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.