Warren Buffett has pointed out that if the price of hamburgers at McDonald's (MCD) fell, he wouldn't worry, he would feel good about paying less for the hamburger than he paid the day before. Buffett applies the same idea to stocks and says, "The lower things go, the more I buy."
Buffett has a unique skill that allows him to know which stocks are a bargain at low prices and should be bought. He also avoids stocks that deserve to be trading at a low price because the underlying business is troubled. There probably won't ever be another Buffett, but there are many ways to apply his wisdom that should allow individual investors to beat the market.
To find low-priced stocks, we have a number of tools available. One of the best tools for long-term investors might be the cyclically adjusted price-to-earnings (CAPE) ratio.
CAPE was popularized by Yale professor Robert Shiller. CAPE is his adaptation of the smoothed P/E ratio first defined by Buffett's teacher, Benjamin Graham, in the 1930s. Rather than using a single year to calculate the P/E ratio, CAPE uses an average of the past 10 years and captures the earnings over a typical business cycle.
Shiller forecasted the stock market crash in 2000 with CAPE. After the indicator reached historic highs, he could see a decline was expected. Conversely, when CAPE is low, the stock market is a buy.
CAPE can be applied to any stock market in the world. It can also be applied to market sectors or individual companies. And it can be used with ETFs and might be less risky than individual stock trades. ETFs hold multiple companies and allow you to avoid the loss of 100% of your capital if an individual company goes into bankruptcy.
Call options on ETFs can also be used with this strategy to find low-cost investments. Since the risk of a call option is limited to the amount you pay for the call, buying calls can be a low-risk way to benefit from market gains.
Internationally, the lowest CAPE ratios for now are found where the economic news is bad. Europe's crisis has been unfolding for years, and stock markets in a number of the countries have become cheap.
In Spain, unemployment fell to 26.3% in the second quarter from 27.2% in the first quarter of 2013, and the country's prime minister believes the two-year recession will end this quarter. Now could be the time to buy the Spanish stock market if he is correct.
Call options on iShares MSCI Spain Capped Index (EWP) offer exposure to Spain's potential turnaround. January 2014 calls with an exercise price of $30 are trading for about $2.35 and would be profitable if EWP gained about 5% before the options expire.
Recommended Trade Setup:
-- Buy EWP Jan 2014 30 Calls at $2.50 or less
-- Do not use a stop-loss (the risk is limited to the price paid for the call)
-- Set price target at $3.50 for a potential 40% gain in 5.5 months
Austria also presents an opportunity where a market is trading at a low CAPE because of a weak economy. Price movements in iShares MSCI Austria Capped (EWO) have been very similar to the price moves of EWP. If EWP moves up, EWO should as well.
Recommended Trade Setup:
-- Buy EWO up to $17.75, the top of a gap formed on the daily chart in June
-- Set stop-loss at $17, a support level established during the filling of the gap
-- Set price target at $20 (based on a trading range breakout) for a potential 13% gain in 6-12 months
A word of caution: Not all bad news is a buy. Market Vectors Egypt Index ETF (EGPT), for example, has a single-digit P/E ratio but there is so much uncertainty in that country that the stock market seems to be little more than a gamble right now.
Market Vectors Junior Gold Miners ETF (GDXJ) is also trading with a single-digit P/E ratio, but the options are richly priced and there is little room for profit at the current prices.
Low CAPEs and low P/E ratios in general are often buy signals, but just like Buffett exercises selectivity, individual investors should analyze why the ratio is low. When the analysis confirms the buy, as it does with EWP and EWO, the profits could be substantial.