I'm always interested to observe how new investors learn different ways to analyze companies and apply new tools. What happens, invariably, is that, having learned and become comfortable with a tool, the investor will use it to death.
Hammer: Avoid stocks with high P/E ratios
It's a bit of a tautology that companies sporting lower price-to-earnings ratios (P/Es) are less expensive than ones with higher P/Es. So when you're looking at Applied Materials (NASDAQ:AMAT), which has a P/E of 20; eBay (NASDAQ:EBAY), with a P/E of 57; and New York & Co. (NYSE:NWY), which has a P/E of 37, the really easy conclusion to draw is that Applied Materials is the best investment, because it has the lowest multiple.
This, of course, makes sense. But by this same logic pattern, NovamericanSteel (NASDAQ:TONS), sporting a P/E of 4, would automatically be the logical choice for your investment dollars -- over all others. But consider this: Over the past 15 years, there's never been a point when Cisco (NASDAQ:CSCO) had a lower P/E than U.S. Steel. Cisco -- the more "expensive" company -- has substantially outperformed its "cheaper" counterpart over the long term.
For an investor with a hammer labeled "P/E," this is a nail that just didn't go in right. Why? Because earnings are a function of a company's operations, while price is a function of the market's perception of the company's future earnings (and, more importantly, cash flows) power. In the long run, expensive companies can be worth every dime.
Hammer: Avoid companies with debt
P/E isn't the only hammer, of course. There are other derivations, such as price-to-earnings-growth (or PEG), dividend yield, free cash flow-to-enterprise value ... you name it. Although each is helpful to the enterprising investor, none should be considered holistic.
It's a widely accepted general rule that companies with little to no debt are preferable to companies carrying large debt loads. The reason for this is obvious: Large amounts of debt expose companies to greater financial risk.
But don't go filing this precept away as your dogmatic investing hammer just yet. You may be shocked to learn, for example, that I recommended Fairmont Hotels & Resorts (NYSE:FHR), which carries a substantial amount of debt, to our Motley Fool Hidden Gems newsletter subscribers. Some of them were shocked, too, and the question started coming in a hurry: Aren't we supposed to avoid debt?
The quick answer was: No, not always. In Fairmont's case, debt had helped the company acquire extremely valuable properties. And for the record, who buys property without incurring debt?
More good debt
Another example of using debt productively is Cemex (NYSE:CX), which I recommended in 2002 for readers of our year-end stock-picking guide. In prior years, the company had taken advantage of the debt market to snap up competitors and expand its market reach. Had Cemex used equity -- issuing new stock to buy Southdown and other companies -- the cost to shareholders would have been extreme, because earnings would have been substantially diluted. Instead, Cemex issued debt, bought the companies, and then set out to aggressively pay that debt back down.
This was a higher-risk avenue -- poor returns for an extended period of time would have caused Cemex shareholders some real pain. But it turned out to be the better capital decision for the company to take, and investors benefited from the decision. Cemex stock appreciated well more than 100%. (You can learn more about this by reading a classic article from Brian Graney, Debt Isn't Always Bad.)
Time to try another tool
A Hidden Gems subscriber recently called my picks for the service "unconventional." I took that as a compliment. A long time ago I learned that while numbers can be great representations of a company's progress, the most valuable information is in the details. So I started hunting for companies that had numbers that appeared bad on the surface, but concealed real value underneath. It might not make much sense to look at the companies with the highest P/Es for value -- but many times that's exactly where I'd find it.
With New York & Co., for example, I found a rapidly growing company that had recently gone public. It used some of its IPO proceeds to pay down a preexisting preferred class of stock. That transaction, though very smart, absolutely killed earnings for the short term. But scratch just a little, and lookie-loo! We discovered a company that is on its way to establishing a cultlike following among fashion- and budget-conscious young professional women. Once you thought about how that preferred transaction might affect current earnings (and you don't have to think too hard -- the company tells you in its report), it started to look pretty cheap. Cheaper than a steel company in what may be the very peak of the cycle, that's for sure, even though New York & Co. sells for nearly 10 times Novamerican's market multiple. (For a look at my other "unconventional" picks, consider a 30-day free trial to Hidden Gems. To date, Fool co-founder Tom Gardner and I are beating the market by more than 20 percentage points.)
Although a hammer may be extremely useful for driving a nail, investing discipline requires a few more tools. The one that may be most valuable of all, though, is likely your noggin.
Bill Mann's favorite crooner, if he had to name one, would be Maynard James Keenan of Tool. Or maybe he's a "warbler." Whatever. Bill is a Motley Fool Hidden Gems newsletter advisor. A free 30-day trial gives you access to the more than 35 Hidden Gems stock picks, investing education, and a world-class community of Fools.
Bill owns none of the companies mentioned in this article. eBay is a Motley Fool Stock Advisor recommendation. The Motley Fool has adisclosure policy.
