DO YOU REALLY KNOW WHAT YOU'RE BUYING?

I am astounded at the number of mutual funds that currently boast triple-digit one-year returns. In fact, for the year ended March 31, 2000 there are 52 funds (excluding clone and seg versions of the same fund) reporting returns from 100% to 335% (source: PALTrak 98). All have one thing in common - high technology. The other thing they have in common is that they own very expensive stocks. The most commonly quoted measurement of whether or not a stock is expensive is the Price-Earnings ratio (P/E). A stock's P/E tells you how much you're paying now, for each $1 of profit reported over the past year. But look under the surface of the often-quoted P/E ratio and what you'll find are built-in expectations for future growth. Estimating those expectations may help to put this euphoric rise and recent decline of tech stocks in perspective for investors who are wondering what to do now. Hence, the focus of this report is to compare what investors are paying to what they can expect in the future.

Market Prices and P/E

I firmly believe that buying stocks or equity investments should generally be approached in a similar fashion as buying a business. When you buy a business or shares of a business, you're essentially buying a stream of future earnings and cash flows. So how would you, as an investor evaluate how much you'd be willing to pay? Your price would probably be based on what you expected the company to return in the form of earnings and cash flows - right? That's really what market prices represent - the market consensus on how a company will perform over the next five to ten years. And of course, built into the price you pay is usually some expectation of the company's growth potential.

For simplicity, let's ignore for a moment the potential for companies to grow their profits. With that in mind, a P/E ratio of, let's say, 20 times means that you're paying $20 up front in exchange for each $1 in annual profits. Taking that a bit further, it would take about 20 years just to
double your money. But nobody wants to wait 20 years. So, why would an investor pay $20 for each dollar in profits? Because the investor is optimistic about the company's prospects for the future. In other words, the investor thinks the company will not only maintain, but that it will grow its earnings and cash flows, and is willing to pay a price for that potential. So what kind of growth is built into today's P/E ratios?

Expectations

Table I below illustrates the level of earnings growth (on a compound annual basis) required to deliver annualized returns of 10% and 15% over a ten-year period, at various P/E multiples. (It is important to note that what I'm talking about and what the table illustrates is growth in bottom line earnings, not just gross revenues.) Continuing with our "20 times P/E" example from above, earnings would have to grow at an annual rate of 7.4% per year just to generate a 10% annualized return from your stock investment. While that doesn't look like a high growth figure, this must be studied in the context of the company and stock in question. This hypothetical stock could be described as speculative if the company in question was in an industry with a bleak outlook or if company fundamentals were weak.

Table I - Estimated Growth in Earnings per Share (EPS) Required to Increase Share Prices by 10% and 15% annually over ten years

P/E Multiple	Annualized EPS Growth Needed to Move Share Price up 10% per year	Annualized EPS Growth Needed to Move Share Price up 15% per year
10	-0.7%	4.3%
15	4.2%	9.8%
20	7.4%	13.5%
30	11.7%	18.5%
50	16.6%	25.3%
100	24.0%	35.0%
200	33.1%	45.1%
500	45.8%	59.1%

Assumptions:

-The resulting required earnings growth rates mentioned above are assumed to be constant for each of the ten years (i.e. using a growth rate of 22%, EPS is 1.22 in year one; 1.49 in year two; etc.). After that ten year period, growth in earnings is assumed to level off to half in year 11, then to a rate of 5% (or half of year 11 growth, whichever is less) per year forever.
-Investors' target return (i.e. growth in share price) is the rate used to discount future earnings (i.e. 10% and 15% are used).
-Two assumptions are possible with this model's earnings figures. First, any earnings that are assumed to be paid out to investors as dividends are assumed to have been re-invested by investors at their stated target rate of return for the ten year period. Second, any earnings that are assumed to be retained in the company (i.e. not paid out as dividends) are assumed to have been re-invested in the business to produce the assumed earnings growth.

Some Actual Examples

Microsoft - Shares of software giant are down more than 40% from its 52-week high. But it's still trading at about 42 times earnings. For investors to earn a 10% annualized return on the stock over the next ten years, Microsoft will have to grow their earnings by more than 15% per year. For shareholders to enjoy a 15% annualized return over the next ten years, Microsoft will have to grow its earnings per share by 23% per year for the next ten years. For comparison purposes, Microsoft's earnings growth over the past five years has been around 41%.

Celestica - This electronic manufacturing services firm is one of the country's hottest tech stocks, and is currently trading at about 97 times earnings. They'd have to grow their earnings by 35% per year just to give equity investors a 15% annualized return for the next 10 years. Though Celestica has more than doubled it's per share earnings over the past year, it has continually reported earnings below analysts' expectations.

So while both of these stocks (and many other expensive stocks) may be backed by solid companies with good long-term businesses, there is a limit to what investors should be willing to pay for future profit potential. But getting further insight into the expectations that are built into stock prices and P/E ratios will hopefully help you in evaluating whether or not certain stocks or funds are suitable for you. It's important to remember that I'm not stating any kind of opinion on these stocks, but rather estimating the level of performance such companies will have to sustain over the next ten years just to deliver what investors have seen as very average returns.

Table II - P/E Ratios of selected North American Funds, Stocks and Indexes

US (date of data)	P/E Ratio
S&P 500 (4/30/2000)	29
NASDAQ 100 (4/30/2000)	177
Microsoft (5/04/2000)	42
Canada (date of data)
TSE 300 (4/30/2000)	28
TSE 200 (4/30/2000)	37
TSE/S&P 60 (4/30/2000)	25
Celestica (5/04/2000)	97
Valorem Canadian Demographic (4/30/2000)	622
Strategic Value Cdn Small Co.s (4/30/2000)	183
Sceptre Equity Growth (4/30/2000)	10
Trimark Canadian Small Co.s (4/30/2000)	10
AGF Dividend (4/30/2000)	15
Standard Life Canadian Dividend (4/30/2000)	13

Source: PALTrak 98 & publicly available data sources

A Couple of High P/E Funds to Steer Clear From

Valorem Canadian Demographic - Mandated to take advantage of demographic trends (namely health care, technology, and wealth management), I find it difficult to recommend this fund for a few reasons, despite its stellar performance thus far. Demographic trends are global in nature, so ideally, money managers should be able to search globally for the best companies to take advantage of these trends. The P/E ratio of 622 makes absolutely no sense and is risky in the sense that even if companies in this portfolio produce awesome earnings growth, it may not be enough to give this fund's unitholders a respectable return. Add to those attributes, an annual expense ratio (MER) of more than 2.90% and you've got the makings of a fund that will have a tough time over the long term.

Strategic Value Canadian Small Companies - Filled with a number of small tech stocks, this fund boasts a P/E ratio of 183 times earnings. This is down substantially from a P/E of 575 a month earlier. Turnover combined with tumbling share prices brought the fund's P/E down from crazy to ridiculous. Offsetting the big tech exposure is a handful of energy stocks which work as a hedge to the tech core currently in this portfolio. From a standpoint of the fund's strategy and from a valuation standpoint, this fund contains a high level of risk at this particular time.

Those are just a couple of examples of funds with a portfolio of very expensive stocks that may represent significant risk if earnings disappoint by even a sliver. Investors would be wise to offset their growth and tech holdings with more value-oriented holdings.

A Few Funds to Consider

Sceptre Equity Growth - This isn't a strict value fund but may represent good value at this time. Lead manager Allan Jacobs is one of the best in the country at finding growth companies trading at very reasonable prices. You'll see some large cap stocks among his top holdings, but the core of this fund is in small and mid sized companies. Trading at just 10 times earnings (as at 4/30/2000), this fund offers solid management, low fees (MER = 1.50%), and is positioned to catch the eventual rise in many of the market's cheap and small company stocks.

Trimark Canadian Small Companies - Keith Graham and Geoff MacDonald are a bit contrarian and spend lots of time looking at what they're buying (i.e. risk vs. reward). The fund typically holds about 50 to 60 stocks and currently boasts a composite P/E ratio of about 10 times earnings. Broad diversification, depth of management, and a value oriented approach all bode well for unitholders in this fund.

AGF Dividend - Managed by Martin Gerber and Gord MacDougall, this team uses a two-way asset allocation system to manage this fund. As conditions get to extremes, this team isn't afraid to pull the trigger and go heavy into cash. In fact, they've been as heavy as 50% in the past (in 1987) and have added lots of value for unitholders of this fund over time.

Standard Life Dividend - The Montreal-based team that runs this common stock fund has done a fabulous job. A big weighting in interest sensitive stocks makes this portfolio vulnerable to further rate hikes, but risk is mitigated by holding cheap stocks with relatively high yields - which typically do well in the face of a widespread decline.

A P/E ratio is simply one method by which to measure the value of a stock. Low P/E stocks and funds that are cheap but they're not always bargains. A bargain is when you can get something valuable for a relatively cheap price. Remember that stock prices and, in turn, P/E ratios represent the market's consensus of future expectations. So in some cases, there may well be a good reason for a stock's low price.

As far as mutual funds are concerned, P/E ratios are not always significant for two reasons. First, a company's earnings can be subject to significant manipulation by a company's management. With funds that use a buy-and-hold philosophy or a value-oriented approach, it can give some insight into whether or not the portfolio managers are staying true to their value style. Alternately, P/E ratios may be meaningless for funds that flip their entire portfolios very frequently (i.e. high turnover). So the P/E is most useful as a tool to gauge the market's expectations and comparing that to your own expectations and return requirements.

Dan Hallett can be reached by e-mail at dhallett@sterlingmutuals.com

All information on mutual fund and index P/E ratios was provided by PALTrak 98 (30-Apr-2000). Stock P/E ratios were obtained from publicly available data sources as of the close of business 04-May-2000.