Page 288 - How to Make Money in Stocks Trilogy

166 A WINNING SYSTEM

has outperformed 99% of all other companies in terms of both annual and
recent quarterly earnings performance.
If the stock is newly issued and the company doesn’t have a three-year
earnings record, look for big earnings increases and even bigger sales
growth over the last five or six quarters. One or two quarters of profitability
are often not enough and indicate a less-proven stock that might fall apart
somewhere down the line.

Are Price/Earnings Ratios Really Important?
If you’re like most investors, you’ve probably learned the most important
thing you need to know about a stock is its P/E ratio. Well, prepare yourself
for a bubble-bursting surprise.
For years, analysts have used P/E ratios as their basic measurement tool in
deciding whether a stock is undervalued (has a low P/E) and should be bought,
or is overvalued (has a high P/E) and should be sold. But our ongoing analysis
of the most successful stocks from 1880 to the present shows that, contrary to
most investors’ beliefs, P/E ratios were not a relevant factor in price movement
and have very little to do with whether a stock should be bought or sold.
Much more crucial, we found, was the percentage increase in earnings
per share. To say that a security is “undervalued” because it’s selling at a low
P/E or because it’s in the low end of its historical P/E range can be nonsense.
Primary consideration should be given to whether the rate of change in earnings
is substantially increasing or decreasing.
From 1953 through 1985, the average P/E ratio for the best-performing
stocks at their early emerging stage was 20. (The average P/E of the Dow
Jones Industrials over the same period was 15.) As they advanced, the biggest
winners expanded their P/Es by 125%, to about 45. From 1990 to 1995, the
real leaders began with an average P/E of 36 and expanded into the 80s. But
these were just the averages. Beginning P/Es for most big winners ranged
from 25 to 50, and the P/E expansions varied from 60 to 115. In the market
euphoria of the late 1990s, these valuations increased to even greater levels.
Value buyers missed almost all of these tremendous investments.

Why You Missed Some Fabulous Stocks!
These findings strongly suggest that if you weren’t willing to buy growth
stocks at 25 to 50 times earnings, or even much more, you automatically
eliminated most of the best investments available! You missed Microsoft,
Cisco Systems, Home Depot, America Online, and many, many others dur-
ing their periods of greatest market performance.