3 Companies to Worry About, 3 That Are Safe

Most Foolish investors want to buy stocks that are priced at less than what they're really worth. That's easily said, but nowhere near as easily done.

Many investors use the price-to-earnings (P/E) ratio to measure a stock's cheapness -- largely because it's so easy. To calculate the ratio, you simply divide the current price by some measure of earnings (trailing 12 months, projected future, average 10-year, etc.). You can then compare that against competitors, the company's own history, or the market as a whole.

But investors often focus too much on the "price" part of the price-to-earnings equation. If the ratio is low -- and therefore, the stock looks cheap -- investors often assume that the price will invariably rise to bring the P/E back up.

Not so
This kind of thinking can get investors into trouble. Like any ratio, the P/E has both a numerator and a denominator. If a P/E looks set to rise, it could very well do so because the earnings in the denominator drop.

A company that is referred to as "cyclical" tends to perform extremely well during economic (or industry) expansions, but suffers significantly during downturns. For investors watching P/E ratios, these companies can be particularly tricky. During good times, profit margins can expand significantly, which brings down the P/E and makes the stock look cheap. But those high margins will only hold through the next cyclical downturn, at which point profits will fall, the P/E will rise, and the stock may sell off.

What do these companies look like? Here are three that currently benefit from above-average margins.

Source: Capital IQ, a Standard & Poor's company.

Should investors sell these stocks simply because they're showing peak margins? Hardly. But when calculating prospective returns, Fools should remember that these margins will likely fall in the years ahead, putting pressure on these companies' bottom lines.

This particularly worries investors with shorter-term outlooks. As the term "cyclical" implies, unless something happens to change the company, a coming downturn in profitability would be followed by yet another upturn, where margins reinflate. But if your definition of "long term" is one year, that won't matter one bit.

Of course, in the case of the companies above and others like them, it's important to consider just how low the current P/E is. I personally own both Intel and Chevron; though their profitability may not stay at its current levels, their respective valuations are so low that the stocks could still be cheap even if profits did fall significantly.

Keeping it steady
Some investors may not want to worry about the prospect of wild cyclicality giving a company's bottom line whiplash. Fortunately, many companies have much more stable margins, even through economic cycles. The three businesses below fit the bill:

Source: Capital IQ, a Standard & Poor's Company.
*Fiscal year ended May 31, 2009.
**Fiscal years starting with May 31, 2001, through May 31, 2010.

What may jump out about this second list is that companies with steadier businesses aren't selling as (apparently) cheaply as the first group. The trade-off, of course, is that there's less worry about drastic changes in profitability over time. This doesn't mean that investors can get by with a complete "set it and forget it" attitude with these stocks. Competitors could move in on J&J, technology could leave Oracle behind, or regulators could make changes that impact Southern Company. But their relatively higher P/Es do make it more likely that year-to-year margins won't swing drastically.

Watch and dig in
Don't assume that you shouldn't invest in one group of companies, and should invest in the other group. Instead, you should simply understand the companies in which you invest, and the dynamics of their industries. For a great way to get to know the companies above, add them to your watchlist by clicking the "+" icon next to each stock's ticker. Don't have a watchlist yet? Click here to start one for free.