Ask Colin

I have done a low PE scan at late December 2003 and most of the stocks with promising PE ratios do not have pretty chart patterns. Do you agree?

Firstly, let me clarify a point. PE ratios are not "promising". I know you probably used this term loosely, but I think it is important in terms of the way we think. PE ratios can be low, or high. However, some growth companies with high PE ratios can be more "promising" than value stocks with low PE ratios. PE ratios are only a guide to value, they are not strictly predictive, which is implied by "promising". If anything, low PE ratios are more often an indication of potential failure, as I will discuss in a moment.

Next, It would be my expectation that most stocks that emerge from a low PE scan would have unfavourable chart patterns. Stocks will have low PE ratios because they are out of favour with the market. The vast majority will be out of favour for good reasons. Their low PE ratio is an indication that the market does not expect them to achieve the same earnings in the next year. Some of them will fail completely and go out of business. However, there will be some stocks that are out of favour, perhaps 'out of fashion' would be a better term sometimes, and are likely to hold or improve their earnings. These are the mispricings that we are looking for in the search for value stocks. Some of these stocks will have been in trouble for a few years and are recovering, but the market still has them underpriced, because it is waiting to see more evidence of their continued recovery.

This is where the charts come in. A stock can be out of favour for many years. We want to know when the market sentiment is changing. The low PE will tell us there is a margin of safety. The chart will tell us that the market, or at least the smart money that knows the stock well, has soaked up the supply of disillusioned investors and is continuing to buy more, creating an uptrend.

Finally, with respect to the present (late December 2003). I have just done a low PE scan myself (I used 10% as the filter). I came up with a few interesting charts. The law does not allow me to discuss these charts with you, as explained on the Ask Colin page of my web site. However, as it happens, the editor of Shares asked me to write up how I go about finding interesting stocks for 2004. You will be able to read my comments on the scan in February 2004 Shares, which will be published in mid January 2004.

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