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Value Investing: Falling earnings and reduced growth spell challenges for value investors

Posted May 18, 2008

“You should continue to look at PE’s, but not give them as much emphasis…. If I see PE’s improving I wonder if the estimates of analysts have kept up with what’s happening on the ground with the economy. If I see the PEG, that is the price earnings to growth — indicating future growth earnings of a company, in the double digits, I’m wondering what is the lag there. So the numbers can be tricky. You can still look at cash flow. You can look at sales growth over the past year, over the past quarter earnings growth. You can look at dividends, of companies giving dividends. If they have the money that’s always a good thing.’ – Andrew Gordon, editor of INCOME

Baltimore – (TFN): The following was taken from the transcript of this week’s TFN Smart Trading video featuring Andrew Gordon. Watch this video.

Laura Cadden: Welcome to TFN Smart Trading. I’m Laura Cadden. Value investors supply rigorous standards to the stocks in which they invest. Their focus is on a company’s earnings in relation to the current stock price. Typically the lower a company’s PE ratio the better.

Of course to determine the PE ratio of a stock, you require actual earnings, and that’s been something that many companies have fallen woefully short of in the past year. After several quarters of record losses, even large multinational companies like Citigroup and General Motors, Countrywide Financial, and UBS no longer feature PE rates in their stock profiles.

With the U.S. and maybe the global economy slowing down, chances are that more companies will join those with negative earnings. My guest today is Andrew Gordon, editor‑in‑chief of the investment research service INCOME.

So Andrew, just running a basic stock screener, I noticed that almost twice as many of the companies you come across have PE ratios between 50 and 100 than PE ratios of under five. Do you think this is a reflection of declining earnings or speculation?

Andrew Gordon: Well, you can argue until cows come home whether eBays and the Amazons deserve their rich valuations. But the point is this, in times of economic duress, these companies are very attractive to investors for two reasons. They show good earnings and they have great charts. They, they show strong momentum. They’re in strong uptrends.

Now I haven’t gone through each and every one of the 404 companies showing a PE of better than 50, but I bet you that most of them have these two characteristics, and that’s a killer combination for investors.

Does that create a little froth with these companies? Yes it does. These companies could be a little bit overbought right now, but you have to hand it to them. They’re showing good earnings — and in a recession or a near recession. So they’re going to get the money from investors.

Now going to the other end, the stocks below a PE of five, well, I looked at those too. It’s a real mishmash. And to tell you the truth, I’m a little suspicious of PE’s below five. My assumption, and I think it’s good to be skeptical in this situation. There must be a reason why they have such a low valuation.

So I really look very hard at these companies. Some are companies that have pretty good earnings and just got caught in the down draft of the market and those are the buys.

But others like Calpine was in there. They’re in big trouble. There are others that show very little, if any growth, and, and they richly deserve their PE of below five.

So you have to be very, very careful. On the face of it they’re extreme value companies, but many of them are that for a reason.

Laura Cadden: A lot of reports recently have shown that foreign earnings seem to be making up for the loss of the North American market. Do you think this is going to continue?

Andrew Gordon: Well yes. I would say it would, but I think that effect is a little overstated. There’s always going to be some companies that are going to benefit from global growth. The McDonalds and IBMs of the world are really being helped by the cheap dollar and a boost in exports.

How many of these companies are there? I would say dozens that get a good part of their revenue from overseas sales. Maybe 30 to 40 percent get a majority.

The thing is, the U.S… we’re not Japan. We’re not China. We’re not Korea. We’re not an export driven economy. We’re not even Europe. There’s only so many companies that really get a good part of their earnings from overseas sales. And it isn’t as though a company sees the dollar going low and jumps into the overseas markets. It takes time and preparation.

So I would say this is an overstated phenomenon and the U.S. recession is going to really hurt U.S. companies, and it will be only partly offset by global growth.

Tired of reading? Watch the financial video.

Laura Cadden: How do you see the growth prospects for the next couple of quarters?

Andrew Gordon: I’ll tell you, I’m amazed by some of the more optimistic projections out there. I think the numbers just came out today for the first quarter and was .6 percent. So technically we’re still seeing some growth.

Laura Cadden: A lot of people anticipated negative.

Andrew Gordon: A lot of people did. I’m not that surprised that it showed a tiny bit of growth. This number is a little fuzzy to begin with. I think real GDP growth probably was in the negative. But if you look at the really important metrics, the employment, and the service sector and the manufacturing sector, they’re all contracting.

If you look at other metrics, consumer confidence, the housing sector’s gone from low to low. Foreclosures are picking up. I mean all the important metrics, they’re getting worse. I see the recession deepening and, and I see the GDP going into negative territory in the next few quarters.

Laura Cadden: Well so what do you think people should do right now when they analyze a company? If the PE ratios are not really something that we can pay attention to, what other fundamentals do you think they should utilize in their analysis?

Andrew Gordon: You should continue to look at PE’s, but not give as much emphasis to PE’s that really impress you. If I see PE’s improving I wonder if the estimates of analysts have kept up with what’s happening on the ground with the economy. And I assume perhaps not, probably not.

If I see the PEG, that is the price earnings to growth — indicating future growth earnings of a company, in the double digits, I’m wondering what is the lag there. So the numbers can be tricky. You can still look at cash flow. You can look at sales growth over the past year, over the past quarter earnings growth. You can look at dividends, of companies giving dividends. If they have the money that’s always a good thing.

You look at debt, you know it’s a bad time for companies to be in debt. But you really have to go beyond the numbers and look at the companies. See if they have the kind of growth strategy and the kind of product mix that can withstand the recession that we’re getting ourselves into.

Laura Cadden: Is there a value stock you could recommend for us today?

Andrew Gordon: Yes. It’s, it’s in the healthcare sector and that doesn’t necessarily follow the economic downtrend.And in healthcare really is following more demographics than economics. And when you talk about healthcare and demographics what are you talking about? You are talking about the Boomer generation. They’re getting older, they’re getting sicker.

This company is called Medical Properties. It’s a REIT, MPW. It’s very small… under a billion cap. It’s not that old. It’s been around for less than three years. But it doesn’t follow the typical healthcare REIT model. Most of them invest in nursing homes and long, and assisted care facilities, communities.

And one could argue, well that’s following the Boomer generation. What’s the matter with that? Well nothing necessarily is the matter with it, but it’s a bit crowded that sector. There’s competition in that sector.

This company, Medical Properties provides finance to hospitals… specialty hospitals, community hospitals, acute care hospitals. And they’re the only REIT that is doing this. So they don’t have much competition, and they’ve got a lot of companies lining up wanting to get finance. So they can pick and choose.

So I would say of the 12, of the dozen healthcare REITS, this is, this is the one I like the most.

Laura Cadden: And that’s with products like filters?

Andrew Gordon: That’s exactly right. With things like filters and better HVAC units, hood fumes, which capture the fumes in chemical industries and all kinds of things like that that just generally reduce the amount of emissions coming out of a factory, whether they be carbon, sulphuric or nitrogen based.

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