Making Money with P/E Entry Points
Swing trading is a high-risk but high-reward investment strategy that involves finding desirable entry points for short-term investments. While there are several methods used by swing traders, an important fundamental analysis tool is looking at changes in a company’s price/earnings ratio over time, and choosing an entry point where the stock’s P/E ratio is historically low, since it is likely to rise in time as the market realizes that the stock is just too cheap. This is particularly effective for large-cap stocks whose values vary within a relatively narrow range, and whose business model is sound and proven by a long history.
In reality, swing trading based on P/E entry points can often involve having money tied up for weeks or even months as investors patiently wait for the market to see that the company’s stock is priced too low and it needs to rise. Timing the market is very difficult–according to some, it’s impossible–so swing trading based on P/E is best combined with secondary data that improves the investor’s conviction rate.
That being said, timing a purchase by waiting for a low P/E ratio will often help investors realize higher short-term gains in the best-case scenario and, in the worst-case scenario, minimize their risk of a falling stock price over the long term.
Let’s take a look at how swing trading three large-cap stocks in late 2012 would realize profits by the middle of February 2013.
The Case of Apple
Apple (AAPL) has been one of the dogs of the market; once a darling, the stock is down over 11% YTD and over 30% over the stock’s highest price point. Concerns over Apple’s market saturation have rendered it a more controversial and less lucrative stock in 2013 than it was in 2012.
So how would timing an entry at a low P/E ratio work? Take a look at this chart:
If we wanted to move in late 2012 at a low P/E entry point, the bear market driven by fiscal cliff fears in November probably provided the best opportunity, when the stock was at a P/E ratio in the 11-12.5 range. This would have meant buying at $520. Since the stock is currently at $466, that would mean a short-term loss 10.3% and a dividend yield-on-cost of 2%. Not a good performance, especially when the S&P 500 has risen around 9.6% for the same period.
The Case of GM
Now let’s look at GM:
GM has been a strong-performing stock after the calamity of 2008, and the stock is up a respectable 13% from a year ago, although it’s flat for 2013 and has underperformed the market in recent days. Its P/E ratio has steadily risen throughout the latter half of 2012, making it a dubious candidate for a good P/E entry point; still, the dip in early November did offer a chance to buy at $23.85 and a single-digit P/E ratio. That would offer a 16% return in about 3 months–an extraordinary return for a large-cap investment. Swing trading the P/E fluctuations definitely worked here.
The Case of Google
Now let’s look at Google (GOOG), which had a volatile 2012 amidst investor worries that online advertising is getting hit by the transition from online to mobile internet usage. Google offered a unique entry opportunity a bit before Apple or GM, thanks to an earnings miss in mid-October:
On October 18, Google announced disappointing earnings which caused a strong rally in the stock to disappear–and the stock’s P/E ratio to fall as well. An investor pouncing then would have secured the stock at $685; a more patient investor could capitalize on a $650 price in early November.
While it’s always good to buy as low as possible, both were well positioned for short-term profits thanks to chasing a historically attractive P/E ratio: the stock is now at $783, offering a three-month return of 14.3% to 20% for the swing trader.
Diversified Results
The swing trader looking at a diversified approach to swing-trading low P/E ratios could have bought shares in these three companies in early November, offering a total return of 7.3%–decent, but not too different from just throwing the money in the S&P 500 SPDR (SPY), which returned about the same amount for the same period. Swing trading on low P/E ratios can offer strong returns, but it is just one of many tools that a diversified investor can use to ensure a return. It cannot be relied upon to offer stellar returns all the time, but it can definitely offer an alternative means of earning a return on an investment than a buy-and-hold, long-only portfolio.