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The Perils of Low P/E Investing

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.

Novamerican
Inflated earning set this value trap.
Click here for larger image.
Source: Robert Marcin

ConocoPhillips, a Low P/E Example

Investors are selling off ConocoPhillips (COP - Get Report) much harder than other oils because of the company's higher sensitivity to oil prices. This is silly. Until the stock price discounts $48 oil, this should not happen.

Right now, the stock is discounting around $7-$8 per share in earnings, which is the company's earnings at $32 oil. The current run rate is closer to $14. Some knucklehead sell-sider will say to avoid the stock until oil bottoms. I think that's a sound-bite mistake. The shares are compellingly cheap right here.

As per my point on steel, if oil drops to the mid-$20s, Conoco is not a low P/E stock. But if oil holds $31-$33 as a bottom and averages around $40, it really is a low P/E stock with good appreciation potential.

The trade all depends on what price is factored into the stock. Right now, that price is $32, much lower than $48. Exploit that negative sound bite about Conoco's oil exposure to your advantage.
At the time of publication, Marcin was long ConocoPhillips, although positions may change at any time.

Robert Marcin is the founder and general partner of Defiance Asset Management. Formerly, Marcin was a partner at Miller, Anderson & Sherrerd and a managing director at Morgan Stanley, where he managed the MAS Value fund (currently Morgan Stanley Institutional Value). Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Marcin appreciates your feedback and invites you to send it to robert.marcin@thestreet.com.

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