Almost 40 years on – does low P/E ratio investing still work?

posted on October 31st, 2014 by Peter

alpha & beta

Way back in 1977, US academic Sanjoy Basu published a groundbreaking research paper in The Journal of Finance, examining the performance of stocks in relation to their P/E ratios. In a slap in the face for Efficient Market Hypothesis proponents, his study found a significant negative relationship between P/E ratios and subsequent returns.

Basu’s study focused on the period 1957 – 1971, dividing stocks into equally weighted, annually re-balanced portfolios based on their P/E ratio quintiles. Over his sample period, the ‘value’ quintile (the 20% of stocks with the lowest P/E ratios) generated average annual returns of 16.3% per annum, compared with the ‘glamour’ quintile, that generated average annual returns of only 9.34% pa. This evidence of a ‘value premium’ of almost 7% per annum, was one of the first robustly researched examples, published in a leading, peer reviewed academic journal, of what has subsequently become known as the ‘value effect’.

But surely, in a modern world with an abundance of computing power, ubiquity of financial information and a competitive marketplace of fund managers and individual investors, such excess returns would by now have been competed away? It seems not.

A recent Australian paper by Basu (no relation) and O’Shea suggest that the predictive power of P/E ratios has most definitely not been diminished by the passage of time. They examined the Australian and New Zealand markets from 1995 to 2009, once again dividing stocks into quintiles based on their trailing P/E ratios. Far from the ‘value effect’ having been reduced by improved access to both financial data and analytical capacity, they found that:

..the return difference between the Low and High quintile portfolios is higher than that found in the major empirical studies to date.

It seems that Australian market (sic) has shown a stronger P/E effect in the short run than other international markets.

In summary:

The absolute returns of low P/E stocks are significantly higher than high P/E stocks as well as the overall market. Even after controlling for volatility, the low P/E stocks have higher Sharpe ratios than high P/E stocks.

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It would seem that despite almost 40 years of well documented research, as well as huge advances in information technology, the value effect is very much still alive and well in the Australian market!

References:

Basu, S. (1977). Investment Performance of Common Stocks in Relation to their Price-Earnings Ratios: A Test of the Efficient Market Hypothesis. Journal of Finance, 32(3), 663-682

Basu, A. K. & O’Shea, L. (2014) The Predictive Ability of P/E Ratio: Evidence from Australia and New Zealand.



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