There are two things that make share prices rise. First, earnings growth which is the long-term fundamental driver, and secondly, multiple expansion which is a reflection of increased investor confidence. It stands to reason that during a crash, P/E multiples fall to cyclical lows as sentiment is negative, and during booms when investors are optimistic or even euphoric, P/E multiples reach cycle highs.
As an investor, I focus on the underlying earnings power and growth runway that I see for a company. My projected returns are provided by the earnings growth of a stock combined with any dividends I get along the way. If I get it right and buy the stock cheap, I may get some multiple expansion too.
For small caps to move higher, confidence needs to increase, this could happen if this bull market matures and becomes a boom, which is typically driven by overly optimistic expectations and a panic to get in. However, in the current market environment, I am not going to predict further p/e expansion for the broader small cap environment that I follow although, I remain confident of finding specific stocks that will undergo re-rating.
As I get older, and greyer, and accumulate ever more market experience, the list of red flags to watch out for in the stockmarket grows. It is a dangerous place for the inexperienced. The list is almost inexhaustible, but six things I avoid are below.
- High multiples, paying high earnings multiples is risky by putting a high probability on a rosy future. I hate losing money and paying a high price for a security is a good way to lose money.
- Very promotional management. If there is one thing I have learned is that managers who are good promoters (salesmen) of their stock usually end up failing and leaving shareholders carrying the bag. This goes for managers who spend a large amount of their time and energy focussing on the share price.
- Concept stocks have great ideas that seem to make a lot of sense when promoted well but more often than not, fail to deliver at the profit line.
- Fashionable sectors, by their very nature being popular are almost never cheap. One is far more likely to buy cheap in an unfashionable sector or stock.
- Management with a poor track record should be avoided.
- Most of the time, companies operating in an industry that is in structural decline should be avoided, having said that, I have made great money owning shares in catalogue printer PMP which is in a declining industry but I bought it too cheap and it has been well run.
Shriro (ASX:SHM) is a simple business that is easy to understand with management that has a long-term, shareholder friendly track record. It trades on a single digit earnings multiple and pays an attractive div yield of nearly 8% fully franked. While at first it appears pretty low growth, it has a global growth strategy that is looking positive, which we are not paying for at all at the current price.
Nigel has been an investor, advisor, newsletter publisher and fund manager in the Australian Stockmarket since 1986