Study after study has shown that stocks with low price-to-earnings multiples significantly outperform high P/E stocks. Research from my favorite investing guru, NYU professor Aswath Damodaran, pegged the outperformance at anywhere from 9% to 12% per year, depending on the study period. That's big money we're talking about.
But you already know that you can't just go out and buy the stocks with the lowest multiples. Companies can trade at dirt cheap prices for a number of dire reasons, including low growth prospects, skepticism about earnings, or high risk of bankruptcy.
These dangerous stocks can quickly crater. Buy too many of them, and you'll increase your own risk of bankruptcy!
Thus, for a firm to be truly undervalued, Damodaran says in his book Investment Fables: "You need to get a mismatch: a low price-to-earnings ratio without the stigma of high risk or poor growth."
Of course, you're unlikely to find any high-growth, low-P/E companies out there. But Damodaran suggests setting a reasonable minimum threshold for earnings growth, such as 5%. There are also various ways to minimize risk, including staying away from volatile stocks or companies with dangerous balance sheets.
The screen's the thing
We're looking for companies with low price-to-earnings multiples, but also a relatively low amount of risk, and the potential for reasonable growth. Our screen today will cover the best value plays in the "Pharmaceuticals, Biotechnology and Life Sciences" industry, as defined by my Capital IQ screening software.
There are 104 such companies with market caps topping $500 million on major U.S. exchanges. They have an average forward P/E of 23.2. Here are my parameters:
- In order to stay away from bankruptcy risk, I used Damodaran's suggestion and only considered companies with total debt less than 60% of capital.
- In hopes of capturing a reasonable amount of growth, I looked at Capital IQ's long-term estimates, and kept only companies expected to grow EPS at 5% annually or better over the next five years. Furthermore, I required at least 5% annualized growth over the past five years.
Of the 25 companies passing the screen, here are the 10 with the lowest forward price-to-earnings multiples:
|
Company |
Market Cap |
Forward P/E |
Debt-to-Capital |
Estimated EPS
|
|---|---|---|---|---|
|
Endo Pharmaceuticals Holdings |
$3,836 |
9.2 |
17% |
10% |
|
Gilead Sciences |
$29,864 |
10.0 |
20% |
14% |
|
Teva Pharmaceutical |
$47,365 |
10.4 |
27% |
13% |
|
Merck |
$113,139 |
10.5 |
24% |
7% |
|
Amgen |
$52,822 |
10.8 |
34% |
9% |
|
Biogen Idec |
$13,576 |
11.2 |
17% |
8% |
|
Abbott Laboratories |
$80,636 |
11.9 |
48% |
10% |
|
Watson Pharmaceuticals |
$5,284 |
12.2 |
28% |
11% |
|
Johnson & Johnson |
$170,665 |
12.9 |
18% |
7% |
|
Thermo Fisher Scientific |
$19,508 |
13.1 |
12% |
10% |
Data provided by Capital IQ, a division of Standard & Poor's.
There are lots of good research candidates here. To further stack the odds on your side, Damodaran says you can eliminate any companies that have restated earnings, or had more than two large restructuring charges over the past five years. And if volatile swings in price cause you to lose sleep, consider only companies with betas less than 1.
What about companies in other industries? I'll be running more screens over the coming days, so be sure to check back in this space.
