Jim Cramer, on his very entertaining show "Mad Money," recommended selling the steel stocks despite their low P/E ratios. In the process of making this good call, he gave the impression, to me at least, that cheap stocks can be bad because they are cheap.
This is partly true. Let me explain.
Over the past few years, I have recommended many stocks that appreciated quite a bit. Most were low P/E stocks. Let's see, my homebuilders are up big with low P/E ratios. My HMO bet, up big despite being cheap. My single large-cap oil stock is up big starting from a low P/E.
If low P/E investing doesn't work, how come these stocks did? They worked because they really were cheap stocks with sustainable earnings levels.As for the steel stocks, I have been in print on the short side despite their ostensibly low P/E ratios. They represent value traps. That is, current reported profit margins are so inflated vs. normal profit margins that the real P/E ratios are much higher. I have included a chart from Novamerican Steel (TONS). As you can see from it, the stock's P/E has always been low. But the company's profit margins were very inflated from inventory profits last year after tax margins hit 9%, when normal was only 2-3%. At $85 per share, Novamerican traded for 30-40 times "normalized" profits. This was not a low P/E stock! I made good money shorting it. Low P/E investing can be extremely profitable when done properly. It takes a bit of analysis however, to avoid the value traps such as the steel group.
Inflated earning set this value trap.
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|Source: Robert Marcin|