Someone recently discussed with me about Price Earning Ratio (PE), he said he has a stock “guru” that always emphasize on low PE/high NTA company. I wrote this as a counter argument for such thinking and for my own future reference.
Sometimes buying low PE company carries greater risk. A low PE company can become a high PE company as its profit fluctuate. Some sector is cyclical. If you happen to buy a company that are at the peak of the cycle, no matter how low the PE, it will still become higher as the company profit become lesser. As a cycle can last few years, your investment will get stuck in that company. Some experienced investors are smart to invest in cyclical company and they know how to exit when the cycle has peaked.
If you found a company that are no cyclical in nature, yet the PE is low, you will wonder whether this is also a good buy. It depends also on the company sector. Some sector inherently has low PE due to their nature of business and vice versa. Example like property sector have low PE overall because of the assets they employed are huge, resulting higher Capital expenditure and lower dividend, capital take long time to deploy, and uncertainty in long investment horizon, naturally Mr.Market will give it a lower PE. Another example is Consumer Staple, where less capital required and higher dividend, certainty of profit, and it is a necessity even during bad times, Mr. Market will of course give a higher PE to consumer sector company.
But by far, the most important deciding factor for PE is growth rate. A lot of people ignore this factor. Supposedly there are two companies:
Company A PE 10, Earning RM1, Share Price RM10;
Company B PE 30, Earning RM1, Share Price RM30;
Both share price difference is RM20.
Fast forward few years:
Company A PE 10, Earns RM3, Share Price RM30;
Company B PE 30, Earns RM2, Share Price RM60;
Both share price difference is now RM30.
Even though Company A is growing faster than Company B, both share price gap is now wider. This is power of higher PE. A higher PE company is more inclined to fully reflect the value of its enterprise. If the market is willing to accept the higher level of PE, although Company B has lesser growth, its share price potential is relatively guaranteed. But in real life, the reverse is true: A higher growth company command a higher level of PE. Mr. Market maybe irrational sometimes, but it is not stupid. A real-life example:
Company A PE 10, Earns RM1, Share Price RM10, grow 0%;
Company B PE 30, Earns RM1, Share Price RM30, grow 100%;
Fast forward few years:
Company A PE 10, Earns RM1, Share Price RM10;
Company B PE 30, Earns RM2, Share Price RM60;
Both share price difference are now a staggering RM50! Some investors thought they bought Cheap by paying low PE, but they only bought Crap. This is the reason I particularly favour high PE combine with high growth company.
Although some might expect to buy a high growth company at low PE, a high growth company often remain high PE. A high growth company relatively lowered down its real PE quickly. Assuming the company grow at 100% per year and selling at PE of 30 currently, by 2nd year its real PE will be 15, 3rd year PE 7, 4th year PE 3, fifth year it PE will only be 1. Investing is an act of using current money in exchange for future money. Such a fabulous growth company would hardly escape any investors radar. If you ever encounter a high growth company but with a low PE, be extra cautious that it might be a con-man company.
Another prominent attributes of high PE company is high ROE. High ROE company is a company that maximise its profit using minimum shareholder fund. A high ROE company have highly efficient capital deployment, therefore have less capital requirement, and are able to return extra unused cash to shareholders while greatly reducing the chances of requiring shareholder to pump in additional capital. Hence, people are willing to pay for a high ROE company.
Imagine there is Company Z:
Equity = RM1
Earning = RM1
ROE = 100%
Growth = 50%
Into 2nd year:
Equity = RM2.5
Earning = RM2.5
Into 3rd year:
Equity = RM5.25
Earning = RM5.25
Into 4th year:
Equity = RM13
Earning = RM13
Into 5th year:
Equity = RM32
Earning = RM32
Into 6th year:
Equity = RM82
Earning = RM82
Into 7th year:
Equity = RM205
Earning = RM205
Fast forward 10th year:
Equity = RM3204
Earning = RM3204
Combining high ROE and high growth, Company Z plow back its profit without require a single cent from its shareholder, able to turn RM1 equity into RM3204 of earning power. In normal condition, a 50% yearly growth rate would only increase 57 times after 10 years, but a high ROE company that constantly reinvest its profit and maintains its growth rate, are able to create an astonishing 3204 times of compounded earning power without any single cent from shareholders! If you ever wonder why a lot of people are willing to pay for such high PE for Facebook, Alibaba, Tencent, Google, Amazon, ask yourself, how much PE are you willing to pay for Company Z? The keyword here is High ROE combining High growth with REINVESTMENT, the market probably knew these company are able to capitalise on high growth at the same time able to reinvest a minimally amount. Investors are willing to pay extra premium for these Star performer.
Company that enjoy it long growth rate also have a high ROE that correlated to its long time-frame. Theoretically, a high growth rate that requires huge assets to generate is unsustainable. Recalling Assets = Equity + Liabilities, it would meant shareholder eventually will need to pump in additional capital to satisfy its growth resulting in lower ROE, or the company would need to leverage financially resulting in higher ROE. If the company asset base is already huge, it would require much more opportunity for further expansion. Once it exhausted it expansion opportunity and unable to reinvest further, it will have to return back its capital to its shareholder and turning it into a Cash Cow. These company usually can’t command too high PE, they are unable to grow any more as they might already dominate their sector, and their ROE will only be marginally higher than their peers reflecting their dominance. The best example is Public Bank. It is much more better to invest in companies that requires less capital to expand, as it would be easier for them to expand to next stage of growth as it requires less capital and their operation remains lean.
Some company have mediocre ROE for sometime, but due to some favourable changes, its ROE are steadily increasing. This change of tides is very essential. Some company might experience this ROE change of tides for some time, then its share price suddenly jump many fold! This is why it pays to take a keen eye on company that experiencing ROE increase. AEONCR ROE has been hovering around 20% before 2012. Starting 2012, its ROE suddenly jumped to 30% and remain that level since then. As a result, the company share price gone up from RM4 to RM14. My Sifu and I noticed that there are two companies are experiencing this phenomena: Samchem and Mynews. It is worthwhile to take a look.
In a nutshell, there are many things to consider when you look into PE, not just because it is cheap. You buy a Cheap Crap but it remain a Crap. Have a overall big picture by combining multiple factor such as High ROE, High Growth or sector. It makes sense to pay an adequate price to purchase a fantastic company.
Footnote: If you are searching for Company Z, Malaysia market probably aren’t sufficiently big to accommodate such high growth company. A few key characteristic required: A) High ROE, less intensive capital; B) Company that serve the world;
If you are interested in my thought, here’s some:
http://thestockme.com/members/wong-loon/
