The P/E (price/earnings) ratio is a measure of value that measures a company’s share price compared to its per-share earnings, sometimes also referred to as the ‘price multiple’ or‘earnings multiple’. Broadly speaking, stocks or stock markets with high P/Es suggest that investors expect higher earnings growth than those with low P/Es. But a high P/E can also be a warning for value investors that a stock or stock market is becoming too speculative.
Most investors don’t grasp that low P/E stocks return the most over time, not high P/E stocks. This is really no different to being a contrarian investor and buying stocks that are out of favor over stocks that are considered ‘hot’ by the masses. Stock market profits are made “in the buying.” Meaning that the price you pay for growth is as important…if not more important…than the price you sell for.
This is backed up by research and multiple studies have shown that investors using a low P/E strategy have outperformed investors using a high P/E strategy. One big study of thousands of stocks on the NYSE and Amex exchanges in the U.S. from 1968 to 1990 showed that stocks with low P/E’s had total 1-year returns of17.9% vs. total returns of 12.4% for stocks with high P/E’s.
According to contrarian investor, David Dremen, over almost every period measured, the stocks considered to have the best prospects (those with high P/E’s) performed significantly worse that the ‘contrarian’ stocks (those with low P/E’s).
There are exceptions because sometime stocks or stock markets are on a low P/E for good reason. Maybe future earnings outlooks really low. Or maybe there’s another internal problem dragging the company/country down.
But, generally, a low P/E strategy works.