Findings show that companies in which the market has high expectations, as measured by the above ratios, have consistently performed the worst. The reason is, that a market premium is paid for near term ‘visibility’ on earning prospects.
To evaluate the value of a company, forecasts must be made with extreme accuracy into the future. We have already discussed this earlier – this is very difficult to do. Investors and analysts also have confidence and optimism that earnings expectations will be met. Over-confidence about information and forecasts, a reliance on ‘experts’, and over-optimism leads to a deadly combination.
This is something that you can easily see for yourself. Identify the latest stock market darling and follow it until a negative earning surprise occurs. This same effect happens again and again…
Findings also show that companies in which the market has low expectations, as measured by the below ratios, have consistently perform the best. Low expectations is what this strategy is based on.
A study by David Dreman and Eric Lufkin, looked at the largest 1,500 publicly traded companies over 27 years. The below table shows the significant results obtain by using this strategy over the long term.
|$10,000 Initial Investment||Market Return||$289,000|
A low P/E ratio (Price relative to Earnings) is often thought of as a typical Contrarian strategy. This is a relatively straightforward strategy that saves an investor from over- managing a portfolio and helps reduce commission costs. This strategy doesn’t require a lot of work to be effective. Initially, you want to position yourself carefully and make fine tunings to the portfolio as needed.
Low P/E stocks also tend to have higher dividend returns which helps maintain the value of the stock through bear markets.
Also used are the Low P/CF (Price relative to Cash Flow), P/BV ( Price relative to Book Value), and P/D (Price relative to Dividend) ratios . Specifically P/BV is a tool that is heavily favoured by value guru Benjamin Graham.
Essentially this strategy buys solid companies that are currently out of favour as measured by their low price to earnings, price to cash flow and price to book value.
Most expensive (i.e. companies to avoid)
- High PE
- High P/CF
- High P/BV
- High P/D
Least Expensive (i.e. companies to investigate)
- Low PE
- Low P/CF
- Low P/BV
- Low P/D
Positive earning surprises have a positive benefit to low P/E stocks and generally a neutral influence on high P/E stocks.
Negative earning surprises have less effect on low P/E stocks than on high flying P/E stocks.
Expectations are very great for high P/E stocks: earnings disappointments are inevitable and it becomes only a matter of ‘when’. This can be seen easily in the latest technology boom in companies with outrageous valuations.
Expectations of low P/E stocks are already low; therefore, a negative surprise has little effect.