Cheap, Riskless Blue-chips.

You have definitely heard this line somewhere:

Invest in blue chips. They are less risky.

This is one of the most dangerous belief to adopt.

Whether one should inject capital into a company depend largely on two main factors:

• Is it good?
• Right price?

There are good companies with bad prices. There are drowning companies with great-looking, seductive prices. Both can be equally dangerous, although I think if you have the tenacity, usually you won't make huge losses with the former, unless you are terribly ignorant.

For instance, let's take a look at a company like Helwett Packard Incorporated (NYSE:HPQ). You definitely have seen a HP printer somewhere, or used their laptops even. To be honest, I like their products. I am even holding a small amount of its stock.

I hope you recall that this blog is about sharing my mistakes!

One of the metrics used by investors is the Price-to-Book ratio. It basically means looking into the balance sheet, and taking the value of total assets minus total liabilities. What you get is call net asset, or equity.

Divide that value with the number of shares, and you get a figure known as book value per share. The ratio between the price and book value per share is known as P/B ratio. If it is lesser than one, it is generally considered cheap.

It basically means you paying less than 1 dollar for 1 dollar of assets.

Companies often report earnings every quarter, and a figure call Earnings Per Share, popularly abbreviated as eps. The ratio between price and eps is known as Price to Earnings, also popularly known as P/E ratio.

Somewhere in November 2015, HP split into two companies, HPQ (printers, desktops and laptops) and HPE (deals with cloud computer and server stuff). HPQ reported earnings and it was bad. The market pull the price down from 14.x to 12.x

The book value per share, ladies and gentlemen, is 15.75 then. This brings P/B to 0.8.
The P/E ratio, was less than 6. You will find this to be an attractive value. Generally, most people will consider a P/E of less than 20, cheap.

And so I went in. On the benefit of hindsight and new knowledge, I regretted.

During the great correction between late Decemeber 2015 and Feb 2016, HPQ dropped to almost the low 9 dollars. If you have done cashflow valuation (I will share this in a latter post), 9 bucks is a very very safe price.

That was Feb 2016 then. We are now in late April 2016, with the Dow at almost 18000 today, HPQ is still only around my buy price, and I am suffering a loss due to a less favorable currency rate.

There were two mistakes that I learnt from this trade.
(a) HPQ was carrying a lot of goodwill in its balance sheet.
(b) P/E and P/B are not great indicators of cheap companies.

Earnings can be largely doctored, and we are usually looking at last twelve months of earnings. What about future earnings? If it plunges, the P/E goes right up.

P/B ... well... rich asset does not translate into money-making, generally. Investors who largely invest in this kind of stock will hold a large basket of stock. This is not a wrong strategy. But you need to be an expert of the balance sheet.

Some assets such as

1. goodwill (excessive amount paid when companies are acquired are considered assets and stored here)
2. intangibles
3. accounts receivable (amount of money customers still owe the company)
4. inventory (stuff that are sold to customers)
5. plants, properties and equipment (assets that are used to create the products or services)

ALL of the above have subjective value.

1. HPQ acquired Compaq in the past and paid too dearly for it. That bulk ends up in goodwill.
2. It is tough to value intangibles.
3. You depending on the good faith of those debtors to pay up in Accounts Receivable
4. Inventory can go seriously out of fashion. Items such as a dental floss will probably de-value slower than the latest iPad. You have to judge...
5. Plants, properties.... well.... good luck selling them when the company liquidates..

Summary: it is what you think that you know, but just aint so, that kills you.
When the price goes up, you make money and nobody asks any questions. It is when you are losing money that doubts creeps in and kills you.

There are a lot of companies listed in indexes that are no doubt good companies but usually they are over-valued. P/E and P/B are useful, but cashflow valuation is still king.