The lower the P/E, the better… really?
Low P/E ratio may not be a bargain if (1) earnings are expected to decline; (2) interest rates are high; (3) financial leverage is high or (4) there are serious doubts over earnings quality
Disclaimer: This is a record of my investment decisions, not financial advice. I may change my decisions without notice. Use this only for education and entertainment. Do not rely on this for your investment decisions.
Background
“The shares are only selling for 1.1x P/E. I am all-in!”
It is Jan 2006. You are browsing Value Investors Club (VIC), a forum for professional investors and hedge fund managers to exchange investment ideas. You see the latest contest winner: a stock pitch on First Natural Foods Holdings (1076; 1076 HK).
“First Natural Foods Holdings is a Chinese seafood processor that is trading for 4 times earnings and less than 25% of my valuation appraisal. If you back out the 35 cents of distributable net cash, the stock is selling for 1.1 times earnings.”
You could feel your heart skip a beat. This is exactly what you’re looking for. 1.1x P/E! You recall what you learnt from the value investing gurus. Mr. Market must be an idiot for giving away these shares at such a huge margin of safety! You hurriedly called your broker, instructing her to sell everything and go all-in into 1076.
In Dec 2008, you received a notification on your Blackberry. The Hong Kong Stock Exchange (HKEX) has suspended trading in 1076. By Jan 2009, provisional liquidators were appointed.
What happened?
In my Substack post, I walk through 4 common reasons why shares trading at low P/E are not always bargains: (1) earnings are expected to decline; (2) interest rates are high; (3) financial leverage is high or (4) there are serious doubts over the quality of earnings.
The lower the P/E, the better… really?
So, what happened at First Natural Foods Holdings? Why were they suspended?
Before we discuss that, let’s make sure everyone is on the same page. What do we mean when we say that a company’s shares are trading at price-to-earnings or P/E ratio of 15 times?
P/E of 15 times means we are paying $15 for every $1 of profits the company will earn. We calculate this by dividing the share price by earnings per share (EPS).
Correct. All else equal, you will want to buy shares with the lowest P/E because they are considered cheap. You will pay the lowest price for $1 of earnings. In developed economies like the USA, long-term P/E ratio has averaged around 15x. As a rule of thumb, if you can buy shares below 15x P/E, that’s attractive.
Makes sense. But there must be a catch, right?
There are instances where shares trading at very low P/E are not bargains. The first instance is when there is a significant risk that earnings may decline. For example, Weibo Corporation (WB; WB US) trades at NTM P/E of only 6x mainly because its monthly active users (MAU) and its earnings per share (EPS) are declining. There is no clear visibility when the decline will stop.
A chicken that can lays fewer eggs in the future will naturally be worth less. What’s the next category?
A company that is trading at low P/E ratio may not be a bargain if interest rates are high. Joint Stock Company Kaspi.kz (KSPI; KSPI US) is a fintech and e-commerce company operating primarily in Kazakhstan. In the past 2 years, KSPI grew its net income by 12% p.a. and the consensus expects it to grow its net income by 7% p.a. over the next 2 years. Yet, it is only trading at NTM P/E of 6x, making it look like a bargain. A high growth company at single digit multiple! That’s the bull case for KSPI.
However, once you consider that Kazakhstan 10y government bond yield is 15%, KSPI now looks expensive. KSPI’s earnings yield is only 16% (1/6.1 = 16%). Why invest in KSPI and earn 16% when you can just invest in Kazakhstan 10y government bond yield and earn 15%? You are only compensated an extra 1 percentage point (1 ppt) for taking on significantly higher risk.
I would argue otherwise. In frontier markets, equity valuations tend to be most attractive when bond yields are elevated. As foreign capital returns, it typically drives bond yields lower and pushes equity prices higher.
Yes, but that is a macroeconomic forecast, not a stock pitch. If you buy KSPI on that basis, you are essentially betting bond yields will decline. If you believe in your thesis that foreign capital will return and push down bond yields, then there is even more reason to prefer Kazakhstan 10y government bonds over KSPI. The bonds carry higher yield and have a direct relationship to changes in interest rates.
Ok… Let me digest that. What’s the next point?
A company trading at low P/E may not be a bargain when its financial leverage is high. Imagine you have 2 companies that are the same in all ways except financial leverage. Company A has very high financial leverage and its bonds are rated junk. Company B has no debt, and it is rated investment grade. If you are an investor, which company is more attractive to you?
Obviously Company B. Its earnings are more secure because it has no financial leverage.
Exactly. On the other hand, you’re not sure whether company A will go bankrupt. Because of its high financial leverage, company A’s earnings are riskier. You will want to pay less for every $1 of company A’s earnings. That’s why companies with high financial leverage will generally have lower P/E ratio.
This is straightforward enough. No need for real-life examples. When are you going to talk about First Natural Foods Holdings?
This brings me to my final point. A company trading at a low P/E multiple may not be a bargain if there are serious doubts over the quality of its earnings. In 1076’s case, the reported earnings turned out to be illusory. 1076 reported cash of RMB 857 mn and RMB 843 mn in 2007 and 2006 respectively1. However, bank statements obtained by the Securities and Futures Commission (SFC), Hong Kong’s regulator, showed a balance of only ~ RMB 20 mn on December 29, 20072. Furthermore, in December 2008, the Chairman of 1076 stole ~ HKD 85 mn from the company’s bank accounts before disappearing.
Wow. How could this have happened? Aren’t the cash balances audited by the auditors?
As the VIC write-up stated, the lead auditor described extensive procedures for verifying cash balances. The SFC reported the auditors had obtained written confirmation of bank balances directly from the banks3. However, the figures shown in the confirmation turned out to be false and fabricated. In some developing markets, it is not uncommon for bank officers to be bribed.
Is there anything we could have done?
The VIC write-up highlighted the biggest red flag: unnecessary capital raising. “It’s bizarre that a company with this much cash on hand and this much cash flow (at least 100m renminbi of FCF per year) should be raising money from outside.”4.
Sadly, the writer later dismissed it as “Maybe it’s a cultural thing.” Whenever companies have a lot of cash but raise capital heavily at a high cost, there is a high probability the cash does not exist.
Can you make it less technical?
It’s like going on a date where the guy keeps bragging about how much money he makes but asks you to pay the bill. If he is indeed so rich, then why can’t he afford the meal? If a company indeed has so much cash, why do they need to borrow more at high interest rates?
That’s definitely more relatable! What other red flags do you look out for?
Imagine you are the CEO of a company. You want to inflate your revenue. You book some fake sales. Whenever you have sales, you have receivables. This is true for most companies, except for those that sell for cash. The more you inflate your revenue, the more receivables will pile up on your balance sheet. People will start becoming suspicious because rapidly increasing receivables is a tell-tale sign of inflated revenue. So, what do you do?
You need to get rid of these receivables. Your first option is to convert it into cash. But in most developed markets, it’s difficult to bribe bank officials. So, your auditor will quickly find out the fake cash. The other options are better. You can ‘spend’ the fake cash on a huge headquarters. It’s easier to forge property documents. You can also ‘prepay’ for some goods or services and record the ‘prepayment’ under ‘other assets.’ Investors typically do not read the notes to the financial statements, so they will unlikely pick this up.
That’s why in my first takes on Jiayin Group Inc. (JFIN; JFIN US) and China Everbright Water Limited (U9E ;CEWL SP), I focused on their unusually high and growing receivables and JFIN’s unusually large purchase of a headquarter. To be clear, I am not accusing them of fraud. There is no conclusive evidence of fraud. All I am saying is that if you are an investor, these are the key areas you would want answers to before you invest.
So, fake profits lead to fake assets. To catch fake profits, we should scrutinise the balance sheet carefully for any unusual assets.
Exactly. If any assets do not make business sense, it’s best to investigate further before investing.
To summarise, a company trading at a low P/E ratio may not be a bargain if (1) its earnings are expected to decline; (2) interest rates are high; (3) financial leverage is high or (4) there are serious doubts over the quality of its earnings.
There is actually a 5th factor that many investors do not fully appreciate. I will save that for a future post. To receive the post when it is published, make sure to subscribe.
Interesting! Im based in the ivory Coast which is in a monetary union with 7 other countries and has a currency pegged to the EUR. It's been pegged to the EUR/French Franc since the early 1900s. Inflation is low in the Ivory Coast, in line or lower than eruzone inflation.
Interest rates on Ivory Coast bonds are high though, but that's because of the sovereign credit risk of the ivory Coast, not because of an expectation that the currency will devalue. In this case I think a low P/E really is a low P/E even if rates are high.
Like Heineken's subsidiary in the Ivory Coast - Brassivoire - will do just fine and keep selling beers even if the Ivory Coast restructures their debt. So unlike Kaspi, in this case you can't take the implied earnings yield from Brassivoire's P/E and compare it to Ivory Coast's high government bond yield. A better comparison is maybe Germany's bond yield plus tail risk of the peg breaking.
Kaspi has long-term earnings growth potential, which the bond does not offer. It is a fixed payout. So you are already "paid" more than the bond, and have upside potential, if you believe that earnings can outperform inflation over the long run.