For about seven decades, academic studies have shown that unpopular stocks — those whose price is low relative to the company's earnings — outperform stocks with higher price-to-earnings ratios.
I was curious about what would happen if one were to take low P-E investing to an extreme. So, beginning in 1999, I have tracked the one-year performance of the 10 stocks that begin the year with the lowest P-E ratios.
These P-E outliers have performed very well. Here is the record, which should not be confused with that of any actual investment portfolio that I manage.
The compound annual return on the outlier stocks for the years 1999 through 2010 was 16 per cent, compared with 1.5 per cent for the Standard and Poor's 500 stock index. In those 12 years, these out-of-favour stocks have outperformed the S and P nine times. The exceptions were 2006, 2007 and 2008.
These performance figures are hypothetical, in the sense that no fund actually carries out this trading strategy. The figures include dividends but disregard taxes, commissions and other trading costs. Bear in mind that the sample size is small, and that past performance doesn't guarantee future results.
Best performer
In 2010, the low P-E outliers notched a 25 per cent return, compared with a 15 per cent return for the S and P 500. The best performer was BreitBurn Energy Partners LP, up 104 per cent. The worst was Mirant Corp — which now, after a merger, is known as GenOn Energy Inc. — down 33 per cent. Eight of the 10 stocks rose.
The rationale behind low P-E investing is that stocks advance by exceeding investors' prevailing expectations. Low expectations are easier to exceed. Thus, paradoxically, unglamorous stocks with well-known problems often outperform glamorous issues that are popular with investors.
Requirements
Buying extremely out-of-favour stocks comes with a large dose of risk. The low P-E outliers declined 61 per cent in 2008, when the bottom fell out of the market and the economy. The S and P 500 was down 37 per cent that year, even taking dividends into account.
The out-of-favour stocks roared back in 2009, notching a 97 per cent return, against 26 per cent for the index. To be included in the study, a stock had to have a market value exceeding $500 million (Dh1.8 billion), and debt less than stockholders' equity. Those two requirements may mitigate the risk to some degree.
The outliers were identified as each year began, except for 2008 and 2009, when they were identified on January 29 and February 27, respectively. In every case, performance was measured for the calendar year. Most of the stocks emerging from this screen are out of favour for some obvious reason, and are high risk. Also, the screen frequently produces a cluster of stocks in a single industry, defying the tenet of diversification.
