In buying low PE stocks, beware of value trap

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#1
A very useful and informative article from Teh Hooi Ling. Big Grin Value Traps are the most insidious obstable to successful value investing.

The Straits Times
www.straitstimes.com
Published on Dec 23, 2012
moneywise
In buying low PE stocks, beware of value trap

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

By Teh Hooi Ling

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 March30 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.

hooiling@sph.com.sg

The writer is editor of Executive Money, a weekly section in The Business Times. Her column is also available on BTInvest (www.btinvest.com.sg), a free personal finance and investment site of The Business Times covering five main categories: personal finance, wealth, markets, insurance and property.
My Value Investing Blog: http://sgmusicwhiz.blogspot.com/
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#2
Very interesting strategy. What happens if you do not liquidate the first decile stocks for the next 22 years and what would be the return?
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#3
Also, with the use of every simple metric or strategy, it's useful until it becomes widely used. One good example is Kenneth Fisher's P/S ratio which he has more or less discarded due to its widespread use.

Vanguard did a study too on the usefulness of metrics vs. short-term returns (full paper here) and for those who want the simplified version, Drizzt's take on it here.

Main point- our markets may still be (or were, in the case of Teh Hooi Ling's data) at an early stage such that these worked but if it catches on (and you know how these things are once it's published in the newspapers) then expect its effectiveness to decrease alot. Especially for those with short-term horizons.

That's what I think.
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#4
Agree with kazukirai up to a point: the point being "effort" Smile

Relying on a single metric for investment decision is no different from get rich quick schemes. Simple singular metric works wonders whenever it is on hindside. It is a catch 22: if it doesn't work DURING THAT PERIOD it doesnt get investigated in the first place. This contributes to the REAL WORLD EXPERIENCE that singular metric investing hardly works.

Buffett has essentially taught us most of what needs to be learnt about stock investing, and it's public info. The problem is that it actually takes a lot of effort. He can make a 10 second decision because he had spent decades understanding companies. Fundy approach is most onerous vs a 10min TA that can essentially tell you where to buy or sell, but it is extremely effective over the long run.
Before you speak, listen. Before you write, think. Before you spend, earn. Before you invest, investigate. Before you criticize, wait. Before you pray, forgive. Before you quit, try. Before you retire, save. Before you die, give. –William A. Ward

Think Asset-Business-Structure (ABS)
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#5
Buffett has another advantage (which retail investors also have) which is that he doesn't have to answer to short-term investors which I believe many of the institutional investors face- imagine a brilliant fund manager who's year end bonus depends on his results for the year and horror of horrors, he's been underperforming the market for most of the year. Is this guy going to stick with relatively 'safe' strategies or go for broke? Imagine the mental pressure. As a fund manager or analyst, you can't tell your boss to go ahead and pay you your bonus but expect results to show up only 3-5 years later. And this was exactly what Buffett faced in the heady years of the tech boom.

So good thing for us all is that, we don't have to worry about the short-term.
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#6
A magic formula to select stocks? Reminds me of the book 'The Little Book That Still Beats the Market' by Joel Greenblatt. IIRC, uses P/B + Yield to screen, very much like what Ms Teh is doing with PE. Interesting read but never did get down to trying it out as too lazy... Tongue

[Image: 0470624159.jpg]

PS. Available in the library and very easy to read as it was written so that even kids can understand.
Luck & Fortune Favours those who are Prepared & Decisive when Opportunity Knocks
------------ 知己知彼 ,百战不殆 ;不知彼 ,不知己 ,每战必殆 ------------
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#7
(24-12-2012, 09:32 AM)KopiKat Wrote: A magic formula to select stocks? Reminds me of the 'The Little Book That Still Beats the Market' by Joel Greenblatt. IIRC, uses P/B + Yield to screen, very much like what Ms Teh is doing with PE. Interesting read but never did get down to trying it out as too lazy... Tongue

PS. Available in the library and very easy to read as it was written so that even kids can understand.

(23-12-2012, 10:16 PM)kazukirai Wrote: Main point- our markets may still be (or were, in the case of Teh Hooi Ling's data) at an early stage such that these worked but if it catches on (and you know how these things are once it's published in the newspapers) then expect its effectiveness to decrease alot. Especially for those with short-term horizons.

And he did mention why his magic formula can still beat the market 5 years after his first book on the little book that beats the amrket

"Unfortunately, those great long-term returns came with plenty of bumps, including some not so short periods of losses and underperformance. But once again, if the formula worked every day, every month and every year, everyone would follow it and it would be ruined. Fortunately, it's not so great, and as a result I strongly believe that long-term investors should continue to benefit from the magic formula for many years to come."

"That’s why we’re so lucky the magic formula isn’t that great. It doesn’t work all the time. In fact, it might not work for years. Most people just won’t wait that long.Their investment time horizon is too short. If a strategy works in the long run (meaning it sometimes takes three, four, or even five years to show its stuff), most people won’t stick with it. After a year or two of performing worse than the market averages (or earning lower returns than their friends), most people look for a new strategy— usually one that has done well over the past few years!" pg 74

Without the appropriate investment timeframe, temperament and emotion control, the magic formula will still be useless Smile

Ms Teh's backtest is done over 22 years
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#8
(24-12-2012, 09:32 AM)KopiKat Wrote: A magic formula to select stocks? Reminds me of the book 'The Little Book That Still Beats the Market' by Joel Greenblatt. IIRC, uses P/B + Yield to screen, very much like what Ms Teh is doing with PE. Interesting read but never did get down to trying it out as too lazy... Tongue

[Image: 0470624159.jpg]

PS. Available in the library and very easy to read as it was written so that even kids can understand.

i found this book on internet

http://www.preterhuman.net/texts/unsorte...Market.pdf
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#9
Lot of insightful views

Let me chip in my not-so-insightful view

I am taking stock picking as customer service. Basic rule applies for good customer service e.g. customer is always right Tongue, but each customer service is a unique experience and deserve a unique approach to provide good service. There is no one-rule-suit-all approach available for good customer service.

Back to stock picking, basic rule applies e.g. focus on value over price, never invest with eye closed etc. Each stock or at least each stock category requires different strategy to win. Similarly no one-rule-sure-win approach for stock picking...

paiseh... paiseh...Tongue
“夏则资皮,冬则资纱,旱则资船,水则资车” - 范蠡
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#10
Thanks for sharing the Little book. Wink

(24-12-2012, 09:42 AM)steven Wrote:
(24-12-2012, 09:32 AM)KopiKat Wrote: A magic formula to select stocks? Reminds me of the book 'The Little Book That Still Beats the Market' by Joel Greenblatt. IIRC, uses P/B + Yield to screen, very much like what Ms Teh is doing with PE. Interesting read but never did get down to trying it out as too lazy... Tongue

[Image: 0470624159.jpg]

PS. Available in the library and very easy to read as it was written so that even kids can understand.

i found this book on internet

http://www.preterhuman.net/texts/unsorte...Market.pdf
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