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Investors have always been conditioned to look for ‘value’ in stocks – and a single-digit price/earnings (P/E) ratio has always been considered the most telling indicator of good value.

But the drawback to this approach is that if the share price falls, the P/E falls as well; and the stock becomes attractive to investors looking for ‘cheap’ stocks. The fact is that the price may have fallen for very good reasons, and what looks like under-pricing is actually spot-on.

The result is a ‘value trap.”

After a shakeout like we have experienced, the market is riddled with value traps,” says Graham Harman, head of investment strategy at Citi. “What has put P/E investing in the doghouse has been the fact that forward (forecast) P/Es depend on the accuracy of analysts’ forecasts for company earnings

“We’ve had a massive price recession, and now we’re probably going to have a massive earnings recession. So if consensus earnings forecasts are too high, you get P/Es that are artificially low – and completely unreliable.

Just look at all of those diversified financials and cyclicals that look like they are trading on 3 times earnings but are really bankrupt – or at least, loss-making (see Table 1). That’s the problem.”

Even an historic P/E (based on last year’s reported earnings per share) is not going to be worth much, says Harman, if the earnings outlook for the stock is changing dramatically.

“The market adage states ‘Never buy a stock on less than four times earnings – someone knows more about that stock than you do.’ The value trap is definitely for real in today’s market. It’s not so much that P/E investing is discredited: if you have a P/E somewhere between seven and 15, it’s probably a meaningful P/E. But if you drop below seven, you’re getting into the value trap – it’s too low to be credible.

“On the way from 14 times to seven times, your value is increasing faster than your credibility is diminishing. Below seven times, your credibility is diminishing faster than your value is increasing,” says Harman.

There is also a value trap in assessing stocks by dividend yield, he says. “Investors are also conditioned to look for high dividend yields as an indicator of cheap stocks. Think of a company where the yield starts to get up to 7 per cent current, 8-9 per cent prospective and 10 per cent two years out: normally that just means that the share price is in freefall, which is a bad sign, and the analyst is scrambling to get the dividend cuts through fast enough. Typically you see companies go from a yield of 4 per cent to 9 per cent yield, but then the company passes the dividend, and you get nothing.”

Many industrials are posting “pretty healthy” dividend yields at present, but it is the same problem with regard to dividend forecasts. “The rule of thumb for the dividend yield trap is that above 12 per cent nominal, I wouldn’t touch the stock,” says Harman.

The thinking that because a stock is now on a much lower P/E ratio, it must be a bargain, is pervasive, but “completely misguided”, says Roger Montgomery, Managing Director of Clime Asset Management.

“If the P/E isn’t discredited as a valuation tool by now, I’m doing my darnedest to make sure that it is. Quite simply, the P/E doesn’t tell you anything. It certainly can’t tell you what’s cheap or not, because price can’t tell you anything about value. When you’re calculating value, it’s got to be completely independent of price.”

Montgomery’s preferred metric is ‘intrinsic value’, as set out by Warren Buffet about in his 1981 letter to Berkshire Hathaway shareholders. “It’s essentially sustainable return on equity, divided by required return, multiplied by equity per share. You’ve got to look at the economic performance of the asset, and base your valuation on that. Multiples lead you astray. P/E, dividend yield, price-to-NTA (net tangible assets) – when you look at multiples, you’re trying to guess what everyone else in the market is going to be willing to pay, because you’re using the share price in the calculation.”

Montgomery’s approach revolves around the return on equity (the higher the better), the debt level (the lower the better) and the dividend payout ratio. “You can have three businesses producing completely different returns, each with the same P/E. But the cheapest one is the one that produces the 20 per cent return. If you’re buying on the same multiple, the higher the return, the cheaper it is. What determines the value is the payout ratio (how much of its dividend it pays out.)

“With only the payout ratio changed and irrespective of the time frame between buying and selling on a P/E of 10, Company A produces the highest return and was therefore the cheapest,” says Montgomery.

Harman also looks at price-to-book (price-to-NTA) and return on equity. “I would be more confident of price-to-book than price/earnings: usually that means that there is some residual value which, provided you’re prepared to pay off the creditors, is going to work. Futuris and Fairfax are examples of stocks that look cheap on this measure.

“I agree that ROE is useful because it doesn’t have price or earnings thrown in. Look at something like News Corporation, which is on a single-digit P/E and a single-digit ROE. Contrast that with BHP, which is on a single-digit P/E and a ROE in the 20-30 per cent range. Computershare, JB Hi-Fi, Leighton – all these stocks look a lot cheaper on a P/E basis than they were, but they still have P/Es that got up into the 30 and are in freefall, so who knows how much of the E in the P/E can vaporise. At least if you have a stock that is on a single-digit P/E and a single-digit ROE, they’ve got more chance of increasing their earnings power than diminishing their earnings power on a medium-term view of two to three years. On that basis, News Corp looks more attractive than BHP,” says Harman.

Harman says investors should be looking for stocks that are under-priced (low PE) and under-earning (low ROE). “You can make money out of those either by the P/E going back up – or at least, not going down – and/or profitability going back up; or at worst, not going down any further.”

A selection of such stocks is shown in Table 3. This excludes diversified financial stocks.