Against Choosing Stocks from the Top Down

By stag89 | timely-snacks | 27 Dec 2022

The earnings yield of a stock is the inverse of its P/E ratio. So, a stock with a P/E ratio of 25 has a 4% earnings yield, whereas a stock with a P/E ratio of 8 has a 12.5% earnings yield. In this sense, a low P/E stock is analogous to a high-yield bond.


If these low P/E stocks had very volatile earnings or a lot of debt, the spread between the long bond yield and the earnings yield of these stocks might be justified. However, many low P/E stocks have more stable earnings than their high multiple counterparts. Some people do use a lot of debt.

Despite some of the lowest bond yields in a half-century, one could find a stock with an earnings yield of 8 - 12%, a dividend yield of 3-5%, and virtually no debt within recent memory. This situation could arise only if investors shopped for bonds without considering stocks. This is equivalent to shopping for a van without also considering a car or truck.

Ultimately, all investments are cash-to-cash operations. As a result, they should be evaluated using a single metric: the discounted value of their future cash flows. As a result, a top-down approach to investing is illogical.

Both times, the decision was false and not merely rash. Even though pitching left-handedly tends to be more productive, the general manager is comparing pitchers, not apples and oranges. Any inherent benefit or drawback a pitcher's handedness may have can be reduced to a single value (e.g., run value). Because of this, a pitcher's handedness should only be one of many factors to take into account rather than a deciding factor. The type of security is the same. For an investor to favour all bonds overall equities, or all merchants over all banks, is no more necessary or reasonable than for a general manager to favour all lefties overall righties.

You do not need to determine whether stocks or bonds are attractive; you only need to determine whether a specific stock or bond is appealing. Similarly, you do not need to determine whether "the market" is undervalued or overvalued; you only need to determine that a specific stock is undervalued. If you're convinced, buy it regardless of the market!

The most prudent approach to investing is to evaluate each security with all others and to consider the form of security only to the extent that it affects each evaluation. Top-down investing methods are unneeded obstacles. There is no need for you to take the same steps that some highly astute investors took to impose it on themselves and overcome it.

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