We investors – as opposed to punters trading tips picked up from forums or that bloke in the office – soon come to learn and perhaps even revere the metrics that relate a company’s financial performance to its valuation.
Appropriately, they are dubbed ‘the fundamentals’. Such metrics compare, for example, a firm’s sales to its market capitalization, or its earnings per share to its share price.
Even the dreaded ‘EBITDA’ mouthful is a fundamental. (It stands for Earnings Before Interest, Tax, Depreciation, and Amortization. So now you know.)
At The Motley Fool we’ve always looked to the fundamentals. I wouldn’t say they come first – we care most what the company does, how it’s run, and what its future looks like – but studying its financial performance is close behind, and tying our findings back to the company’s valuation a tight third.
This might sound obvious to Collective veterans. But look to the traders of Twitter or the small cap stock jockeys of the bulletin boards and you’ll find thousands who care more about how a share’s closing price compares to its opening price, than how that price compares to earnings.
We think investing without the fundamentals makes as much sense as going into an auction house and bidding on paintings based on the work’s name or the lot number.
Sure, computationally cutting-edge hedge funds might turn price signals into profits.
But the average person trading when the boss isn’t looking via their online broker window they’ve tucked behind a spreadsheet?
Count us as sceptics.
Fundamentally challenged
However there is a fly in my rather sanctimonious ointment.
What if the fundamentals have stopped working?
I don’t mean the mathematics – divide a share price by its earnings per share and you will always get its P/E ratio.
But what if that number – or some of the other, ahem, fundamental fundamentals, don’t help you make money these days?
Here are three examples to explain what I mean.
1. Price-to-book value
This ratio (shorthanded to PTB or P/B) has been crowned the king of valuation metrics. It compares a firm’s market capitalization with its book value – a way of stating the net assets on its balance sheet. A low PTB ratio may be a sign of undervaluation.
Price-to-book’s pedigree goes back to Benjamin Graham – Warren Buffet’s mentor and arguably the father of value investing – and the finding that shares with a low price-to-book ratio (dubbed ‘value shares’) tended to outperform those with a high ratio (‘growth shares’) was a Nobel Prize winning discovery for stock market academics.
For decades cost-conscious investors have gone out hunting for low PTB shares in their search for bargains.
The only snag is the ratio has – to oversimplify – stopped working. For the past decade or so, low PTB shares have underperformed growth shares.
Is the king dead, abdicated, or is this just a temporary interregnum?
2. Dividend yield
Once new investors realize it’s practically impossible to divine the short-term direction of a share price, they often swing to the other extreme, and declare they buy shares and never sell – and instead look to dividends for their returns.
And certainly, dividends are worth having. You’ll come across claims that reinvesting dividends makes up the bulk of all long-term gains we see in those studies that say if Great Uncle Bulgaria had invested £100 in the market on VE Day and you reinvested all the dividends, you could now buy a mansion on Wimbledon Common, whereas if you’d spent the divvies you might still be scavenging for the things everyday folk leave behind.
Okay, the actual studies are more specific than that – but you get the picture!
Cue countless dividend converts scanning the market for the highest yielders, and hence they presume the best shares.
However the dividend yield of a company – simply its annual dividend per share divided by its share price, expressed as a percentage – has always been a very narrow way to judge a company. Today it could be positively dangerous for your returns.
For one thing, many fear the high yielders in the UK market can’t sustain their payouts. Dividends’ prime attraction is they represent pure cash in hand to an investor, but a firm must earn sufficient cash from operations to hold or increase their dividend long-term. Digging into many high-yielders’ accounts at present is not reassuring.
At the other end of the spectrum, strong companies might want to do other things with their cash. Even leaving aside all-important reinvestment in their business, they may buyback their own shares. In financial theory this is a return of capital as much as a dividend, but repurchases don’t factor in the dividend yield.
Buybacks are ever more popular, but some dividend investors seem stuck in the past.
3. The price-to-earnings ratio
No! Surely I won’t cast aspersions on the faithful price-to-earnings – or P/E – ratio?
The first investing ratio many of us learn, P/E is calculated by dividing a share’s price by its annual earnings per share. If two companies have the same price but one has a high earnings per share and the second lower, then the first company will have a low P/E ratio – and so appear cheaper – and the second a high P/E ratio, and may be called expensive.
This seems obvious – and it’s true as far as it goes – but there’s always been more to it than that.
Crucially, the P/E ratio tells you nothing about future earnings. If a firm is growing earnings rapidly, you may want to pay a higher P/E ratio today to get your slice of tomorrow’s pie.
And you know what? That is exactly what investors have chosen to do since the financial crisis. Like the price-to-book ratio, companies with low P/E ratio – as a group – have historically outperformed high P/E ratio companies – except, once again, over the past ten years or so, when they’ve lagged horribly.
Ever heard of the FANG stocks? These US tech giants are emblematic of the high P/E companies that have delivered the best returns in recent years. In fact one plausible reason why the UK stock market has lagged its US counterpart in this period (leaving aside the ‘B’ word…) is we lack ‘expensive’ tech companies.
Another problem with the P/E ratio is the earnings part can vary hugely depending on accounting treatment.
For both good reasons and bad, companies adjust the bottom line they present to investors in different ways. At the very least you need to read the company’s reports to understand what’s going on before putting the P/E ratio to use.
Fundamentally flawed?
It’d be wrong to write these metrics off for good. In particular, this is not the first time that shares dubbed ‘expensive’ by certain fundamentals have beaten cheaper value shares for a time – but in the past value has eventually triumphed.
However we all have to keep learning as investors – and while moving on from share tips and speculating on the impact of Presidential tweets to using fundamentals is an important first step, investing in businesses Fool-style will never come down to pure fundamentalism, either…
