Study after study has shown that stocks with low price-to-earnings multiples significantly outperform high P/E stocks. Research from my favorite investing guru, NYU professor Aswath Damodaran, pegged the outperformance at anywhere from 9% to 12% per year, depending on the study period. That's big money we're talking about.
But you already know that you can't just go out and buy the stocks with the lowest multiples. Companies can trade at dirt-cheap prices for a number of dire reasons, including low growth prospects, skepticism about earnings, or high risk of filing for bankruptcy protection.
These dangerous stocks can quickly crater. Buy too many of them, and you'll increase your own risk of bankruptcy.
Thus, for a company to be truly undervalued, Damodaran says in his book Investment Fables, "You need to get a mismatch: a low price-to-earnings ratio without the stigma of high risk or poor growth."
Of course, you're unlikely to find any high-growth, low-P/E companies out there. But Damodaran suggests setting a reasonable minimum threshold for earnings growth, such as 5%. There are also various ways to minimize risk, including staying away from volatile stocks or companies with dangerous balance sheets.
The screen's the thing
We're looking for companies with low price-to-earnings multiples, but also a relatively low amount of risk and the potential for reasonable growth. Our screen today will cover the best value plays in the oil patch, or what my Capital IQ screener calls the "Energy Equipment and Services" industry.
There are 54 such companies with market caps topping $500 million on major U.S. exchanges. They have an average forward P/E of 24.1. Here are my parameters:
To stay away from bankruptcy risk, I used Damodaran's suggestion and only considered companies with total debt less than 60% of capital.
In hopes of capturing a reasonable amount of growth, I looked at Capital IQ's long-term estimates and kept only companies expected to grow EPS at 5% annually or better over the next five years. Furthermore, I required at least 5% annualized growth over the past five years.
Only 13 companies passed the screen, and I've sorted them below by their forward price-to-earnings multiple:
Debt to Capital
RPC (NYS: RES)
Complete Production Services
Atwood Oceanics (NYS: ATW)
Ensco (NYS: ESV)
Diamond Offshore Drilling (NYS: DO)
Helmerich & Payne
National Oilwell Varco (NYS: NOV)
Schlumberger (NYS: SLB)
Dresser-Rand (NYS: DRC)
Source: Capital IQ, a division of Standard & Poor's.
There are lots of good research candidates here. To further stack the odds on your side, Damodaran says you can eliminate any companies that have restated earnings or had more than two large restructuring charges over the past five years. And if volatile swings in price cause you to lose sleep, consider only companies with betas less than 1.
At the time thisarticle was published Fool analystRex Moorehas an oily patch,tweets around, and owns shares of National Oilwell Varco.The Motley Fool owns shares of Diamond Offshore Drilling, Ensco, and Schlumberger.Motley Fool newsletter serviceshave recommended buying shares of Atwood Oceanics and National Oilwell Varco. Try any of our Foolish newsletter servicesfree for 30 days. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.
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