Understanding value and the P/E ratio
My name's Tim Clarkson, and I'm happy to be doing these podcasts for Van Clemens. And today, we're going to be talking about probably the simplest part of investing, but a very important part of investing. And that's being right on price. And I call this value investing. And one of the original gurus of value investing Ben Graham, proved in his famous book, The Intelligent Investor, that a group of low price-to-earnings ratios would outperform the market in excess of 15%; that is average return in the market is usually about 10%. By investing in low P/E stocks, you could make in excess of 15%. And it's based on simple arithmetic. So, it's a very powerful idea. Very simple idea. And price-to-earnings ratios are simple. You divide the price of the stock by how much the company has earned in the past year. So, what low P/E investing does for me is it creates a clear map. And it protects the investor from the two biggest risks in the stock market, which are unprofitable businesses and overpriced stocks.
A good analogy and one that, you know, helps me when I'm advising my clients is to think of investing like driving a car. There are certain things, obvious things you don't want to do, and you tell your children not to do to be safe. And so, things like you don't want to drive drunk. You don't want to speed. You don't want to go out in an ice storm. You don't want to be texting while driving. These are just obvious things. You want to wear a seatbelt. These are obvious things that protect the driver. Nobody in their right mind would argue against those things. In the stock market, the profitability of a company and a low valuation are similar obvious things that protect the investor from losing money in the market. However, most amateur speculators violate these rules over and over and over and typically lose money.
A Van Clemens & Co. success story
To illustrate this, my friend and colleague Mike Ross, who is president of Van Clemens, typically does use price-to-earnings ratios almost exclusively as his tool to create wealth for his clients. And one of his most successful stocks was a company called Fonar. It really illustrates the success and the simplicity of low P/E investing. He heard about this stock from another one of the Van Clemens partners, Dennis Felix, and Dennis Felix is brilliant at coming up with new ideas. He typically owns over a couple of hundred small companies. So, he's a great person to get new ideas from.
Anyhow, Fonar was a company that had received a large settlement from General Electric because the founder, Dr. Damadian, had developed the original MRI technology that we use all the time now. And the courts found that General Electric, GE owed him over $80 million. Well, he took that money and put it into Fonar. Using that money, he developed a new application using MRIs, which is upright MRIs. And for certain people, they just cannot lay down in an MRI machine and other situations, it's just better for the image to be standing up. But for many odd reasons, the stock after being very profitable for a number of years and was very cheap, trading less than seven times earnings. It just perfectly fit the Ben Graham low P/E investing system. And Mr. Ross not only bought the stock, but he was patient with it, held on to it for about three to five years. He watched the stock increase from $5 to $30 to $40 per share. Yes, Mr. Ross held on to his winners, which is our first point. So, it's not just enough to be right on a stock, you really want to get paid for it. And you know, a stock going from five to 30, or 40 is a substantial profit.
Here at Van Clemens, that's what our goal is to not have a bunch of small profits, but substantial profits. Not every stock does as well as Fonar, but we've had many that have done even better. So, low P/E investing is simple, and it also does require two emotional moves for the investor. One, you need to be contrarian. And the sad truth on this Fonar is that I'd actually accumulated a small position in it. And it was kind of an unusual idea. And I listened to one of the guys in the office who was complaining about they had too many receivables, and I listened to an institutional guy I talked with. He said, oh, we've looked at it, we don't like it. And I ended up selling my position that I bought at five for about six. What a mistake. So, you need to be able to think differently than other people, and have other people not agree with you. That's what we call being contrarian investors, being courageous. Secondly, it does require patience. This stock took about three to five years to go from $5 to $30, to $40. So, you know, nothing substantial in this world is easy, unfortunately. But here at Van Clemens, we're not about easy, we're about success.
Tim Clarkson's keys to success thus far
At Van Clemens, what we're trying to do is to get you discounted stocks. So, one way of looking at commissions is to think about if you're buying an automobile, would you rather pay $60,000 for an automobile, no commission? Or would you rather buy an equally good car for $25,000 with a small commission, say $500. Which is the better net deal for the buyer? I think the $25,000 plus a small reasonable commission is a better net deal. At Van Clemens, we can get you involved in undervalued stocks that really get you a significant discount to give you the best opportunity to make money in the stock market.
In conclusion, the beauty of price-to-earnings ratios is they're an objective black and white way of determining whether you're buying something that's really undervalued. And the earnings portion of it forces you to be in companies that are at least profitable. And I think investing in unprofitable companies is a losing game, on balance. In later podcasts will talk about certain ways that maybe you can invest in unprofitable companies and still make money. But typically, the best way to lower your risk is to stick with profitable companies that are undervalued. And at Van Clemens, we know about many small companies trading at value prices. We also follow many larger companies that trade less than 10 times earnings and pay significant dividends, much higher than the bank. So, at Van Clemens, we're bullish on our clients, and we're bullish on value investing, and we're bullish on low P/E stocks.
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