In Buying Low PE Stocks, Beware Of Value Trap

Foreword from ShareInvestor

This article “In Buying Low PE Stocks, Beware Of Value Trap” by Teh Hooi Ling was first published in The Straits Times on 23 Dec 2012 and is reproduced in this blog in its entirety.

While stocks with the lowest PEs generally offer the best returns, there are duds as well.

Last week, 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 earnings multiple.

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. As such, 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 worked 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 per cent downgrade in earnings can potentially cause a 62 per cent plunge in stock price in a high PE stock, and how a 5 per cent upgrade in earnings can lead to a 150 per cent 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 the Singapore Exchange in the last 22 years.

I ranked all the stocks listed here based on their PEs every year. The ranking is done at the end of March so as to capture companies with financial year ending Dec31.

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. The average return of the stocks in each group was taken.

Let’s assume that I start with $100,000 in 1990. After doing the ranking on March 30 that year, I put $10,000 equally in the stocks in Decile 1.

At the end of March in 1991, I liquidate these stocks and put my pot of money, including dividends received in that past year, into the basket of stocks with the lowest PE in that year. The next $10,000 is allocated to stocks in Decile 2 and so on. I keep doing that for the next 20 years.

The accompanying chart shows the performance of the 10 baskets of stocks with the return rolled over for 22 years.

The $10,000 put into the lowest PE stocks would have grown to $199,847. That’s a compounded annual return of 14.6 per cent 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 10.1 per cent a year. Not too bad. It grew the original $10,000 to $83,684. (Please note that all the calculations exclude transaction costs.)

How would someone who consistently goes for the high PE, glamour stocks have done? Well, they managed to grow their original $10,000 to just $16,766 for a compounded annual return of a mere 2.4 per cent a year. That doesn’t even quite beat inflation.

In comparison, buying and holding the Straits Times Index from March 1990 until March this year would have yielded you a capital appreciation of about 4 per cent a year. Add in dividends of say 3 per cent a year, and your $10,000 invested in the STI would have grown to $44,300 over that time, with the dividends reinvested in the market.

In other words, buying a basket of low PE stocks would allow you to vastly outperform the Straits Times Index.

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 falter.

Many of the S-chips, or China stocks listed in Singapore, were trading at very low PEs. And as we all 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. We will talk about how to ascertain the quality of earnings in a future article.

But all things being equal, holding a low PE stock beats holding a high PE stock.

Just to give you an idea of which stocks made it to the lowest PE stock list in 1990. They were Dairy Farm, QAF, SIA, Jardine Cycle and Carriage, Jardine Strategic, Hongkong Land, and Boustead.

Stocks which made it to the second-lowest PE group were Jardine Matheson, Mandarin Oriental, ICP, Chemical Industries, Sing Investments & Finance, UOB, The Hour Glass and Wing Tai Holdings.

In recent years, however, the low PE stocks are made up mostly of micro cap stocks, or as mentioned S-chips. So, investors have to be more discerning in making sure that the underlying business is sound before buying into these low PE stocks.

Next week, we will look at another valuation metric used by the market to value stocks and we will see how they perform vis-a-vis the low PE strategy.