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Despite the simplicity and performance of passive investing, many people actively pick stocks with at least some of their money.
Some people do this based on gut feelings or emotion—perhaps they think Apple products are cool so they buy shares of Apple.
Others do this based on some level of fundamental analysis.
This article speaks to the latter—pointing out the fallacy of what I call partial fundamental analysis.
Partial fundamental analysis
According to
Investopedia,
fundamental analysis “involves examining a company's financial statements and broader
economic indicators to uncover a security's intrinsic value.”
Some recreational investors partake in this activity, but frequently in a very limited way.
For example, they may consider P/E ratios, P/B ratios and/or a limited view of earnings growth.
Considering some aspects of a business’s intrinsic value, but knowingly not all, is what I refer to as partial fundamental analysis.
In my view, partial fundamental analysis is employed too frequently and to the detriment of investors.
Many professionals perform comprehensive analyses, even with the help of elaborate computational resources and teams of peers.
Trading against them based on your partial analysis is akin to donating money to them.
P/E Ratios
As an example of this, consider a recreational investor selecting stock A over
B because the former has a lower P/E ratio.
There’s almost definitely a reason why the market priced A lower relative
to earnings—it’s not like no one notices P/E differences.
If B is poised for higher growth, for example, it could outperform
A even if the P/E ratios revert to the same value in the future.
What may be more overlooked is that, even if A and B grow earnings at the same rate,
B needn’t earn a higher return.
Perhaps this is the case with the
S&P 500, which has been at a very high P/E for quite a while.
It’s tempting to think its P/E will decrease closer to its longer-term average.
However, it’s very possible there’s a systematic cause of this higher P/E.
For example, perhaps many workers made a long-term commitment to invest
retirement savings in a S&P 500 index fund.
The constant demand could easily counter sellers trying to dodge the high P/E ratio.
Active investors could have even concluded that the S&P 500 deserves a higher P/E.
For example, risk/uncertainty with
international and
small-cap stocks may cause
investors to want to pay more for the S&P 500.
Or perhaps active investors believe the US government (including its military) will
help ensure these big businesses succeed.
House analogy
Here’s an analogy I find useful.
Would you buy a house only knowing the price per square foot (PPSF) is low?
You can probably come up with a bunch of reasons why that would be insane.
If you think about it, many of those reasons apply analogously to buying stocks based on P/E or other simple metrics.
Let’s pick a few.
At the highest level, you may realize that the house has been listed for sale publicly.
If it’s a great deal, someone has probably bought it already.
If no one bought it, people likely found reasons not to.
The only exception I can think of is if you’re the first to see the listing.
The same can be said for low P/E stocks listed publicly, and it’s unlikely you’re the first to notice the low P/E.
If others found the stock attractive, they would buy it and hence push the price up.
So why would a house sit on the market with a low PPSF?
Maybe the air conditioners, floors, and roof need replacing.
Likewise for a low P/E business–it could mean the business has upcoming expenditures.
A home with a low PPSF may be in a bad location with increasing crime.
Or maybe the house is out of style—the design and all the finishings are from a previous era.
Likewise a stock with low P/E may be in a bad industry that’s declining.
Perhaps the home is located in a flood zone or otherwise susceptible to natural disasters.
Likewise a low P/E stock may be unusually susceptible to small changes in laws or economics.
The intent of all this is not to dissuade you from looking at price metrics.
They are useful just as PPSF is often useful.
The point is to keep them in context within a larger, more comprehensive
evaluation (as you would with the PPSF of a home).
Exception
There is an exception where partial analysis may be useful and warrant a buy/sell.
This is if you know the consensus value for a variable, but disagree with it.
For example, if you know the consensus earnings expectation for next year, but have a reason to believe it’s too low.
Without knowing anything more, this can be a valid reason to buy shares.
Why is this?
Assuming the business has been well studied by others, its current share price should roughly reflect a complete fundamental analysis.
For example, if the business has looming debt or legal troubles, it should be mostly “baked into” the share price.
If everything is baked into the price except one erroneous value, the error in that value is enough to establish the error in share price, and this the reason to buy/sell the stock.
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