Research Review: PE Ratios Basu 1977
posted on September 15th, 2015 by Bellmont Research Team
Stockmarket research is everywhere. Investment banks and stockbroking firms spew out voluminous quantities of analysis, overwhelming investors with complexity that many falsely correlate with precision. Unfortunately much of the research is driven by the incentives of their paymasters – either the encouragement of turnover, or jockeying for corporate deals. And almost all of it is sufficiently opaque to ensure that it is difficult, if not impossible to question their results.
The last four decades however has also seen a growing body of academic finance research, driven not by the profit motive, but by intellectual curiosity. This research, with methods and results laid bare in peer-reviewed academic journals, and many having truly stood the test of time, can justly claim a far higher level of independence and robustness than that of their industry counterparts. And the results have direct implications for the management of share portfolios, that can be used by both individuals and professionals alike to improve long term returns.
In this series of papers, we review some of the most influential papers in academic finance, translating them into every day language, and highlighting the key takeaways that will assist you to become a better investor.
This paper by Sanjoy Basu, published in the Journal of Finance in June 1977, was one of the first wldely cited works that questioned the dominant financial theory of the time – the Efficient Market Hypothesis (EMH).
Under the EMH, stock prices were assumed to be a perfect reflection of all known information about a company. That is, while some stocks would inevitably be cheaper or more expensive than others, this simply reflected the different outlook for the future profits of each company. A company with bright prospects should justifiably trade at a higher multiple of its earnings (or book value etc) than one with a less positive outlook, as it is expected that its future earnings will grow at a faster rate. But assuming the two are equally risky (volatile), the total return from investing in each company should be equal – with the faster growth in profits offset by the higher price paid, and vice-versa. The only way for an investor to generate higher returns is to take on more risk – either through investing in riskier (more volatile) companies, or by taking on leverage.
This paper sought to challenge that assertion, by examining the performance of stocks in relation to their Price to Earnings (P/E) ratio – a commonly used yardstick for security valuation. It looked at the period from 1957 to 1971, and ranked every company by its trailing P/E ratio, then divided the universe into 5 portfolios based on their calculated ranking – from the lowest P/E quintile (value stocks) to the highest P/E quintile (growth stocks), with the portfolios rebalanced on an annual basis. If the market was efficient in respect of earnings multiples, then there should be no discernible difference in performance between these 5 portfolios.
Basu’s results however told a very different story. Over the 14 year study period, the two highest P/E ratio portfolios earned average annual returns of 9.3% and 9.5%, while the two lowest P/E ratio portfolios earned returns of 13.5% and 16.3%. In fact, the results show that the average annualised returns decrease fairly consistently as you move from the low P/E (value) portfolio to the high P/E (growth) portfolio. An annualised differential of 7.1% pa between the value portfolio and the growth portfolio was extremely significant, while the value portfolio also outperformed the market over that period by an impressive 4.2% per annum.
The traditional rebuttal from EMH enthusiasts is that the lower PE portfolios must inherently be riskier – and these stronger returns are just compensation for the additional risk borne by investors in the value portfolio. However the exact opposite was found to be the case in this study, with systematic risk of the low P/E portfolios actually lower than the high P/E portfolios, leading to risk adjusted returns (Sharpe ratio) for the value portfolio of almost three times that of the growth portfolio.
The conclusion of the authors was that “..the low P/E portfolios seem to have, on average, earned higher absolute and risk-adjusted rates of return than the high PE securities.” Even after taking into account tax and transaction costs, “..opportunities for earning ‘abnormal’ returns were afforded to investors.”
Especially at the time, this was a groundbreaking conclusion to have reached. Whilst EMH proponents would encourage investors to use index tracking investments in the belief that it’s impossible to outperform the market over time, this study instead suggested that a very simple approach of buying a diversified portfolio of low P/E firms outperformed the market by a substantial 4.2% per annum. Over the 14 year period of this study, the cumulative impact of this simple change is a 67% improvement in the final value of a investment portfolio compared with the performance of an index tracking alternative.
This paper set the foundation for numerous additional studies, the culmination of which would become known as the ‘Value Effect’ – one of the most extensively researched, robust and widely acknowledged anomalies in financial markets.
A full copy of the research paper can be read here.