INDEX:

I. Market News: Continued Light Holiday-Week Trading
II. Heroes: Mastec, TheraTech, Systemed, Ha-Lo
III. Goats: Cordis, Netstar, Safety 1st
IV. Investment Perspective: What Does the P/E Ratio Really Mean?
V. Calendar: Thursday's Economic Events

MARKET CLOSE

DJIA: 5105.92, down 4.34
S&P 500: 614.53, up 0.23
NASDAQ: 1048.13. down 1.24

MARKET NEWS

The government is still partially shut down. The powers that be aren't really talking. Market traders are sitting on their hands. And we've got BOWL WEEKEND coming! Ignore the market (everyone else is) and go register your picks for Fool Bowl in the FoolDome. (In other words, there wasn't much news today except slipping consumer confidence numbers. . . like that was a big surprise.)

HEROES

Even if you do not have CNBC, the market is never far from the touch of Dorfman. Mastec Inc. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NASDAQ:MASX)") else Response.Write("(NASDAQ:MASX)") end if %> soared $2 3/4 to $12 today when Dorfman parroted the comments of Parket Quillen, who manages about $17 million at Quilcap Corp. Mastec, controlled by the Cuban Mas family, owns pay-phones in the United States and provides telephone service in Mexico and South America. Mastec owns 15% of Mexico's second largest provider of public telephones and stands to benefit if Cuba ever gets back in capitalist good graces. The estimates quoted were $0.78 a share in 1996 and $1.10 in 1997, compared to $0.47 this year. Since no analysts apparently follow the firm, it is hard to double-check these numbers, but they do sound great. As always, double-check any Dorfman story. If these numbers are for real, it is worth much more than today's close, despite the big rise.

TheraTech <% if gsSubBrand = "aolsnapshot" then Response.Write("(NASDAQ:THRT)") else Response.Write("(NASDAQ:THRT)") end if %> powered ahead $3 1/4 to $19 1/4 today after an agreement with Proctor & Gamble <% if gsSubBrand = "aolsnapshot" then Response.Write("(NASDAQ:PG)") else Response.Write("(NASDAQ:PG)") end if %> was announced. The two companies have submitted a New Drug Application (NDA) for an estradiol transdermal patch. This would provide hormone replacement for menopausal women through the skin rather than through painful shots or hard-to-swallow pills. Under the agreement, TheraTech would manufacture the patch and Proctor and Gamble would market it worldwide. Submission of an NDA is not at all akin to approval, though, which will take time.

Systemed <% if gsSubBrand = "aolsnapshot" then Response.Write("(NASDAQ:SYSM)") else Response.Write("(NASDAQ:SYSM)") end if %> received a panacea for its share price blues---a three year contract with Priority Health, a 127,000-member managed care company in Western Michigan. Shares of the full-service pharmacy benefits manager rose $1 to $5 today when it reported it would provide Priority Health clients exclusively with mail-order pharmacy services. With $153 million in trailing earnings and earnings of $0.31 a share expected next year, this low-margin pharmacy service still seems to be shaky, even in light of the contract.

Promotional giant Ha-Lo <% if gsSubBrand = "aolsnapshot" then Response.Write("(NASDAQ:HALO)") else Response.Write("(NASDAQ:HALO)") end if %> continued its rapid advance today, closing up $2 5/8 to $26 3/8. The firm specializes in creating promotional campaigns, complete with products, for major corporations. Their acquisitive expansion strategy has fired up earnings and revenue growth over the past four quarters, producing EPS gains of 167%, 50%, 75% and 113% on slightly smaller revenue gains. Slated to make $0.95 in 1996 while growing in excess of 30%, there seems to be an opportunity here. Investors are cautioned to keep Cyrk <% if gsSubBrand = "aolsnapshot" then Response.Write("(NASDAQ:CYRK)") else Response.Write("(NASDAQ:CYRK)") end if %> in mind when investing in Ha-Lo, another promotional firm laid low when it lost a huge contract with one customer.

GOATS

Some feathers were ruffled at Cordis <% if gsSubBrand = "aolsnapshot" then Response.Write("(NASDAQ:CORD)") else Response.Write("(NASDAQ:CORD)") end if %> today when potential partner Johnson and Johnson <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE:JNJ)") else Response.Write("(NYSE:JNJ)") end if %> requested that the review period prior to the proposed merger be extended until January 22nd. Cordis fell $11 1/4 to $95 1/4 today in heavy trading as shareholders took their profits and bailed out on fears that the $109-per-share merger would fall through. Some commentators questioned whether the deal would go through, given that Johnson and Johnson has had 45 days, but Cordis's complex cross-licensing structure might require extra work to examine. The marriage between Cordis's cardiac catheters and Johnson and Johnson's stents still seems like a nice fit. Cordis competitor Guidant <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE:GDT)") else Response.Write("(NYSE:GDT)") end if %> was up $3 1/8 to $40 1/2 on the news. Guidant had been crushed initially on news of the merger as the Johnson & Johnson/Cordis double team is a marketing fantasy.

High-flying Netstar <% if gsSubBrand = "aolsnapshot" then Response.Write("(NASDAQ:NTSR)") else Response.Write("(NASDAQ:NTSR)") end if %>, home of the gigarouter and championed as the next great networking stock, gave back some of its gains today, losing $1 1/8 to $18 3/8, apparently in a round of profit taking. Netstar is one of the few publicly traded networking equipment concerns with products which might rival the big guns of the industry, Cisco Systems <% if gsSubBrand = "aolsnapshot" then Response.Write("(NASDAQ:CSCO)") else Response.Write("(NASDAQ:CSCO)") end if %>, Bay Networks <% if gsSubBrand = "aolsnapshot" then Response.Write("(NASDAQ:BNET)") else Response.Write("(NASDAQ:BNET)") end if %>, 3Com <% if gsSubBrand = "aolsnapshot" then Response.Write("(NASDAQ:COMS)") else Response.Write("(NASDAQ:COMS)") end if %> and Cabletron <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE:CS)") else Response.Write("(NYSE:CS)") end if %>. Its gigarouter is reportedly the highest capacity router available commercially.

Child safety products giant Safety 1st <% if gsSubBrand = "aolsnapshot" then Response.Write("(NASDAQ:SAFT)") else Response.Write("(NASDAQ:SAFT)") end if %> got hosed big time today, losing $4 1/8 to close at $15 1/8. The company reported that it will take a significant charge against earnings in the fourth quarter to write off some of its bulging inventories. The company is also increasing its reserves for bad debt while it has the chance; the fourth quarter looks like it will see a loss of $0.28 to $0.29 a share on $25 million or so in revenues. Although this appears to be a one-time charge, the size of the write-down and the reserve for bad debt make one wonder if more bad news might be forthcoming.

INVESTING PERSPECTIVE: A P/E Primer

The price-earnings ratio (P/E) is at once the most helpful and most damnable convention that investors have at their disposal.

The price-earnings ratio first saw the light of day as the earnings-price (E/P) ratio in Graham and Dodd's investment opus, "Security Analysis." The genius of the price-earnings ratio, as well as the concept of book value, was that it placed all equities on a level playing field and allowed one to compare them using similar criteria. The appearance of "Security Analysis" in the post-Crash era was a watershed in investing because suddenly a few startlingly simple conventions gave investors a way to gauge the relative merits of different stocks versus the return offered by bonds, allowing them to make rational investment decisions.

The world Ben Graham wrote for was a world where mass screening of stocks via computer was impossible. Only good old elbow grease and a few thousand pages of tables and newspapers to churn through were available for an investor to determine if a company was selling for a low P/E ratio, at or below book value, with positive net working capital. Today any investor with a computer and $10 to $100 a month for access to massive databases can complete such a screen in minutes. Even as recently as the 70s and 80s, before the personal computer and online communications revolutionized investing, the kind of information required to invest intelligently was either locked away in brokerage houses or too expensive for the individual investor. Anyone with less than $100,000 to invest was left out in the cold.

Because such a small number of market participants had ready screening access to P/Es and such, many attractive stocks could be found selling for low P/Es. Even taking out the cyclical stocks, companies whose business was so deeply tied to the economy that it was either boom or bust for them, there were still scores of unknown and unappreciated companies, and most importantly, undervalued ones. The low-P/E approach to investing made perfect sense because so few investors could take advantage of it.

Like any cliche, though, P/E ratios can be abused if forced into situations where they really don't belong. When the historical context changes, as it has today with easy computer access to screening software, the majority of stocks with low P/Es now have low P/Es for a reason. That is not to say that these reasons aren't sometimes wrong. Rather, it is to say that the stakes are higher for jumping on a low P/E situation than they were 20 or 30 years ago.

For instance, cyclicals confuse most investors. How can a stock like Micron Technology, for instance, trade at only 10 times earnings when it has been growing at more than 100% for the last four quarters? How can a company like Rexene trade with a P/E of only 2? There has to be something wrong here, many think, and they dive right into these stocks without pausing for a moment to consider why they might trade at such low P/Es.

A P/E is simply the ratio between the trailing twelve months' earnings per share (EPS) and the current price. Equities, however, are valued by looking forward as objectively as possible to future growth. A commodity chemical company like Rexene, whose main product is a key component of plastic called ethylene, trades at a low P/E because the past four quarters have been massive---stellar. But the next four quarters are cloudy as we hear rumblings of an economy slowing down; for a company tied so closely to the larger economy, such a murky forecast pulls it back to earth rather quickly. With huge fixed operating costs to keep the plants running, management salaries and the monthly bill for the huge loans the company took out to pay for its newest factories, an outfit like Rexene can lose a lot of money in bust times. Or at least that is what the current 2 multiple tells you the Street is thinking.

In a situation like Rexene's, or Micron's, or what have you, where the valuation is out of whack because of concerns of cyclicality, the task for the individual investor is more research to determine whether or not this concern about cyclicality is truly warranted. In the case of Micron, there is currently a lot of work being done in the stock's folder on how much upgrading of memory everyone's PCs will need. This is a step in the right direction, as demand is part of the equation that cyclical companies operate within. The other half of the equation---supply---is best researched on the supplier end through what the companies themselves are saying or what monitoring organizations like Dataquest believe.

Investing in a stock simply because it has a "low P/E" is no longer sufficient to ensure the "margin of safety" Ben Graham wrote of when he cautioned investors that there were limits to their knowledge. In a world where screening is rampant and information so well dispersed, the approaches he championed need to be updated. A low P/E in isolation, or even together with a low price/book ratio and positive net working capital, does not necessarily a good investment make.

CALENDAR: Thursday's Economic Events

---Weekly Initial Unemployment Claims (8:30)
---November Conference Board's Help-Wanted Index (10:00)
---Money Supply Statistics (4:30)
---APICS Business Outlook Index

Byline: Randy Befumo (MF Templar)

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