Apply Your Own Discount

In our previous Bargain Hunting article, we provided six tips for investing in this unsettling market.  One of the tips -- "Apply Your Own Discount" -- elicited some feedback that asked for additional insight.  Today, we aim to offer that insight, but before doing so, here is a recap of what we said with respect to that tip:

"Look at a company whose consensus earnings estimate has already been cut at least 10% and then reduce that estimate by another 20%.  If the corresponding P/E multiple is still below an historical average, you can feel better about the idea of having invested in the company at a reasonable price.  Both earnings and the stock price should ramp up in a more normal operating environment."

We made this remark with the understanding that consensus earnings estimates for the market, and most stocks, were likely to come down further -- and perhaps significantly.  That is an important point since stocks have been known to follow the trend in consensus estimate revisions.

When looking at the severity of recent losses, however, two things were evident: (1) emotion had trumped fundamentals in many instances as a major driver of stock prices and (2) the market had gotten ahead of analysts in marking down earnings expectations.

In emotion-charged markets where forced selling occurs, stocks that appear cheaply-priced can certainly get cheaper.  This is a painful happening and it tends to lead to a period of asset price deflation where prospective buyers hold off buying a stock on the belief/fear that it will fall further in value.

This is an understandable fear, especially in light of the market's behavior this year where repeated rally attempts have been made, only to give way to renewed selling and new lows.

There is no way of knowing when a new bull market will begin.  That will only be proven in hindsight.

With the market down close to 50% from its high, though, and many stocks down more than that as the market has aggressively discounted earnings cuts, long-term investors have been presented with a great opportunity to accumulate stock in quality companies that will see their way through this economic down cycle and produce much stronger earnings and stock returns down the road.

Trying to pick a bottom on individual stocks is little more than a guessing game.  What one should concern themselves with at this juncture is the idea of whether they believe they are buying a quality company at a reasonable price.

One way to do that is to "apply your own discount."  Look to see if a consensus earnings estimate has been slashed at least 10% and then consider what a stock's P/E ratio might look like if there was another reduction to the consensus estimate of at least 20%, which the market looks to have discounted already and then some in many cases.

If the corresponding P/E multiple, after you apply your own earnings discount, is still below a long-term historical average, then there can be some peace of mind in the thought you are acquiring the stock at a reasonable price.

There is no guarantee, of course, that you are buying the stock at the absolute bottom price, yet this approach reduces the anxiety of trying to pick the bottom, as well as the frustration that hits when the market rallies and you don't benefit because you held off buying the stock thinking it will come down further in price.

In the table below, we have identified several companies that fit the profile of trading at a reasonable price.  We did so by going a bit further and applying a 30% discount to the current consensus estimate for 2009. 

Mindful of the heightened risk aversion in the stock market, we also only included companies that are free cash flow positive, have a negligible debt burden (if any), and pay a dividend.

In each instance, the companies below had a total debt to equity ratio below 20%.

(a) We used a five-year historical average to eliminate the impact of the abnormally high P/Es seen during the technology bubble

--Patrick J. O'Hare, Briefing.com