Outside of my options trading, most of my investing has a long term orientation. Which means I focus heavily on economic and business fundamentals.
Because of this, I’ve encountered an issue that most people will eventually run into as well, when they follow a fundamental investment philosophy: the so called “earnings trap”. What is this, you ask?
Well, a common way to know if stocks are over or undervalued is to check the price-earnings (PE) ratio. This simply means the multiple the stock price is at, compared to the earnings per share. So if a stock is trading at $60 and has an earnings per share of $3.00 then the PE ratio is 20.
Now, from experience and over time, investors have concluded that, as a general rule, a PE ratio of 15 and below is good and higher than 15 is over-valued. Of course exceptions exist in different industries but that’s the general rule. So if you start out investing and you see a company trading at 8.5x earnings, you often are correct in assuming they’re undervalued. However, it’s never that simple as we all know. There is always a catch. And in this case, the catch is among cyclical stocks.
Cyclical stocks are stocks that experience a fluctuation in earnings power according to the business cycle. For instance, airlines. Their expenses are fixed but in times of economic downturn, demand falls, prices go lower and their earnings are very small if at all. However, when the economy starts improving, air travel creeps up, and their earnings increase rapidly until it reaches its highest during the most favorable business period, a phenomenon known as peak earnings before crashing back down once the economy contracts. Construction, companies that make raw materials for manufacturing and a few others have the same rough profile. Businesses like pharmaceuticals, healthcare, entertainment, consumer basics like Procter & Gamble etc on the other hand that have relatively constant or in elastic demand no matter what the business cycle does are known as non-cyclical stocks.
Anyway this is what peak earnings does for an unsuspecting investor. Say an airline makes $0.50 earnings per share and is trading at $12.00 their PE ratio sits at 24 which looks high. As the economy booms, their earnings increases to almost $4.00 at its peak, while their stock goes up to $35.00 giving you a PE ratio of 8.75 which looks cheap. Now if you were looking at PE ratio alone, you would buy the stock right at the point it’s earnings are due to head south and the stock to decline. Or you’d consider it overvalued and sell it right at the point it is poised to rise. If you do it enough times, your money is all gone.
This is what the earnings trap is. The only way to mitigate against it is to do thorough research into the underlying fundamentals of a business before you invest in it.
Don’t just use a “hack”. That’s how you get screwed.