A Common Value Investing Trap
Peak earnings are a common value investing trap that most often hurts inexperienced investors who look only at the earnings per share and not the underlying driver of those profits.
The last big round of peak earnings value traps occurred at the end of the housing bubble. By knowing what to look for, you’ll be better equipped to spot value traps, lowering the chances your portfolio will be damaged by them.
What Is the Peak Earnings Value Investing Trap?
The peak earnings value investing trap refers to a phenomenon that occurs when a company that is highly cyclical, such as automobile manufacturers, construction firms, steel mills, or insurance companies, are at the top peak of the earnings cycle. At this moment, the price-to-earnings ratios of these companies will appear incredibly low, perhaps 4x or 5x earnings, making them look like potentially perfect value investing stocks. When earnings fall to their cyclical lows, however, the p/e ratio would skyrocket to 20x earnings without the share price budging a penny! Experienced investors know this and call them value traps because to new value investors with no prior experience, they look, at first glance, like a textbook example of something Benjamin Graham would purchase.
A Sample Peak Earnings Value Investing Trap
Let’s look at a well-run company, Toll Brothers, and examine how the peak earnings value investing trap could have ensnared inexperienced investors. In 1998, the year before the housing bubble was to take off, the company’s stock stood at $5 per share with earnings of $0.62 per share. The average p/e for the stock throughout the year was 11.9 according to the Value Line Investment Survey. In 2005, at the top of the housing market, the stock had gone as high as $58.70 per share with earnings of $4.78 per share. The average p/e ratio for the stock throughout the year was 8.6.
In other words, the moment before the stock was to go up nearly 1,000%, the stock traded at a p/e of nearly 12, and the moment it was about to collapse back to $13.70, it traded at a p/e of only 8.6. This was due to the cyclical earnings cycle of homebuilders. Buying only when you saw a low p/e ratio with a value investing stock of this type would be an unmitigated disaster. It would only take a few business cycles to lose nearly every penny of your capital!
Lessons to Learn from the Peak Earnings Value Investing Trap
- Those of you who believe in value investing cannot buy cyclical stocks in a buy-and-hold strategy. It doesn’t work.
- The stocks are going to appear most expense when they are, in fact, the cheapest.
- The stocks are going to appear most attractive and cheap when they are, in fact, the most expensive.
- Theoretically, a person could make a lot of money if he or she knew how to price cyclical earnings in companies such as these by investing in either the common stock, trading options, or speculating in futures on the underlying stock. Alternatively, he or she could lose everything if wrong. This type of investing strategy is not for the inexperienced nor is it for the weak of heart.