To print article, click Print on your browser's File menu. Go back Posted 11/16/2000	sponsored by: The Speculator Place a bet on strategic long-shot investing Several readers weighed in with critiques of our column on the lure of high P/E companies. But we persist with new evidence of the reasons to own the riskiest, large money-losing companies. By Victor Niederhoffer and Laurel Kenner Invariably, when an animal wins at long odds, you will hear a rousing exclamation from the crowd as the prices light up the tote board. In reflection, many players will turn to their papers to see if this surprise could have been played. -- Joseph N. Brogan, "Follow-Up Longshots," Treasury of American Turf (1975) Many experienced racetrack bettors lay money on powerful horses that performed worst in recent races on the theory that the public has developed such a hearty aversion for these long shots that the odds actually become favorable. And when these steeds do win, the payoff more than covers the dismal failures. Money Plus. Easy online tools and free Bill Pay, too. We can make a similar case for investing in the shares of large but money-losing companies on the theory that public avoidance creates opportunity for big payoffs in the market. In fact, we've found that Nasdaq 100 ($NDX.X) and mid-cap stocks with income deficits regularly outperform their peers. Call our approach "strategic long-shot investing." It's the opposite of value investing, which favors low price-to-earnings stocks, and paradoxically, it's also the opposite of growth investing, which favors companies with evident earnings growth. Our first study on this subject, presented last week ("Why high P/E stocks are good for you"), elicited a certain amount of booing and hissing. And before we present new evidence that bolsters our claim, we'll let the critics have their say. Critics' corner Our specific guidance was to buy money-losing Nasdaq 100 companies at the end of the year. Not only did our basic conclusions defy the most fundamental underpinnings of academic and conventional wisdom, they came during one of the worst declines in high price-to-earnings (P/E) stocks ever. Indeed, the Standard & Poor's Barra Value Index ($SVX.X), for the first time in nine years, was actually performing better than the S&P Barra Growth Index ($SGX.X); at least it managed to end August little changed in 2000 while its growth counterpart was down 18%. The Nasdaq 100 itself, with an airy multiple exceeding 130, managed to decline 13% in the week our column appeared. The following is a letter from Richard Hosey, a manager at Reznick Fedder & Silverman: "Is it possible to qualify your MSN article enough to make it responsible? How many 1,000 P/E and higher companies would you like your followers to buy? If your average reader is entering the market with even $100,000, which I doubt greatly, how many shares of buy.com (BUYX, news, msgs) at its height or the other 100 high-flyers are they going to buy? Did you care to mention that they should really buy enough different stocks to make it through the 2000-like years? "Did you care to research the low-P/E stocks with even the most basic positive fundamentals such as high growth rate relative to P/E or quick ratios greater than two? Would you rather buy Krispy Kreme Doughnut (KREM, news, msgs) right now or Federal-Mogul (FMO, news, msgs)? If Krispy Kreme grows to the size of Dunkin' Donuts without blowing up -- remember Boston Chicken (BOSTQ, news, msgs), all the medical backroom stocks and the funeral industry -- then it will still have a 30 P/E. "Right now you have a company selling for $1.15 billion that has $6 million in earnings -- 157 P/E! According to you I should sell my house and family and rush out and buy the stock. I'll be able to buy them all back and retire within a year or so, right??? "I think this is merely speculation and the authors have NEVER taken this high P/E criteria as the sole or even primary factor when investing their own money!" We take this kind of comment most seriously and want to make it clear that we would never, ever advise anybody to sell their family. We'd also like to point out our study was limited to Nasdaq 100 companies, a group that has achieved a certain gravitas, whether or not justified, in the marketplace. Krispy Kreme is not among those hallowed ranks. Nor is Federal-Mogul. For the record, Krispy Kreme, after a 21% decline since Nov. 2, now trades at a P/E of around 140, while Federal-Mogul sports a multiple of 2. Our conclusions were attacked a little less violently on another front by reader "JMNets2:" "P/E ratios reflect the totality of enthusiasm at any given time for a stock, an industry, a market sector, etc. Somewhere along the continuum of fear and greed lies the fluctuations of enthusiasm. Like the purebred black tulips that could, at one time, be exchanged for estates, some dot-coms were little more than black holes sucking in capital and burning same at somewhat equivalent rates. The speculator (one who seeks to profit by a favorable change in the price of the stock market vehicle) must exercise due diligence. "Everyone, from the novice to the seasoned player, needs to be on occasion reminded that risks exist and that P/Es do not necessarily reflect the desirability of committing capital. We have experienced the greatest bull market in history. Much that is reflective of this market (and) may not be of similar import in markets of less vigor and direction."
We are heartened by the conclusion of Value Line research chairman Sam Eisenstad that the last time value stocks outperformed growth stocks was in the 1930s.	Well, we did say, less eloquently: "We note a few cautions. For one, the high variability of the returns gives us only 90% confidence that these results are not due to chance variations alone. For another, our results are confirmed to Nasdaq 100 companies for the last three years, during which Nasdaq prices generally have soared." There is much merit in what Hosey and our other distinguished correspondent are saying. We're sure that their qualitative insights and cautions are well worth considering. We're aware of our own limitations in the qualitative area. Even if we were not fallible, the cycles are always changing, making analysis that's useful in one cycle, totally dysfunctional in the next. However, we are heartened by the conclusion of Value Line research chairman Sam Eisenstadt, whose own studies of P/E's relation to performance are a notable exception to the usual flawed undertakings, that the last time value stocks outperformed growth stocks was in the 1930s. Count, test and retest When confronted with a controversy like this, we always find it helpful to count, test and then retest. We took a random sample of 50 middle-market companies -- members of the S&P Midcap 400 Index ($MID.X) -- from each of the last three years. We used the last 12 months of earnings reported before year-end in the S&P Stock Guides published at the end of each year, to assure that the public had access to the information at the time. (Many other published studies make the assumption that earnings were reported within a certain time period after the end of the year. So much of the mischief perpetrated on the public -- and so much of the erroneous conclusions of academic studies -- are based on retrospective sampling with companies that happened to make it into some database through extensive filtering and rejiggering.) We used earnings-to-price ratios rather than P/E ratios, to allow for proper ranking of companies that lost money. In each year, we divided the companies into three groups: those that lost money, giving them negative E/Ps; those with E/P ratios between 0 and 0.05; and those with E/Ps of 0.05 or more. The results for our sample again support the view that the worst financial performers had the best returns. The average return for the 17 companies that lost money was a nice 46%, compared with -4% for the 0-0.05 E/P group and 0.4% for the 0.05-plus E/P group. Financial losers, market winners A random sample from the S&P Midcap 400 Year E/P * # of companies 1-yr % return 1997 < 0 3 10   0-0.05 22 3.9   > 0.05 25 -6 1998 < 0 10 86   0-0.05 19 -19   > 0.05 21 -2 1999 < 0 5 43   0-0.05 17 3.1   > 0.05 29 9.2 * Earnings divided by price; a 20 P/E is equivalent to a .05 E/P Returns by E/P group E/P Avg. % return < 0 46 0 -0.05 -4 > 0.05 5 Because the average variability of the return for the individual deficit stocks in our sample is a relatively high 100%, we have only 95% confidence, statistically speaking, that the average returns for such a group are significantly above zero. However, it is interesting that for this sample, as well as for the previous Nasdaq 100 study, the companies with deficits performed significantly better than their more value-full counterparts.
Recent Articles • Why high P/E stocks are good for you, 11/9/00 • Wall Street prefers Democrats -- and gridlock, 11/2/00 • The long and short of year-end momentum buying, 10/26/00 more...	To what may we attribute these continued nice returns for the worst performers? Our speculation is that these companies appear on the surface to be the most distressed and risk-prone. For the investor, it must take tremendous courage to go against the advice of brokers and friends who greet his or her decision with scorn: "What, that dog? It's losing money faster than Ricky Henderson can steal a base." Similarly, among the master arbiters at S&P who must decide whether to keep a company in the Midcap 400 index or not, there must be terrific pressure to eliminate all the deficit companies on the grounds that if something goes wrong with them, there will be substantial egg on their faces. Put risk avoidance together with the high hurdle of inclusion in the index, and you have a stock with chutzpah. End note The theory that willingness to accept higher risks is rewarded with higher returns is why Edwin Marks -- the leveraged buyout magnate at Carl Marks & Co. whose 32% return over 30 years makes him, in our opinion, the greatest investor of all time -- is buying stocks right now. He kindly shared with us that he has been "buying carloads" of Science Dynamics (SIDY, news, msgs) and Harris & Harris Group (HHGP, news, msgs) over the past two weeks. He adds: "I still like BMC Software (BMCS, news, msgs) and Xerox (XRX, news, msgs), also. Opportunity to buy at cheap prices has been a boon; impatient investors have been bailing out prematurely. These are strictly long-term deals. I am comfortable with these picks at these prices." At the time of publication, Victor Niederhoffer owned BMC Software, and Laurel Kenner owned Xerox. MSN Money's editorial goal is to provide a forum for personal finance and investment ideas. Our articles, columns, message board posts and other features should not be construed as investment advice, nor does their appearance imply an endorsement by Microsoft of any specific security or trading strategy. An investor's best course of action must be based on individual circumstances.