor's library. While not an easy or short read -- it comes in at 525 pages not including the preface or index -- it should make a valuable read. It helps the reader look below the surface of the "latest" great investment strategy and shows why and when that strategy might work.
So the next time you hear someone say, "This strategy can't miss!", pick up this book and don't be bamboozled by all the glitter.
Fool contributor Jim Mueller was on the edge of his seat as he came to the end of the Harry Potter book. That doesn't mean he doesn't enjoy investment books, but even Fool writers have to take a break now and then. He does not own shares of any company mentioned. The Fool's disclosure policy never made it through Hogwarts. We're not sure if it was Fawkes' fault or not.