Summary and Conclusions
The interpretation of stock market data is rather like studying the handicap and form for a horse race. Share price listings also contain a vocabulary all of their own, which can seem like a foreign language to the uninitiated. Fortunately, financial gurus, such as the legendary investors Warren Buffet in the States and Jim Slater in the UK, have long thrown lifelines to investors before they dive into the stock market. Seek out their publications and you will discover investment strategies designed "to beat the system" using public information, such as share price listings, corporate and analyst reports, plus press, media and internet comment. Invariably, their advice explains how to "hedge" your bets in the presence of risk, beginning with a fundamental "stock market law".
The higher the dividend yield, or the lower the P/E ratio, or the lower the dividend cover: then the higher the financial risk and lower the price of an investment (and vice versa).
In the latest edition of his best seller, Beyond the Zulu Principle (2011) legendary UK investor Jim Slater expands upon his "golden rules for investment" based on analyses of stock market criteria. He likens these criteria to an investor's "quiverful of arrows". They need not be fired all at once, some may miss their target altogether, but hopefully, you will score a substantial number of bull's eyes.
Using his pragmatic approach, the following guide to stock market prices based on this Chapter's analysis is not guaranteed to make you rich. But it should make share trading easier.
- The P/E ratio (earnings yield reciprocal) shows how a company's value is rated in relation to the profit it earns. The higher the P/E ratio, the greater confidence there is that profits are going to rise and the lower the P/E, the greater the concern that it might be unable to sustain profits.
- Conversely, a low P/E ratio could reflect the fact that a company's shares are undervalued by the market relative to its profit performance and thus make it attractive to speculative investors.
- Shares in companies that are expected to produce rapid growth in profits and hence capital gains, offer lower dividend yields, while higher dividend yields are offered by what are regarded as relatively mature, stable "blue chip" businesses with little prospect of increasing profits and dividend.
- Conversely, part of stock market law is "the higher the yield the higher the risk". This applies particularly to shares where a higher dividend yield usually signals uncertainty over whether the dividend can be maintained in future, particularly if earnings cover is low.
- In general, if any investment offers either a higher dividend yield or earnings yield (a low P/E ratio) than similar investments, it is advisable to be cautious, unless the market hits rock bottom, (for example the crash of 1987).
Of course, there have always been exceptions to these rules. A yield may be high (or a P/E ratio low) not because investors pay less for risky dividends (or earnings) but because the company has been overlooked by the market and is genuinely undervalued. This is why Slater developed sophisticated analyses based on the P/E and growth prospects (more of which later). The rules have also broken down spectacularly since the 1980's.
Apart from the 2007 banking fiasco, consider the dot.com-techno crash of 2000-01. With no shortage of naive investors tracking pure speculation (crowd behaviour) prior to the millennium, many techno-companies reported nil-dividends (zero yields) nil-earnings (no P/E), or alternatively, huge P/E ratios (sky-high prices with miniscule earning earnings) and no cover.
So, familiarize yourself with the financial press and other source material. Use them consistently. But remember, that in an imperfect capital market (which also includes an imperfect market for information) it can sometimes pay to follow your own instincts and not the crowd, as we shall discuss in the next Chapter.
Slater, J., Beyond the Zulu Principle, Harriman Press (2011).