Bottom trawling has always been an attractive investment strategy for many newcomers to share market investing.  They quickly learn from some of the world’s greatest investors that the key is to buy low and sell high.  The core idea of bottom trawling is casting your net in the hopes of finding shares so low they appear to have hit bottom with nowhere to go but up.

Regardless of whether an investor searches the 52 week rolling low daily lists, or for shares with very low P/E ratios, the hidden reef in bottom trawling is the fact the bottom can keep dropping.  How low can it go?  

There are three potential outcomes to bottom trawling:

1.    You can be right and the share price begins to recover overt time.
2.    You can be early and the share price continues to drop.
3.    You can be wrong and the share price fails to recover.

There are few examples of the dangers of bottom trawling better than the demise of an iconic American investment bank – Lehman Brothers.  The CEO of the firm insisted they were fine and the share price drop was largely due to short-selling.  You know the end of the story.

However, there are success stories with bottom trawling as well.  On 11 September 2011 Australians learned of a voluntary recall from industry leader Cochlear (COH) of its latest implant line, the Nucleus CI500 implants.  The share price plunged to a new 52 week low.  A major concern expressed by analysts was loss of market share.  As often happens with shares in decline, COH continued to make new 52 week lows over the next month.  The following 6 month share price movement chart shows what happened next:

Cochlear is still far from its pre-recall highs, but the share price began to recover quickly, although modestly.  This pattern is not typical of most shares in a bottoming trend.  Low P/E ratios and share price reaching or approaching 52 week lows are indications the collective judgment of share market participants is the future of the company is not bright.  It takes time to alter perceptions.  One of the keys to successful bottom trawling is patience.  Another is faith in the markets and in shares as investment vehicles that pay superior returns in the long run, as well as faith in the company in the bottoming trend.

BHP is the world’s largest diversified resources company and right now it is a candidate for bottom trawlers.  Its current P/E Ratio of 9.69 is below the ASX P/E of 12.28 and below the Materials Sector P/E of 11.64.  With a current share price of around $37, it is trading about 10% above its 52 week low of $33.68.  Let’s look at their one year chart:

BHP hit its 52 week high of $49.81 in early April of 2011 and it has been downhill since then.  In late September it reached the 52 week low and has revisited that level three times in the subsequent months.  Despite the downward slide, analysts from Macquarie, Citi, UBS, Credit Suisse, Deutsche Bank, and RBS Australia all have Buy or Outperform ratings on BHP as of early 2012.  BA-Merrill Lynch and JP Morgan have neutral ratings.

To make bottom trawling work for you there are several “safety valves” you can check to help estimate the chances the share you are considering will eventually bounce back.  Analyst opinion is one.  While some experienced retail investors might not care what the analyst community has to say, most of us get a measure of comfort knowing at least some analysts see the same rosier future we suspect might be there.  Here are all six safety valves:

1.    Dividends per Share (DPS)
2.    Return on Equity (ROE)
3.    Debt to Equity (Gearing(
4.    5 Year Average Annual Earnings per Share (EPS) growth
5.    5 Year Average Revenue per Share growth
6.    Analyst Opinion

The strategy begins with a list of target shares and then assessing each against the safety valve measures.  The simplest way to create a list is to use a stock screener looking for shares with P/E’s under 10 and P/EG’s less than 1.0.  The P/EG is in effect another safety check since it uses forward or projected earnings in its calculation.  A PEG of 1.00 in theory is perfectly priced with the share price matching the projected earnings.  Ratios under 1.0 tell us projected earnings per share are greater than the current share price.

Here are seven target shares that meet those criteria with the added measure of analyst recommendation.  Every share in the following table has at least one analyst with a Buy, Accumulate, or Outperform rating on the company:

Looking at these preliminary numbers you can see all are up from their 52 week lows, but none more than 20% up.  MGX appears to have the most attractive combination of P/E and P/EG but we need to look at the remaining safety valves.

Dividends per Share looks strictly at the amount paid without considering the share price of the company.  The six safety valves we are using are all independent of the daily price per share.  Dividend yield for shares at the bottom will be artificially high, since the share price is low.  

Return on Equity (ROE) is another measure of the inherent soundness of the company regardless of market perception as indicated by the share price.  ROE is a measure of how well a company uses what it owns (assets) to produce earnings.  Again, ROE has nothing to do with share price.  As you may know, an ROE at 15% or above is a health indicator for most business sectors.

Five year average annual growth rates for both revenue and earnings per share is an important safety check for bottom dwelling shares.  They tell us what the company has done in the past and while no guarantee they can repeat the performance, good companies generally repeat good performance over time, despite setbacks.

A low Debt to Equity Ratio (Gearing) tells us the company uses more of its own money rather than borrowed money to operate.  Companies with high debt and high gearing who find their share price falling dramatically may find it hard to borrow or to raise capital through issuing new shares.  

Air New Zealand along with consulting and technology company Oakton and industrial products manufacturer Nuplex are immediate candidates to be culled from the list.  Simply put, their growth performance over the last 5 years is sub-standard.  Remember, we are talking about safely bottom trawling.  Investors willing to tolerate higher risk should consider a number we deliberately eliminated – the 2 Year EPS Average Annual Growth Forecast.  You can find this number but as you know forecasts can be missed.  The 2 Year EPS Growth Forecast for AIZ is an astounding 108.2%.  Research them further if you will, but we think there are safer choices.

Rio and BHP are world renowned companies and it is hard to argue against their being long term holdings in any investment portfolio, especially at current prices.

Investment management services provider Henderson Group pays a respectable dividend with a solid ROE and acceptable growth over the last five years.  However, before investing we would further examine their financial statements regarding debt, as a debt to equity ratio of 50% may be a cause for concern.  For your information, HGG’s 2 year EPS forecast is for 40% average growth.

Mount Gibson Iron appears to us to be the safest choice.  Although their dividend is modest, their debt to equity, ROE and 5 Year growth rates are solid.  Their 2 Year forward projection is for 39.2% growth.  If you have been following the company, you know they missed estimates in December 2011.  Deutsche Bank maintained its Buy rating on 01 February, 2012 while dropping its price target.  RBS Australia downgraded the company from Buy to Hold on 27 January 2012.  Here is their share price movement over the last year:

Please note that TheBull.com.au simply publishes broker recommendations on this page. The publication of these recommendations does not in any way constitute a recommendation on the part of TheBull.com.au.You should seek professional advice before making any investment decisions.