Friday, July 15, 2011

Electronics Retail: High P/E Investing

Even if a company performs well, it can still make for a lousy investment. This is because the price paid plays a massive role in determining whether an investment will work out or not.

Six months ago, three electronics retailers were discussed on this site and compared to their respective asking prices. While not a single one of those companies has seen its price appreciate in these last six months, the merits of investing based on price (and not earnings growth or recent company performance) are still clear. Consider the following table:

NameJanuary P/EEarningsStockP/E Today
Best Buy
11
Down 5%Down 13%
10
RadioShack
9
Down 18%Down 24%
8
hhgregg
17
Up 44%Down 35%
11

As the table shows, though hhgregg continues to grow its earnings as it adds stores and expands, its stock actually fell dramatically over this period. The stock fell much further than the stock of its competitors even though Best Buy and RadioShack have been struggling, posting declining net income. Why is this? Because of how high hhgregg's P/E was at the beginning of the period.

Of course, this is just one example of low P/E versus high P/E investing. Nevertheless, it is consistent with research that suggests that stocks with the lowest P/E's outperform. In fact, research by David Dreman suggests that this performance difference based on P/E even occurs between firms in the same industry, as are the three stocks we have compared here.

What's interesting now is the fact that hhgregg, which is aggressively growing its store count while maintaining solid returns on capital, has now become cheap. So while it didn't look like a great investment 6 months ago, it looks a lot more enticing today. The company hasn't changed much in the last six months. But more importantly, its price has, and that is what will play the dominant role in determining whether the investment works out.

Disclosure: Author has a long position in shares of BBY and RSH

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