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The low P/E strategy is one of the most popular contrarian strategies available and it has come to light recently due to volatility in the market as investors believe investing in low PE strategy has margin of safety. In this article we will explain about the strategy, its’ advantage & disadvantages.
Let’s start by understanding the PE ratio, it is a standardized financial ratio that is calculated by dividing the market price of the company by its earnings per share (EPS), usually the trailing 12 months. The ratio is a measurement of what the market is willing to pay for the current level of operations and the growth that is expected of the company. For Example: If Company is trading at Rs.1000 per share & had a trailing twelve months or TTM earnings of 10, then the PE ratio would be 1000/10 = 100
The metric by itself is of not much use however if there is a comparable then it helps investors in determining the relative position of the company that is whether the stock of a company is overvalued or undervalued comparatively. For Ex: If “Company A” has a PE of 90, “Company B” has a PE of 80 and the industry has a PE ratio of 100. It implies Company A is undervalued compared to the industry however it is overvalued relative to Company B indicating Company B is more likely to have a higher upside potential and lower downside if the market corrects. The Low PE Strategy is to Buy stocks that have PE lower than the industry or its peers and wait till the market notices the error and reprices the stock. This simplicity in understanding and implementation is the reason for the popularity of the strategy however there are factors that the PE ratio fails to consider.
In the first example a PE ratio of 100 implies an investor would be paying Rs.100 for claiming just Rs.1 in earnings. While it may seem like a bad deal at first glance that may not be the case because if Company A has the potential to grow at significantly higher rates and it is highly likely to realize such rates compared to a company in the same industry with lower PE than it is worth buying company A even if it has a high PE ratio because investors will face less risk by investing in more-certain earnings instead of less-certain ones.
The average P/E ratios tends to differ by industry. Companies in extremely stable, established sectors with limited growth potential often have lower P/E ratios than companies in relatively young, rapidly rising industries with bright prospects. When a potential investor compares the P/E ratios of two firms, it’s vital to examine companies in the same industry and with similar features. Otherwise, if an investor just bought stocks with the lowest P/E ratios, one would end up with a concentrated portfolio skewed to a low growth sector that may be riskier compared to a portfolio diversified into other industries. An important factor the PE ratio doesn’t take into consideration is the risk, companies may have idiosyncratic risk that could have been avoided if looked at other metrics rather than just looking at PE ratio before investing.
The Fourth issue with PE ratio is some companies may have negative earnings in which case one cannot estimate the PE ratio. When considering Low P/E as an investment strategy, an investor should also be aware that the company may have a low PE simply because the growth rate is as per industry averages and future earnings may grow at a slower rate and if one is considering buying a company with high PE investors must look at how much of a premium one is paying for the company’s profits now, whether the growth is certain and if the expected growth deserves the premium.
While investing based on low PE ratio has its advantages it doesn’t show the complete picture to investors and one can overcome shortcomings by looking at other factors. We at Right Horizons over the years have addressed such shortcomings and have pioneered analysing & investing thereby enabling our PMS strategies to generate alphas over the benchmark.