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, New York University 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 bankruptcy.
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-P/E 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 pharmaceuticals, biotechnology, and life-sciences industry, as defined by my Capital IQ screening software.
There are 103 such companies with market caps topping $500 million on major U.S. exchanges. They have an average forward P/E of 20.5. Here are my parameters:
1. To stay away from bankruptcy risk, I used Damodaran's suggestion and considered only companies with total debt less than 60% of capital.
2. 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.
Of the 25 companies passing the screen, here are the 10 with the lowest forward P/E multiples.
Teva Pharmaceutical Industries (NAS: TEVA)
Life Technologies (NAS: LIFE)
Novartis AG (NYS: NVS)
Gilead Sciences (NAS: GILD)
Thermo Fisher Scientific (NYS: TMO)
Amgen (NAS: AMGN)
Abbott Laboratories (NYS: ABT)
Source: S&P Capital IQ.
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 one.
If you're interested in keeping up with any of these companies, add them to your free watchlist by clicking the appropriate "add" button in the table.
At the time thisarticle was published Fool analyst Rex Moore tweets but is not a twerp. He runs a real-money Rising Star portfolio based on his screens, and owns no companies mentioned here. The Motley Fool owns shares of Teva Pharmaceutical Industries and Abbott Laboratories. Motley Fool newsletter services have recommended buying shares of Gilead Sciences, Abbott Laboratories, Novartis, Thermo Fisher Scientific, and Teva Pharmaceutical Industries. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
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