Low P/E Stocks Great Performers
Think you are a rational investor, carefully weighing the upside and downside before investing? Quit kidding yourself. Investors as a whole are an irrational lot. They are far more sensitive about big earnings increases or drops or other surprises in the highest and lowest priced stocks but hardly react at all to surprises about so-so stocks.
According to prevailing market wisdom, all new information about companies is instantly absorbed by the market and fairly incorporated into their stock prices. But new information is not absorbed equally.
Researchers David Dreman and Michael Berry divided a large basket of stocks into five subcategories based on their price-to-earnings ratio. The P/E is a classic way of measuring whether a given stock is cheap or expensive. Neurogen, a biotech company, for example, has an extremely high P/E of 1,068, meaning that its current stock price is 1,068 times its net earnings. PECO Energy, by contrast, only has a P/E of about 7.2, making it a cheaply priced stock.
The researchers found that surprising news (such as big gains or drops in earnings, acquisitions, etc...) has a powerful effect on the share prices of the highest and lowest P/E stocks but had relatively no impact on the 60 percent of stocks in the middle groups.
Dreman and Berry also found that positive news about low P/E stocks and negative news about high P/E stocks "result in a much larger impact on absolute prices than reinforcing events," meaning good news about high P/E stocks and bad news about low P/E stocks.
The most interesting and potentially profitable part of their research concerns low P/E stocks. Low P/E stocks almost always outperformed high P/E stocks between 1973 and 1993 whenever there was a surprise, regardless of whether it was positive or negative.
When there was a positive surprise in a given quarter during the 20-year period, low P/E stocks enjoyed an annualized return of 20.1 percent and high P/E stocks returned 6.6 percent. When there was a negative surprise, low P/E stocks fell by 4.2 percent while high P/E stocks fell by 18.5 percent.
Low P/E stocks significantly outperformed high P/E stocks for at least a year after the surprises, regardless of whether they were positive or negative. It takes about five years after the surprise for the low P/E and high P/E shares to start yielding the same returns (the low P/E shares begin to return less and the high return shares begin to return more).
The professors conclude that "investors are not always rational according to the classical economic definition." They argue that many investors don't invest rationally for many reasons, such as believing that high P/E stocks will continue to make huge amounts of money or that low P/E stocks will always be dogs. The professors also blame overconfident stock analysts in whom many investors misplace their faith.
Bottom line: don't overpay. Low P/E shares are great performers.
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