Period 10 Low P/E Stocks 10 High P/E Stocks All 30 DJIA Stocks 1937-1942 -2.2 % -10.0 % -6.3 % 1943-1947 17.3 % 8.3 % 14.9 % 1948-1952 16.4 % 4.6 % 9.9 % 1953-1957 20.9 % 10.0 % 13.7 % 1958-1962 10.2 % -3.3 % 3.6 % 1963-1969 8.0 % 4.6 % 4.0 %

One time gain. Sometimes the earning is high because of something which is not going to be repeated every year, like a huge insurance payment or gains from selling a part of the business. One needs to look out for these items when judging if the company can maintain the elevated level of profits.

Higher net margin. Sometimes a company can achieve higher net margins due to a fluke which may not be sustainable. Maybe it just had a fabulous year because everything turned out to be its in favor. A very good example which led me to write this article is a Swiss company called “Bossard Holding AG” which makes fasteners (screws, nuts and bolts etc).

Look at other companies in the same industry. If the margins are wildly different, find out why.

Look at free cash flow. If the FCF has not risen correspondingly with earnings, that is a sign to dig deeper.

Look at the historical margins of the company. Have a look at the numbers of the company over a period of time. See if the company has every achieved such high margins ? If not, why is this time different ?

Price/Share CHF105 #(Shares) 3m Sales (2010) CHF477.6m Net margin (2010) 9.8% EPS (2010) CHF14.81 P/E 7

Year 01 02 03 04 05 06 07 08 09 Sales 507 449 433 497 514 559 600 565 395 Net margin -2.4 2.1 2.2 3.8 4.2 2.3 5.3 6 4 EPS -3.89 3.14 3.16 5.99 6.57 3.98 10.03 10.68 4.97

About the author:

Chandan Dubey I invest because I want to be free by the time I reach 40 years of age i.e., 2025. My investment style is to find a small number of bets with large margins of safety. I pay a lot of attention to management and their incentive. Ideally, I like to buy owner operator businesses. I am fortunate to have a strong inclination towards studying. I aid my financial understanding by extensive reading in psychology, economic, social sciences etc. I invest because I want to be free by the time I reach 40 years of age i.e., 2025. My investment style is to find a small number of bets with large margins of safety. I pay a lot of attention to management and their incentive. Ideally, I like to buy owner operator businesses. I am fortunate to have a strong inclination towards studying. I aid my financial understanding by extensive reading in psychology, economic, social sciences etc.

It was December 2009 when I started investing and bought my first stock. I had read a few books before deciding to take the plunge, because they say you learn by trying. If you wait until you know everything about investing, you will never be able to do it.Among others, I read the book “Contrarian investment strategies” by David Dreman and “The little book that beats the market” by Joel Greenblatt . Dreman first makes the case that the current investment methods do not work. For this he analyzed several strategies followed by mutual funds and pros and showed that “throwing darts to pick stocks” beats them by a large margin. An investor will be better served by owning an ETF on the whole market than putting his money with a money manager. Because over long term, they lag the market average. Dreman then makes the case of contrarian investment strategies, which are buying companies that are unloved and the market is assigning low price multiples for them. He talks about low P/E, low P/B and low P/CF investing and how over time they have beaten the market. The second book which is by Joel Greenblatt talks about buying “good” companies with good earning yield (low P/E ratio) and good return on capital. He claims that buying such companies beats the fact beat the S&P 500 96% of the time, and has averaged a 17-year annual return of 30.8%.Let us talk numbers for a moment and define some terms which we are going to use. The physical business and the one you see on the stock market under a ticker are two very different entities. This fact can not stressed enough. The price you need to pay to buy shares in a stock can be very far from the price of the business itself. But then again, let me tell you that there is no sure-fire way to determine the price of a business. No one can do it with any certainty. Even the best investors (like Warren Buffet, who has clocked in a return of 20% annualized over several past decades) have been wrong quite a few times. So, what does an average investor do ?Let us simplify how a business works. The company makes buys raw material and labor (“cost of goods sold”) and produces a product which it sells in the market ("Sales"). The profit it makes is called “Gross profit” (=”Sales”-”Cost of goods sold”). But then the company has to pay for marketing and pay the management (CEO and board of directors). Subtracting these from the “Gross profit”, we arrive at the operating profit. We are still not done. When a company buys an equipment, builds a factory or makes an acquisition, it has to pay or invest a lot of money for it. But if we directly subtract it from the “Operating profit” the results will be quite weird. For example, let us take the example of building a factory. Building a factory will increase production and if the company is able to sell the new products too, it will have larger sales for years to come (until the factory breaks). So, the effect of building a factory can been seen for years in the form of increased sales, but the cost of building the factory is put in just one year. In this year we may have a loss because we put in so much money building the factory but later on we will have “bigger” profits (no cost of factory and increased sales). So, it is only fair that we decide a life of the factory and then divide the cost of putting up a factory in equal parts over the life of the factory and each year subtract it from the “Operating profit” (called “depreciation”). “Amortization” is the same thing but it relates to intangible assets (like “brand value”, “goodwill”). Now we are quite done. We pay taxes on the rest of the income and we have the “net income”.To summarize, pay the “costs of goods sold”, make “sales”, pay “operating expenses”, pay “depreciation and amortization”, pay “income tax” and what results is the “net profit”.If we are comparing across industries, it is amazing how much information can be gathered by looking at these figures for different companies. For companies in similar industries, you would expect that the “cost of goods sold” are comparable. What this means is that for every $100 in sales, if company 1 has “cost of goods sold” $87 then company 2 will also report a similar figure. But from here on things may diverge. The management may overpay itself in company 1, effecting the “Operating profit”, or it may need to spend a lot of money on “Marketing and advertising” because they are trying to gain market share. Management may have a history of badly allocating capital, making bad acquisitions which do not pan out which will result in higher “Depreciation and Amortization” charges, hence resulting in a smaller net profit.But if we are only interested in P/E, we only need to see how much net profit the company makes for each $100 in sales. This is called the “net margin” and is reported in %, for example, if a company has net margin of 10% then it will have net profit of $10 on every $100 in sales. So, we have thatProfit=NetMargin*Sales/100Low PE stocks are desirable. Let us take an extreme example. Let us say that you can buy a company for $1 (“Price”) which earns $1 (“Earning”). If the company can keep on doing this for even two years, this is a tremendous bargain !So, how can we go wrong investing in a low P/E stock ? There are several ways in which earnings can be unsustainable and may result in a low P/E. One needs to do due diligence to weed out these companies. Following is a list of pitfalls to avoid.How do we avoid such a trap? How do we even detect it? There are three ways (maybe more, you are welcome to offer suggestions in the comments section)The example I want to discuss is Bossard Holding. Bossard is a fastening technology and logistics company operating worldwide. Its full service package focuses on fasteners, and includes worldwide sales, technical and engineering support, and inventory management. Selling screws has been there business for more than 180 years. They are first company in this branch of industry to meet the quality assurance criteria of ISO-9000, all over the world. This, with the help of other country specific certifications, gives their customers security and allows them to do away with cost-intensive controls and tests. For multinational companies it can be particularly important to be able to depend on consistent quality.The company was selling for CHF177 on April 6, 2011 and it went down with the market. After this precipitous drop my watchlist alarm was activated and I decided to dig a bit deeper.If we pull up the data on Bossard since 2001, we have the followingAs we see, Bossard has never managed a margin as high as 9.8% in the last decade. The maximum has been 6%. If the sales recover to their original value of CHF600m (which is the highest in the last decade), with 4% margin (the average 10y margin), it will earn 24m, which is CHF8/share. The P/E then would be 13, destroying my low P/E theory.There is no discussion in the annual report about the sudden profitability except vague generalities like "we managed it [the crisis] so impressively and that mere words were turned into action and results". Maybe if I dig a lot deeper, I will find the explanation hidden inside the numbers. But as 10% is very high margin for an industrial company, I am less inclined to do so. I will guess that they will not be able to keep it up for very long.With thousands of stocks to choose from, at any given time, you will find good bargains. But it is important to do due diligence to weed out the companies with flaws beneath good numbers they achieve.