Guest Post from Saj Karsan

When considering the market in the aggregate, this is a very difficult question to answer. Some companies will have cost structures that prove too rigid,
and will therefore be unable to adapt to a lower revenue environment.
Other companies, on the other hand, will have flexible cost structures
or will see revenue continue to grow, despite the downturn. But to
determine which of these forces will exert more pull on the market's
earnings in the coming quarters is not only extremely difficult, but
unnecessary: unless you're trying to value the entire index, you don't
have to answer this question for the market in the aggregate. Instead,
you can try to answer this question for individual securities, which
are much easier to understand.

For example, consider Key Tronic (KTCC),
a manufacturer of electronic devices. The company has a P/E of 23,
which makes it appear overvalued. But earnings are down because
year-over-year quarterly revenue is down 15%. However, the company has
little in the way of debt, and has the vast majority of its operating
leases coming due in the near-term, giving it further flexibility in
reducing its costs. Operating expenses are down 17% this year, and the
company sees sales starting to rebound in January of 2010. In fact,
based on KTCC's past margins and returns on assets (which it should be
able to return to by continuing to cut costs and with a modest recovery
in revenues in the years to come), it appears to trade at a normalized
P/E much, much lower than the 23 that stock screeners currently
display. (KTCC is a stock we've previously discussed here.)

Determining
whether the market is over- or under-valued is a difficult exercise
indeed. But by focusing only on those companies for which it is easier
to compute earnings (circle of competence), and ensuring that companies
trade at discounts to those earnings (margin of safety), investors put
themselves in positions to profit in the long-term whether the
aggregate market offers potential or not.