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One Simple Way to Find Great Investments

Working at The Motley Fool Singapore, it’s perhaps no surprise to find out that I love investing. Over the years, my interest in the subject has led me to seek knowledge from great investors who have walked the talk.

And in the course of my learning, the more I delved into the subject, the more I realised how different equally successful investors can be in the way they thought about investing. But at the same time, I would occasionally stumble upon investment ideas from very different investors that are similar, startlingly simple, and effective.

Great minds think alike

John Neff, Peter Lynch, and Shelby Davis were all great investors who thought about investing somewhat differently. Neff was widely considered to be a value investor who favoured low PE shares, while Davis and Lynch were somewhat more comfortable paying up for more expensive shares if the growth prospects were indeed good.

By manner of speech, Neff would thus be an investor who’ll prefer to buy companies growing earnings at 8% but yet would sell for a PE of only 5; meanwhile, Davis and Lynch would fish at ponds where companies growing profits at 15% to 20% were fetching earnings multiples of around 12 to 15.

On the outset, these investors’ approach would seem quite different. But the idea behind their thinking was similar: the market would likely bid up the price-to-earnings (PE) multiple of a share if the share’s growth rate would end up being higher than its PE ratio.

Putting it in action

The concept might sound abstract, but the potential for profit can be great. The table below, which is adapted from Neff’s book John Neff on Investing, can provide some illumination on the concept using hypothetical figures:

 

Company A

Company B

Earnings at March 2014

$1

$1

PE Multiple at March 2014

15

8

Share Price at March 2014

$15

$8

Growth rate

11%

11%

Expected Earnings at March 2015

$1.11

$1.11

New PE multiple reflecting growth at March 2015

11

11

Potential share price at March 2015

$12.21

$12.21

Possible change in share price

-19%

53%

Note how a losing investment can become a winning one because of a change in the earnings multiple at the start of the investment period. This illustrates the power of having an expansion in the earnings multiple of a share. Davis even had a catchy name for such a situation, calling it the ‘Davis Double Play’.

With a ‘Double Play’, we can not only profit from the growth in the company’s earnings, but we can benefit from an improved appraisal of the company’s prospects by the market through a higher PE. Clever!

Seeing it in action

Vehicle inspection and testing firm Vicom (SGX: V01) and instant coffee maker Super Group (SGX: S10) are just two great examples of the idea at work.

Six years ago on 28 March 2008, Vicom’s earnings per share was S$0.16 and at that time, it carried a trailing PE of 10. Fast forward to today, and Vicom’s profits have grown by a compounded annualised rate of 12.4% to S$0.32 while its PE ratio has expanded to 18. This has resulted in its share price jumping by 250% from S$1.68 to S$5.88 even as its earnings had grown by a cumulative total of ‘only’ 102%.

Meanwhile, Super Group’s share price had grown by 438% from S$0.66 to S$3.55 even as its earnings per share figure had increased by ‘only’ 229% from S$0.054 to S$0.180. This was the result again of an expansion in Super Group’s PE multiple from 12 to 20 in a better reflection of the company’s compounded annual growth rate of 22% for its earnings per share.

Foolish Bottom Line

It might take a little digging, but if you are able to find companies that are selling at PE ratios way below what you think its future growth rates might be, you might yet be able to witness a ‘Davis Double Play’ in action and be richly rewarded for it.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Chong Ser Jing owns shares in Super Group.