How anyone can beat the street (page 2 of 2)

A common rule of thumb employed by analysts is to compare their percentage growth forecast for the company's earnings to the price/earnings ratio. If higher, the rule says 'buy'. Whether the rule earns good returns is another question.

The ratio of market value to the book value of the firm's assets (M/B) is another way of looking at this phenomenon of 'value' shares. A regularity that has emerged from over a decade of international academic work on world stock markets, including recent analysis conducted by Nottingham University Business School is that low priced shares (with low B/M) tend to earn systematically higher returns in following period. This may be because stock markets over-react to bad news. It may also be because share prices cannot be negative. If they fall so far, there is only one way they can go.

If we consider why a company's share price falls to low levels, there are two possible reasons. One is that the firm's profits have been affected by a cyclical downturn. In which case the price earnings ratio or B/M ratio will not have fallen far relative to the sector average.

On the other hand, the firm's profits might be affected by something highly specific. Examples might be a disastrous acquisitions strategy, poor design and marketing, as illustrated by the recent experiences of Marconi and Marks and Spencer in the UK.

Companies in crisis are worth watching closely. Track their share price downwards as events unfold. To rescue themselves, these companies will usually have to take drastic action. Sales of significant assets, replacement of senior management, re-branding exercises are likely to follow.

These are events that financial markets find difficult to price accurately, because they are one-off, highly specific to circumstances and are often isolated from more general economic trends affecting other shares. It is also likely that as market capitalisation falls, the shares disappear from the portfolios and off the radar screens of the professional institutional analysts.

This is the opportunity for the active researcher looking for evidence of the turnaround in significant news events about the company. Careful timing is crucial and is of course, easier said than done. Companies in this situation are necessarily risky investments. But bankruptcies are bad news and most economies provide safety nets for companies to trade out of crisis situations.

This strategy, like all others cannot guarantee profits and the usual health warnings apply. Repeated tests on large portfolios of low market to book value companies show profits for some years but losses for others. On average, however, there are substantially more winners than there are losers. This conclusion is neither science nor alchemy. The shares are indeed mis-priced, but for rational reasons.