Fool's Eye View

[ December 1, 2000 ]

Events, Dear Boy, Events

By Rob Davies

Carburton Street, London -- When Prime Minister Macmillan was asked what he feared most he replied "Events, dear boy, events". That is a sentiment that many investors will agree with this week after crushing declines by some shares. Indeed, TMF Gibson, in this article last night on Fool.com, threw up his hands and said stock market performance was down to sheer luck; for most mortals anyway. His argument is that random events, like US elections, stuff up the market in totally unpredictable ways and it is virtually impossible to construct a portfolio that will always outperform.

That may be true to some extent, but it is also valid to point out that it is possible to reduce your risk of suffering sharp falls by buying lowly rated shares. Although many of us mouth the mantra of buying companies on low valuations, usually price to earnings (P/E) ratios, it is worth just repeating the arithmetic of why that is so.

As a hypothetical example let's look at Leg.com (LSE: UP). Shares in this sexy high tech, high growth company are priced at 1200p because it has a superb record of raising earnings in recent years. Although as it is only forecast to make profits of 6p a share it trades on a P/E of 200. However, one wet Wednesday it puts out a trading statement to say that because of bad weather, the weak euro and the world croquet championships, profits for this year will be slightly lower than forecast. As a result of these unpredictable events investors cut EPS forecasts to 5p a share. So does that mean the shares fall to 1000p?

No it doesn't, because that P/E is suddenly no longer relevant. The market now thinks the ratio should be lower, a lot lower. After all it's not much of a growth share any more. Maybe the right ratio is 50, making the share price 250p. Even that is twice the average for the market so the downside is still there.

A fall from 1200p to 250p is pretty ferocious, but is not exceptional in today's markets. It means the value has dropped nearly 80% yet the EPS forecast has only come down 17%. It is this "second-order leverage" that makes expensive shares so risky.

Unpredictable events will always be a problem for investors. But it is possible to minimise the effects of them on portfolios by investing in cheaper shares. We can't ignore luck but, as Gary Player said, the more he practised the luckier he got.

Where Next?

• TMF Gibson's article is here.

• How to Value Shares -- the Fool's Guide to the basics of valuation.