Three Strawman Investing Strategies

Regular reader and commenter Strawman left an insightful and interesting comment on a recent post about cash in investing strategies.  It was such a good comment, and so central to the theme of this blog (the search for the ultimate investing strategy), that I thought that it deserved it's own post.

Strawman starts:

I also accept that the strategy of buying into quality companies when the price is good, but holding cash is only one way to make this happen.

All good so far. Strawman continues:

Basically your strategy seems to be:

STRATEGY1: 'Move my wealth from cash into X when the (real long term) P/E for X is really good'.

That's correct.  But let's just clarify a few things.  Firstly, the P/E in instantaneous, and changes over time.  Every time the market presents you with a price (P), you can calculate the corresponding P/E (based on either last years earnings (E), or sometimes, projected earnings).  Therefore, I don't really know what you mean by "real long term P/E".  Also, I think that you are trying to use "P/E" as a pure indicator of value, which is not quite right, as it depends on the growth prospects of the company.  However, let's assume that you can generate a "value indicator", and, to keep the language consistent within this post, let's call that value indicator "P/E".

Share Prices - Significant factors affecting

I've recently had a go at trying to determine the most significant factors affecting prices of houses and gold and silver, but now it's time to tackle the difficult one - share prices.

One of the things that makes it difficult is that it's a different answer depending on whether we are talking about an individual company verses an equity index (eg. ASX All Ords).

Let's start with what appears to be the most obvious answer - profitability.  The most significant factor affecting the share price of an individual company, and perhaps even the indexes, are their profitability.  In general, the more profitable companies are, the higher price they can command.

Price Earnings Ratio

The Price Earnings (P/E) Ratio is a well known and easily computed number regarding the value of a company.  Yet, it's really not that well understood.  What exactly does a P/E of 14 indicate?  Is it better, or worse than a P/E of 16?

The way I see it, there are two main components that make up the P/E ratio, and they are not price and earnings - well, they are - but, if you slice it another way then you get two more revealing components.