In today's episode of Market Foolery, host Chris Hill and MFAM Funds analyst Bill Barker answer some of your most pressing listener questions. What's this whole P/E multiple thing, and what can investors really do with it? Why do so many big stock drops lead to a wash of lawsuit announcements, and why don't those lawsuit announcements drop those stocks even further? What happens in those class action lawsuits, anyway?
Plus, an update on the body of medical literature extolling the virtues of coffee. Is something amiss with all this good coffee news? Bill finds it unlikely -- go ahead, drink that seventh cup of hot bean water. Tune in to find out more.
To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. A full transcript follows the video.
This video was recorded on July 2, 2019.
Chris Hill: It's Tuesday, July 2nd. Welcome to Market Foolery! I'm Chris Hill. Joining me in studio, from MFAM Funds, Bill Barker. Thanks for being here!
Bill Barker: Thanks for having me!
Hill: As I mentioned yesterday with Ron Gross, we're off this week, basically. But we don't want to go with no episodes. It's a short week. We'll be off tomorrow, we'll be off Thursday. But we were here yesterday and today.
Barker: Go to the beach!
Hill: Go to the beach! Take a little time off! Hopefully, folks get a little bit of time off.
Barker: Pay some attention to your family for once! Stop listening to podcasts all day long! Is that what you're saying?
Hill: That was directed at me, wasn't it? We're going to dip into the Fool mailbag because we got a bunch of great questions. Let's start with Jordan White, who writes to us from Yale University, your alma mater!
Barker: A fine, fine institute if ever there was one.
Hill: Jordan, a little bit younger. He's class of 2020.
Barker: Little bit.
Hill: Jordan writes, "I was hoping you could explain P/E multiples a bit. I was confused why Shake Shack's multiple was super high. Why would a stock's earnings per share go down when their stock price goes up?" It's a math question, so clearly, it's not for me.
Barker: The P/E multiple is one data point made up of two data points, the price and the earnings. It's a shorthand to get into part of the story on a stock. If a stock is trading at 20 times earnings and the market's 20 times earnings, OK, it sounds like an average amount of enthusiasm for that company based on that very limited bit of data. What if a company is trading at 70 times or 80 times earnings, like Shake Shack? Why is it trading that high? There may be a number of reasons. Typically, it's going to be -- other things being equal -- that the present earnings are low, but the future earnings are going to be much greater, and it's a fast-growing company to trade at such a high P/E multiple. Something like a carmaker -- Ford, GM, they tend to trade 5 times to 7 times earnings. They're cyclical companies. They make much, much more money, they have much longer histories than Shake Shack. But that long history also shows they do not grow 10% year after year after year; rather, they have bursts of money making in a good year, and then the cycle turns. So they don't compound the growth of the company in a meaningful way, the way that at least the enthusiastic people out there for Shake Shack right now look at the number of restaurants they have, the number of restaurants they could have in the future, the number of restaurants they say they're building every year, and they say, "Look, that's worth a lot more."
Hill: I find that, in my own investing life, I use the P/E ratio only when it's an outlier. And now that I think about it, really just on the high side. I will maybe avoid buying shares of a company if the P/E is so insanely high that I just look at it and go, wait a minute, there's so many assumptions built into this in terms of growth that I don't think I can justify putting my money here and I'm going to find investing ideas elsewhere. On the flip side, I don't think I've ever bought a stock simply because the P/E was super low. I've never looked at a company and been like, God, look how cheap this is. By the way, plenty of people invest that way and do quite well investing that way.
Barker: And most of the history of the stock market involves that being a successful strategy. People focusing on lower-P/E companies made more money than people buying stocks at higher P/Es. That has not been the case for certainly the last 5 years and the better part of longer periods like 10 and 20 years, where growth has outperformed value. Those that would say, "Look, the P/E multiple for your NASDAQ stocks has gotten out of control. P/Es always come back to the last 120-year average. Just you wait, it can't go like this." That argument stems from, typically, you need to grow a company 20%, you need to keep buying more stuff, you need to build another factory, there's more physical demand on what you need in order to grow. With software companies, things which can scale very, very fast with very little incremental new investment, there is a reason to consider whether it's different this time, as some people point out, that that's the word you should be most frightened by. But Ford can't really change. Ford is not benefiting from the scalability of the internet particularly. So they're trading at about the same range they've always traded. Whereas the Microsofts and other software companies trade at a different multiple.
Hill: Got a question from Matthew Livsay. Another college student, University of Central Florida. Go, Knights!
Barker: Also a great institute.
Hill: As he writes, "Occasionally, after a negative earnings report or unexpected development, an avalanche of class action lawsuits will suddenly be announced on behalf of investors a variety of law firms. You can find news alerts and press releases on a variety of websites. They tend to be worded something like 'such and such a law firm has announced a class action suit against 'insert name of company' on behalf of investors.'" The email continues. It's a very detailed, thoughtful email, which basically boils down to, I think Matthew's question is essentially, "What is going on here? What are investors like me supposed to make of this? Is this a scare tactic? Is this short-sellers?" You sometimes see instances where, if you just look at the news feed of a company, you'll see a bunch of press releases from law firms, and then those lawsuits will disappear. Again, I think the overarching question, what are we supposed to think when this happens? Because this happens more frequently than I think the average investor might expect.
Barker: I've only done one class action lawsuit in my previous life as an attorney, and that was on the defense side, not on the plaintiff side. But what they are doing, a stock goes down, it announces missed earnings, whatever. "Oh, we've got an accounting issue." That is a much better basis for your typical class action suit. But let's just say there's an earnings miss and the stock goes down 25% in a day, which doesn't happen every time there's an earnings miss, but it does some of the time, especially with a high-flying stock. What the class action announcements are after is getting plaintiffs to join with them to be a named plaintiff. You can't just sue, you can't just be a lawyer who has not him- or herself suffered any injury from the decline of the stock price and sue because you would like some money. You have to represent somebody who is actually a victim of this. Whether they're a victim or they've lost money, and that's the nature of investing, what they want is some plaintiffs who are going to pass the scrutiny of the court. That is to be somebody who says, "Look, I bought this stock based on my research. I had looked into the company. I'd looked into what management said they were going to do. I paid what I thought was a fair price after doing my valuation. Then they came out with this news that was completely different from what was out before, and I lost money. I'm a victim." And there's going to be an allegation in the suit that management knew that they were misleading investors, and that when they finally disclosed they had been misleading investors and the market reacted to that, the jig was up. You have to have a couple of other elements, typically that somebody in management sold shares, so that's how the construct of the suit is. Like, "Management kept the price high so that they could sell their shares, and then announced that things weren't as good as they'd said, and they were already out and everybody else was holding the bag."
Hill: I'm glad you mentioned the insider selling, because that's one of those things that, I think a lot of people look at insider selling and automatically assign a negative connotation to that. It's like, "Well, if the CEO or the CFO or anyone with a C at the front of their title is selling, they must know something, so I'm getting out." That is sometimes the case. But a lot of times, it is simply a situation where the executive has so much equity that they have essentially set up an automated selling plan, where it's just, "I'm just selling 1% of my holdings," or insert your number, but, "I'm just selling a little bit every quarter on an automated basis. Please don't read anything into it other than I'm looking to diversify like any investor is looking to diversify."
Barker: Yeah. And that is typically going to be the case. Certainly is going to be the defense if the case survives the summary judgment motion -- not to bore people with how these things play out. But what the listener has written in about here is that there's all these announcements of lawsuits, and that announcement stream doesn't itself seem to affect the stock. The stock goes down 20%, you know there are going to be these suits. To incorporate efficient markets theory, as soon as a piece of news bad enough to drive a stock down 20% comes out, everybody knows there's going to be these suits as well. The initial reaction incorporates, that's an undisclosed piece of news that accompanies the bad news, but everybody knows, yeah, there'll be the suits, there'll be a bunch of them. What happens is, the court ultimately decides which attorney has acquired the best set of plaintiffs and is most equipped to handle this case, and then they're all consolidated, because the company doesn't face 12 different class action suits from the same decline of its price. Everything gets consolidated and there's a lead attorney, and ultimately, everything settles.
Hill: Did you win your case?
Barker: Uh, it... I...
Hill: That sounds like a no.
Barker: In court, we won the part of the case that I was on the team for. We won a big part of it. Class action kept going for some period of time well after I had moved on to another job.
Hill: You did your part.
Barker: It was the first time I really got to do some interesting stuff in court, which was very, very exciting.
Hill: Nice, like actually interacting with the judge and that sort of thing?
Hill: Was it like Law and Order? Did you ever shout down the other attorney on the other side?
Barker: Take my shoe off and start banging it --
Hill: Maybe not that.
Barker: [laughs] "You're out of order!"
Hill: Not to that extreme --
Barker: No, I didn't do that.
Hill: -- but just, like, "Point of order," or something.
Barker: No. I'd just say "Your Honor" a lot.
Hill: Question from Tom Sikorsky. I misspoke. It's not actually a question. It was a single line that Tom sent in. Longtime listener Tom Sikorsky with a couple of news links, and the email that Tom wrote simply reads, "The most important topic of the day, coffee." Tom is referring to a couple of new studies that came out. Thank you Tom and other listeners who either tweeted or posted this in our Facebook group. Yet another study about the health benefits of coffee. This is one that surprised some people, including the science community. A new study about how coffee -- look, there's plenty of documented scientific data on the health benefits for your heart, how it fights all manner of diseases. This is one, a new study that coffee could help burn fat. It helps fight obesity. It is, in short, a superfood.
Barker: You get a lot of emails, a lot of tweets, about this, because we have gone on at some point -- just to let people know, we are not actually, either one of us, doctors or scientists. We are fans. Fans of coffee. We highlight the things that make us feel better. The number of studies which show there might be some danger to drinking coffee is greater than zero. But we like to round it down to zero because the number of studies that show that it has benefits is now in the millions.
Hill: Maybe not in the millions, but it is growing. One side is growing, the other is not. Which leads to this question, and this is a serious question.
Barker: [laughs] You can ask a serious question, am I expected to answer it seriously? I'm not a scientist.
Hill: I know you're not. But you are an investor, and you are a fan of coffee. I am curious, because I did have this thought when I was looking at this latest batch of studies. Is the embarrassment of riches -- and that's really what it is, in terms of scientific studies -- is the embarrassment of riches in terms of coffee-related studies making you even 1% nervous that something is amiss here? Like, when we first started talking about these, it really was something where it was like once a year, a study would come out. I'm going back to the beginning of Market Foolery -- 2011, 2012, that sort of thing. It's now coming on a more frequent basis, covering more health conditions. And this is the first time I've looked at this and thought, "My gosh!" This is like, if you're a fan of a sports team, and they're winning the championship every year for a decade. On some level, as a fan of that team, you have to think to yourself, "This is great, but at some point, this is going to end." I'm wondering, on any level, are you at all nervous about, another very reputable study is going to come out and be like, "Actually, no, we've been wrong about this."
Hill: [laughs] OK.
Barker: Are you?
Hill: As I said, part of my reaction to this latest round was, this is running up the score. I'm happy --
Barker: Are you worried that big tea is going to fund some counterresearch?
Hill: If you were big tea, wouldn't you fund counterresearch? If you were big any other beverage, wouldn't you do that?
Barker: Well, I'm not as much of an evil big manipulator as there are out there, I guess. But, no. Everybody should be promoting this so that the word gets out. I don't know. I think it probably will attract more study, more research. I don't know who's going to fund the research that looks for the bad stuff.
Hill: In the meantime, there's no reason not to have a seventh cup of coffee.
Barker: Yeah, no, the danger is not having enough coffee, as we've pointed out for years.
Hill: Right. Again, we are off tomorrow. We're off Thursday. Happy Independence Day to everyone! Hope everyone has a good bit of time off. If you're on the roads, be extra careful, because this is one of the busiest times to be on the road in America. And for crying out loud, be safe with the fireworks. Please, please just be safe with the fireworks! Don't be one of those people who ends up on the Darwin Award list. Just be safe with the fireworks!
Hill: For us and for the kids. Do it for the kids! Again, off Wednesday, off Thursday, but back, next week, Mac Greer, live from Colorado.
Barker: It's my 25th anniversary today. Did you know that?
Hill: Wedding anniversary?
Barker: Yes. And here, you've left it uncommented upon.
Hill: Once again, I buried the lede. Happy 25th to you and your lovely bride!
Barker: Thank you!
Hill: I'm assuming a fabulous meal is an order, or perhaps more than one.
Barker: Yeah. We're going to adjourn to Bermuda.
Barker: Not today, but very soon.
Hill: Very nice! You know what they have in Bermuda?
Hill: Coffee. Bill Barker from MFAM Funds, thanks for being here!
Barker: Thank you!
Hill: As always, people on the program may have interest in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. That'll do it for this edition of Market Foolery! The show is mixed by Austin Morgan. I'm Chris Hill. Thanks for listening! We'll see you next week from Colorado!