IN the last article, we discussed one of the
measures used by the market to value stocks – the price-earnings, or PE,
ratio. We noted that the market likes high-growth companies and accords
them a higher PE ratio.
The higher the price a stock trades at relative to its current earnings, the more difficult it is for it to meet the market’s expectations and the higher the probability its share price will underperform.
In one of my finance courses years back, the lecturer told us that we should distinguish between a growth stock and a growth company.
Most times, growth companies are not growth stocks, because the hype of the growth has been factored into the share price.
Growth stocks, on the other hand, are stocks whose price will grow
because they have unappreciated value or business fundamentals. We want
to buy growth stocks but not necessarily growth companies.
Using a hypothetical example, we showed how a 21% downgrade in earnings can potentially cause a 62% plunge in stock price in a high PE stock, and how a 10% to 15% upgrade in earnings can lead to a 150% jump in share price for a low PE stock.
So what proof is there that this is actually happening in the market, that buying low PE stocks pays?
Well, I carried out a study of the stocks listed on Bursa Malaysia in the last 24 years.
I ranked all the stocks listed here based on their PEs every year, from stocks with the lowest PE to the highest. The ranking is done at the end of March so as to capture companies with financial year ending Dec 31.
I then clustered them into 10 groups with equal numbers of stocks. Decile 1 is made up of stocks with the lowest PEs. Decile 2 has stocks with the second-lowest PEs, and so on. Stocks with the highest PEs go into Decile 10. I then tracked the performance of these stocks a year later.
Let’s assume that I started with RM1mil in 1990 – RM100,000 to be allocated to each of the 10 baskets of stocks. After doing the ranking on March 30 that year, I used the first RM100,000 and split it equally into all the stocks in Decile 1. The next RM100,000 is allocated equally to stocks in Decile 2 and so on.
At the end of March in 1991, I liquidate all the stocks bought a year ago. Money obtained from the Decile 1 stocks – calculated based on the share price on March 31, 1991 plus the dividends received in that past year – was redeployed into the Decile 1 stocks in the second year. Money from Decile 2 in the first year would be rolled over to the Decile 2 stocks the following year. Similarly for Decile 3 till Decile 10. I keep doing this for the next 23 years.
The accompanying chart shows the performance of the 10 baskets of stocks with the return rolled over for 24 years.
The RM100,000 put into the lowest PE stocks every year would have grown to RM4.3mil. That’s a compounded return of 17% a year. Guess what the bonus is? Low PE stocks on average also have higher dividend yields.
The second basket of stocks, those with the second-lowest PEs, returned 15.7% a year. Not too bad. It grew the original RM100,000 to RM3.3mil. (Please note that all the calculations exclude transaction costs, and yes, a small difference in growth rate translates into a big difference if compounded over the long term.)
How would someone who consistently goes for the high PE, glamour stocks have done? Well, they managed to grow their original RM100,000 to just RM128,600 for a compounded annual return of a mere 1%. That doesn’t even beat inflation and when transaction costs are factored in, he/she would have lost money.
In comparison, buying and holding the FTSE Bursa KLCI from March 1990 until March this year would have yielded you a capital appreciation of about 4.9% a year. Add in dividends of say 3.5% a year, and your RM100,000 invested in the Malaysian stock index would have grown to about RM2mil over that time, with dividends reinvested in the market.
In other words, buying a basket of low PE stocks would allow you to vastly outperform the KLCI.
But note: Some stocks trade at low PEs for a reason. They could be value traps, in that their stock prices would go lower as the company’s operations continue to deteriorate.
Many of the S-chips, or China stocks listed in Singapore, were trading at very low PEs. And as some of you may know, many of them have bombed. Those still listed are trading at very low PEs because the market doesn’t quite trust the numbers due to the poor corporate governance issues of their peers.
Meanwhile, some stocks trade at PE of 100 times or 200 times because they are transitioning from a loss-making patch to profitability.
So when we look at PEs, it is also important to look at the quality of earnings, and the sustainability of the earnings. But all things being equal, holding a basket low PE stocks beats holding a basket of high PE stocks.
In the next article, we will look at another valuation metric used by the market to value stocks – price-to-book value – and we will see how it performs vis-a-vis the low PE strategy.
The author is a partner in Aggregate Asset Management, manager of a no-management fee Asia value fund.
Source : The Star Online
The higher the price a stock trades at relative to its current earnings, the more difficult it is for it to meet the market’s expectations and the higher the probability its share price will underperform.
In one of my finance courses years back, the lecturer told us that we should distinguish between a growth stock and a growth company.
Most times, growth companies are not growth stocks, because the hype of the growth has been factored into the share price.
Using a hypothetical example, we showed how a 21% downgrade in earnings can potentially cause a 62% plunge in stock price in a high PE stock, and how a 10% to 15% upgrade in earnings can lead to a 150% jump in share price for a low PE stock.
So what proof is there that this is actually happening in the market, that buying low PE stocks pays?
Well, I carried out a study of the stocks listed on Bursa Malaysia in the last 24 years.
I ranked all the stocks listed here based on their PEs every year, from stocks with the lowest PE to the highest. The ranking is done at the end of March so as to capture companies with financial year ending Dec 31.
I then clustered them into 10 groups with equal numbers of stocks. Decile 1 is made up of stocks with the lowest PEs. Decile 2 has stocks with the second-lowest PEs, and so on. Stocks with the highest PEs go into Decile 10. I then tracked the performance of these stocks a year later.
Let’s assume that I started with RM1mil in 1990 – RM100,000 to be allocated to each of the 10 baskets of stocks. After doing the ranking on March 30 that year, I used the first RM100,000 and split it equally into all the stocks in Decile 1. The next RM100,000 is allocated equally to stocks in Decile 2 and so on.
At the end of March in 1991, I liquidate all the stocks bought a year ago. Money obtained from the Decile 1 stocks – calculated based on the share price on March 31, 1991 plus the dividends received in that past year – was redeployed into the Decile 1 stocks in the second year. Money from Decile 2 in the first year would be rolled over to the Decile 2 stocks the following year. Similarly for Decile 3 till Decile 10. I keep doing this for the next 23 years.
The accompanying chart shows the performance of the 10 baskets of stocks with the return rolled over for 24 years.
The RM100,000 put into the lowest PE stocks every year would have grown to RM4.3mil. That’s a compounded return of 17% a year. Guess what the bonus is? Low PE stocks on average also have higher dividend yields.
The second basket of stocks, those with the second-lowest PEs, returned 15.7% a year. Not too bad. It grew the original RM100,000 to RM3.3mil. (Please note that all the calculations exclude transaction costs, and yes, a small difference in growth rate translates into a big difference if compounded over the long term.)
How would someone who consistently goes for the high PE, glamour stocks have done? Well, they managed to grow their original RM100,000 to just RM128,600 for a compounded annual return of a mere 1%. That doesn’t even beat inflation and when transaction costs are factored in, he/she would have lost money.
In comparison, buying and holding the FTSE Bursa KLCI from March 1990 until March this year would have yielded you a capital appreciation of about 4.9% a year. Add in dividends of say 3.5% a year, and your RM100,000 invested in the Malaysian stock index would have grown to about RM2mil over that time, with dividends reinvested in the market.
In other words, buying a basket of low PE stocks would allow you to vastly outperform the KLCI.
But note: Some stocks trade at low PEs for a reason. They could be value traps, in that their stock prices would go lower as the company’s operations continue to deteriorate.
Many of the S-chips, or China stocks listed in Singapore, were trading at very low PEs. And as some of you may know, many of them have bombed. Those still listed are trading at very low PEs because the market doesn’t quite trust the numbers due to the poor corporate governance issues of their peers.
Meanwhile, some stocks trade at PE of 100 times or 200 times because they are transitioning from a loss-making patch to profitability.
So when we look at PEs, it is also important to look at the quality of earnings, and the sustainability of the earnings. But all things being equal, holding a basket low PE stocks beats holding a basket of high PE stocks.
In the next article, we will look at another valuation metric used by the market to value stocks – price-to-book value – and we will see how it performs vis-a-vis the low PE strategy.
The author is a partner in Aggregate Asset Management, manager of a no-management fee Asia value fund.
Source : The Star Online
