Screening - Earnings Yield
This should be my last post regarding the book “Value Investing Today” by Charles Brandes. I think I’ve already given the book too much coverage, but I couldn’t pass up writing about this last screening variable.
According to Brandes, value investors should not invest in a company if the “earnings yield is less than twice current long-term (20 year) AAA bond yields.” (The earnings yield is simply earnings/price — the inverted P/E ratio.)
Presumably, if an investor pays more than two times current bond yields, he would be better off buying bonds. The rule, like many others, sets an arbitrary limit without justification.
Let’s take a look at what this rule means in the current market environment. As of today, 20-year AAA bonds are yielding 5.71%. Using Brandes’ math, we should only look for companies with an earnings yield of 11.42% or higher. Putting this into more familiar terms, we should only be investing in companies with a P/E ratio under 8.76!
This is, needless to say, hard to do.
This rule is ridiculously out of date. It reminds me of companies Graham and Dodd wrote about in “Security Analysis.” Companies that were reasonably profitable and could be bought for less than their liquid assets. These companies are harder to come by today.
A P/E ratio lower than 8.76 is almost always associated with operational difficulties or the end of an economic cycle. If you screen on such a low P/E ratio today, you will likely find many mortgage finance firms, some oil companies, and a few firms that recently reported unusually large non-operating gains.
If you want to find good long-term investments, you would be better of raising the P/E ratio of the screen and adding a return on equity/investment variable to weed out weak operators. While you will still have to sift through many dogs, you will raise your chances of investing in a good company.
