Stock Selection

I believe that the Price-to-Earnings (P/E) ratio and Book Value are highly useful tools, though my application of them is quite distinct. By observing the P/E and Book Value of the broad market and comparing them against historical levels, you can derive an ideal secondary indicator that signals overbought or oversold conditions for the overall market. Furthermore, you can compare the P/E and Book Value relationships of individual stocks against the broad market indices. This relationship serves as a secondary (perhaps even tertiary) indicator to assess the relative overbought or oversold performance of a stock compared to the market.

The Rate of Change in Earnings Growth Fundamental analysis reveals an exceptional statistical relationship: the correlation between the rate of change in earnings growth and the rate of change in stock prices. As Gordon Holmes stated in his 1969 writings: "The slope of the price trend almost always leads the corresponding or equivalent slope of the earnings trend. The time lag is usually about three months."

Assuming this correlation between earnings and stock prices exists, the following applies to buying: if the rate of earnings growth is less than the rate of price change (or the slope of the trendline), the stock can be considered for purchase. Conversely, if the rate of earnings growth is greater than or equal to the rate of price change, one should look for other opportunities. The same logic applies to short selling.

If you trade using this method, I must offer a word of caution: many people trade based on corporate earnings. In such cases, estimated quarterly earnings reports can lead to ruin, especially with high P/E stocks—they are prone to precipitous plunges. It is essential to know exactly when the actual earnings report will be released. If the stock price is already near its peak, you should exit the position before the announcement. If the actual data falls short of expectations, the price may gap down, and your accumulated profits could vanish overnight!

The purpose of observing dividend yields and P/E ratios is to identify high-growth potential stocks. However, in reality, earnings growth is the factor that most accurately reflects growth potential. Dividend yield is calculated as dividends divided by the stock price. A high dividend yield is inevitably the result of either high dividends, a low stock price, or both. But why is the price low? Often, it is because earnings are poor!

Other Fundamental Considerations When choosing between two stocks that appear similar in most respects, I rely on additional fundamental factors for the final decision. First, between two charts showing identical bullish momentum, I will choose the stock with the lower P/E ratio. Likewise, between two charts with identical bearish momentum, I will short the stock with the higher P/E ratio. The teachings of Graham and Dodd still hold significant weight! Second, when considering a purchase, I prefer companies with lower credit expansion; the more overleveraged a company is, the more vulnerable it becomes to monetary tightening. I apply similar logic to short selling. Third, whether buying or shorting, there must be sufficient market liquidity.