by Archie M. Richards, Jr., CFP^®
January 10, 2005

It's time to recommend this year's batch of low-PE stocks. The ones I suggested a year ago have performed well. (Visit archierichards.com to see the list; the column is dated 1/12/04.)

The stocks are chosen by John Dorfman, columnist for Bloomberg.com. John selects stocks with low price-earnings ratios.

Price-earnings (PEs) are the principal method used by investors to evaluate the worth of stocks. Say a stock is priced at $40 a share. The company's earnings for the latest four quarters total $2.00 a share. The price is 20 times larger than the earnings. The price-earnings ratio is 20.

Numerous studies have shown that stocks with low PE ratios outperform the market. Why? Because the companies have problems that cause most investors to avoid them. But the problems are often exaggerated, making the prices too low. When conditions turn out to be milder than expected, the stocks rebound.

Here's how Dorfman makes the selections:

• He identifies all U.S. stocks whose market values exceed $500 million. (A company's market value is the number of shares held by everyone times the current price per share.) The $500 million floor omits small companies, whose prices tend to fluctuate too much. This leaves about 1,900 stocks.

• John omits companies that reported losses during the last four quarters.

• He also omits companies whose debt exceeds the equity. Let's say a company has $500 million in assets and $300 million in debt. The difference ($200 million) is the equity. With the debt exceeding the equity, this company would be excluded from the list. Omitting those with high debt reduces risk.

• From the 1,200 stocks that remain, John selects the 10 stocks that have the lowest price-earnings ratios.

With a method so mechanical, Dorfman calls the stocks his "Robot Portfolio." Here are the candidates for 2005:

• American Axle & Manufacturing Holdings (AXL)
• Commercial Metals (CMC)
• General Maritime (GMR)
• Intergraph (INGR)
• LandAmerica Finanial Group (LFG)
• Louisiana-Pacific (LPX)
• Maverick Tube (MVK)
• Metal Management (MTLM)
• Tesoro (TSO)
• USG (USG)

John reports that the average PE of these stocks is 7. The average of the 500 stocks in the S&P index is 21.

I recommend purchase of these stocks. Place an equal amount of money into each.

LandAmerica and USG were also included in last year's list. If you already own them, adjust the number of shares so that the market value of each is equal to that of the other stocks in the new list.

Disregard bad news that has driven the prices down. Exaggerated misfortune is your ticket to profit.

Do not override the method of selection by exercising judgment about whether you think each stock is suitable. It's the system you're buying, not individual stock ideas.

According to Dorfman, last year's list gained 38 percent for the year, including dividends.

John has been recommending Robot Portfolios for 6 years. He reports that the cumulative gain has been 540 percent. During the same period, the S&P 500 advanced only 7.5 percent, total.

A five-fold increase in 6 years, versus a tiny gain. Low price-earnings ratios are the way to go.

Emmett writes that he began buying whole life insurance policies on the lives of his three children 14 years ago. The policies cost $29.50 a month. The face values total $25,000. The cash values total only about $1,000. The children are now 20, 14, and 7. Should he keep paying on the policies or cash them in?

You're spending $29.50 a month, Emmett, to benefit your grandchildren after your children die perhaps 90 years from now. Why not let the children take care of their own estate planning? Their education and your retirement are more important now. The low cash values show that the policies are bum deals. I estimate that if you'd invested the premium money instead of buying insurance and the account grew at 8 percent a year, it would be worth over $6,500 today, not a lousy $1,000. Some people buy life insurance for children to demonstrate its value. Some value! You've taught them how to blow money with good intentions. Cash in the policies, if only to blow the money on something more fun!