Smart Investing

A couple of weeks ago I saw a article in the Wall Street Journal titled "Why Investors Need to See the Light and Slow Down." In the article the author mentions that in March, stocks traded as low as 11.7 times earnings, which put the market at the lowest valuation since January 1986. However, stocks are now selling at 18.4 times earnings.

A couple of assumptions have to be made here; first I'm assuming the columnist is talking about the S&P 500 -- he just states stocks. He also mentions that this is based on professor Robert Shiller's measure of earnings. Both of these could be completely different to my assumptions, but my best guess is he is talking about the S&P 500 and the measure of earnings is the PE (price to earnings) multiple.

Based on this it would make some sense to slow down a little, when stocks trade at a PE of 20 -- that is, when I look at them as a possible sale. But there is more to the story than what meets the eye and why I think many investors will miss more increases in their portfolios if they decide to sell, because the market and their companies are too pricey.

What I have noticed over the past nine months or so is large amounts of write offs in the unusual line on the income statement or goodwill impairment, as it is called. This is when a company has to write off the value of an intangible asset that is no longer worth what it is valued at on the company's books.

There is no real cash that went out the door, just the value of that asset is not worth what the value was listed at. It's the same as saying your house was worth $400,000 at the peak of the market but is now worth $375,000 because that is the true selling price now. The $125,000 write down in your house value would be like goodwill write down; the value is worth less.

With these write downs many companies had much lower earnings; some even had losses because the write off was so large. Companies such as NYSE Euronext wrote down $1.59 billion in Goodwill, which resulted in a $1.34 billion fourth quarter loss. The paper company Weyerhaeuser was hit with an $827 million write down contributing to a $1.21 billion loss. Even Hartford Financial had a $597 million after tax-tax write off of goodwill.

So what effect does this have, you may ask? It lowers the earnings over the last 12 months. If the earnings are lower then the price to earnings will rise, which makes perfect sense. However, these are frequently a one-time charge. Some of the companies I hold in portfolios have written off the entire amount of goodwill, in excess maybe, but over the next 12 months I know on these companies there will be no more goodwill write offs -- it can't go negative. But even with the companies that wrote off large amounts of their goodwill, they probably wrote off more than needed since everyone was doing it. The write off won't stand out or be mentioned in a negative story on the business news. Simply stated, there were too many to write about.

What edge does this give you? Think about it, if the company has written off all or most of its goodwill, over the next 12 months the company should post pure earnings, no unusual write-offs. If that happens, the earnings will be higher even if sales and other expenses stayed the same and the PE will drop.

Going forward the PE may not be as high as in the past without the goodwill write offs once again making stocks attractive and not too expensive to warrant being sold. Be sure to check each of your own companies before selling because the PE was too high. Was there goodwill write off last year, and next year it will be gone? Another thing I do is to check the mean of the analysts estimates going forward, check the variance between the high and low estimate and then compute the PE going forward for the next year or so. Know your companies inside and out; it will help keep you on course through the ups and downs and when others are telling you to sell.