Ask Colin

You suggest looking for stocks with a low PE ratio. Yet William O’Neil and Stan Weinstein both warn against buying low PE ratio stocks because they could be weak-inferior stocks. How can we be more certain of good value?

I agree entirely with O’Neil and Weinstein. To simply buy low PE ratio stocks is asking for trouble. Stocks can have a low PE ratio for several reasons. One is the obvious – that the market has sold them off (which lowers the PE ratio) because it does not expect that they will repeat their last earnings numbers. However, it can also be because the company or its industry is out of fashion. It can also be because the company has been in some trouble and is still recovering, something the market has not entirely recognised yet in the price. These are the potential gems that we are looking for.

Cast your mind back to what I said. I suggested that we look for well-managed companies that were cheap. Cheapness could be found initially by looking for low PE ratios and high dividend yields. However, this is a two-edged sword, because it also finds potential failures which are on the way out. The secret, if there is one, is to look at the charts and use what I teach as Charting 101. Unless the chart is heading upwards to the right hand top corner of the chart, or is breaking out upward from a broad trading range, it is a failure on the way out, or we are too early and should wait for those signs.

In other words, use the fundamental ratios to find a group of companies that may be interesting and then use charting to winnow the grain from the chaff. Nothing is foolproof, but this should give you a short-list of stocks to be researched in depth and maybe you will want to build a position in them if they continue to trend upward.

This approach is described in detail in my book Building Wealth in the Stock Market with examples and case studies.

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