Investor's Business Daily, August 1st, 2008
There are at least two big reasons not to buy stocks based on low price-to-earnings ratios. Such a strategy often eliminates the best-performing stocks. The top IBD 100 stocks, for instance, have P/E ratios that tend to be much higher than many pundits recommend.
An investor fishing for low P/E stocks will often filter out not just the highfliers, but the second-tier winners as well. Occasionally a low P/E stock will turn into a huge winner, but it's a long shot.
Even finding modest winners can be tougher. An IBD screen run in 2006 for low P/E stocks with three-year sales and earnings growth rates of 16% or better turned up 128 stocks. About 57% were up or unchanged for the year.
Did that figure beat the broad stock market? Hardly. Among all stocks in the IBD database, 69% were up or unchanged for the year. And that's without screening for a quality performance.
A second reason to avoid a low P/E strategy is because it can shift an investor into sectors that traditionally carry low P/Es.
Those sectors may not be the best performers. Utility stocks carry lower P/Es than tech stocks, but that alone is not a good reason to buy them.
The low P/E approach can also put you in troubled sectors that are on the downside of a peak.
That low P/E screen also turned up plenty of housing stocks with their highs well behind them.
Meanwhile, some investors are drawn to a high-dividend strategy. That approach can also backfire.
A big dividend yield can be a sign of trouble. It may belong to a company whose stock has fallen for reasons that should keep you out. Such firms also may be on the cusp of cutting or eliminating the dividend.
It's better to focus on a top firm in a leading group.
