Does value investing or cheap buying still work?

Before we dive into the numbers, it’s important to understand what the Price-to-Earnings (PE) ratio actually means. In simple terms, the PE ratio is a way to measure how much investors are willing to pay for a dollar of a company’s earnings. It’s calculated by dividing the current share price by the earnings per share (EPS). A lower PE ratio might indicate that a stock is undervalued, while a higher PE ratio could suggest it’s overvalued.

But why does this matter? Because the PE ratio gives us insight into what the market thinks about a company’s future prospects. If the PE is low, the market might be skeptical, but that skepticism can create opportunities for savvy investors who see the potential that others don’t.

A Look at Decades of Data

Over the decades, studies have consistently shown that stocks with low PE ratios tend to outperform those with higher PE ratios. The data doesn’t lie: from 1951 to 2023, a dollar invested in the lowest PE decile, rebalanced each year and weighted by market capitalization, would have grown to an impressive $31,764. That’s a compound annual growth rate (CAGR) of 15.3%. Meanwhile, an equal-weighted approach would have yielded an even more astonishing $149,690, with a CAGR of 17.7%.

Between 2009 and 2023, the long-standing trend of low PE ratio stocks outperforming high PE ratio stocks did not hold. During this period, stocks in the 8th lowest PE decile delivered the highest performance, achieving a compound annual growth rate (CAGR) of 14.5%. In fact, high PE ratio stocks tended to outperform their lower PE counterparts.

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The Anomaly of Recent Years

The Rise of Technology and High PE Stocks

The last 15 years have presented a curious challenge to the established wisdom of investing in low PE stocks. The rise of technology and growth companies has led to a dramatic shift in investor behavior. Companies like Amazon, Tesla, and Apple, with their sky-high PE ratios, have delivered incredible returns, capturing the imagination of investors around the globe.

But what does this mean for the low PE strategy? Have we entered a new era where high PE stocks are the new norm? The data suggests that while these companies have performed exceptionally well in recent years, this trend may not necessarily continue indefinitely. Markets are cyclical, and history has shown that what goes up often comes down, particularly when prices become disconnected from fundamentals.

The Impact of Market Sentiment

One of the key drivers behind the performance of high PE stocks in recent years has been market sentiment. Investors have been willing to pay a premium for growth, driven by the belief that these companies will continue to expand at a rapid pace. This sentiment has been fueled by low interest rates, a booming technology sector, and the proliferation of retail investors eager to get in on the action.

But sentiment is fickle. It can change on a dime, and when it does, the companies with the highest PE ratios are often the first to feel the pain. The key takeaway here is that while sentiment can drive short-term performance, it’s not a reliable indicator of long-term value. This is why sticking to a strategy that focuses on low PE stocks, even when it’s out of favor, can be a wise move.

What Makes the Last 15 Years Different?

So, what exactly has made the last 15 years an anomaly? Several factors have come into play:

1. Technological Innovation: The explosion of new technologies has created opportunities for companies to grow rapidly, leading to higher valuations.

2. Monetary Policy: Central banks around the world have kept interest rates low, making it easier for companies to borrow money and invest in growth, which has driven up stock prices.

3. Market Participation: The rise of retail investors, fueled by platforms like Robinhood, has increased market volatility and driven up the prices of popular stocks, often without regard to fundamentals.

These factors have created a perfect storm for high PE stocks, but as with any storm, it’s important to remember that it will eventually pass. When it does, the tried-and-true strategy of investing in low PE stocks is likely to come back into favor.