If you want to profit from the FTSE 100, I can’t think of a better time to do it than during/after a stock market crash. You see, even great companies can often be speculative investments. But a market crash can remove some, if not all, of the ‘speculative’ bit.
Often, for many FTSE 100 companies, the price you pay can be far higher than the actual tangible value of the company on its accounts — its net asset value (NAV). Indeed, this is why many value investors will often look for stocks trading at prices close to the NAV figure. And after the coronavirus crash, there are definitely more of these firms in the Footsie.
However, a stock is not necessarily a great investment just because it’s trading near its NAV. If you want to profit from the bear market, you need to find a stock with three additional factors: a moderate price/earnings (P/E) ratio, a strong financial position, and a realistic prospect of future earnings.
1. Moderate P/E ratio for the FTSE 100
The P/E ratio is the current share price divided by the earnings per share (EPS). It gives a rough idea as to how a firm’s price compares with its actual value. My advice is to work this out this yourself using the average EPS figure from the last three years and the current price. This will give you the best estimate of earnings because it evens out fluctuations.
The late financial sage Benjamin Graham advised limiting your company selection to stocks whose average P/E is no higher than 15. I can’t disagree with him, but bear in mind that a normal P/E range for one industry will differ from another one.
Due to the crash, many Footsie companies will now be trading on a lower P/E than previously, meaning values are better aligned to prices.
2. A strong financial position
Right now, a company needs a sizeable pot of working capital to get it through the hard times. Benjamin Graham used a current ratio test of 2:1. This means that current assets should be twice the current liabilities. This ratio, and a long-term debt figure lower than the amount of working capital, are good indications that the firm will likely have the cash flow to survive the bear market.
3. Prospect of future earnings
A realistic prospect of future earnings implies a well-managed company with stable income and some year-on-year growth. It’s a good sign if a firm can grow EPS year-on-year for a decade or more, through different stages of the business cycle and varying economic climates.
Positive earnings per share for the last 10 years is a good test. Even better if a firm has increased its EPS by one-third over that 10-year period. This test is tough enough to eliminate risky firms but not too restrictive when it comes to choosing stocks. The 10-year period is long enough to see if management knows what it’s doing, and will include good and bad times.
An investor needs to be realistic with expectations after a stock market crash. Forget brilliant company prospects for the time being. However, if you focus your stock picking on the above three criteria, I think you’ll find some good FTSE 100 investments to profit from in the future.
