Price / Earnings Hybrid Strategy

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Grant Macdonald

28 Jun, 2005

in Fundamental Analysis and 1 more

It is appreciated that Trade2Win is first and foremost a "technical analysis" site. Those that know of me from T2W may be aware that my methodology is one of  "fundamental analysis". From this rather black and white perspective, what do I have to offer the committed technical analyst? I offer you the price/earnings ratio.

The P/E ratio, as it is more commonly referred to, lends itself well to the non-financial analyst for a number of reasons. I shall suggest a methodology that is hybrid in nature, combining the P/E ratio (exclusive of any knowledge, or reference to, the financial statements) with a technical chart that acts as a filter for the P/E ratio, imbuing the P/E’s calculation with a factor of safety. We shall end up with a methodology that has been statistically tested through 60 years of varied market conditions, returning on aggregate 24% actualised returns. Still interested?

The P/E ratio is derived from the current market price for the common stock, divided by the earnings. The "earnings" can take one of three types (expressed as "per share" ) :

  1. "TTM", or trailing twelve months, i.e. the last four quarters’ earnings.
  2. "Current", from the last "year’s" earnings as per the "Annual Report".
  3. "Forward", on projected earnings for the next financial year.

Which format to use? Traditionally, analysts would use "current" earnings. This is probably less true today, as the emphasis has shifted to "forward" and "TTM". I recommend, of course, referring to "current" earnings. The reasons are quite technical, and it is beyond the scope of this article to explore them in detail. It is however relevant to provide an explanation, as we are putting into operation a “contrarian” strategy, and therefore wish to avoid the crowd.

Embedded within a low P/E ratio are some powerful psychological truisms that can benefit the conservative trader. The market has made, and is making, some very definite statements within a low P/E ratio. Let us examine them in some detail. The market has passed judgment upon this common stock thus:

  • Poor growth prospects and poor earnings expected in the future
  • The industry has poor growth prospects and  poor earnings expected in the future
  • There is a decreasing trend of earnings; this company, and industry, may be finished.
  • This stock and industry are boring
  • No analysts follow this stock and it’s not worth paying attention to.
  • Neglect, generally, as a second tier stock. 

Low P/E stocks have some pitfalls and traps that you must be aware of. The dependability of the earnings cannot be relied upon. Accounting tricks and artifices can seriously distort earnings, upwards, or downwards. Without a thorough and penetrating analysis, aberrations will slip through undetected and even with said analysis, mistakes can still be made by the analyst. Again, due to the limited space available in the article, a detailed explanation of the methods used to detect these distortions is inappropriate.

However, all is not lost. An effective filter exists: the price chart. The specific pattern that will be employed will in most, if not all, cases eliminate the need ever to look at a financial report; this combined with adequate diversification provides excellent risk management. By taking this approach (chart analysis combined with adequate diversification), we can therefore dispense with the requirement of reading the annual report, or performing ratio and commonality analysis. The effect is to avoid jumping onto the issue on the basis of good news, and eliminating the risk of too much money in one stock.

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blipper

No I haven't had any luck via the internet either. Yes it was the Journal of Finance.

I sourced my reference from originals, which was "Eugene Fama & Kenneth French" " The Cross-section of Expected Stock Returns" Journal of Finance 47 (June 1992) pp 427-465

There are many studies done in this field, I have work in which the results go back to the 1900's.

The idea of diversification was not specifically referred to, or actively practiced by Fama & French, they simply took all the low PE stocks and aggregated the results, which is diversification in net result. Therefore, to reproduce the findings diversification must be a component.

If you pick and choose your low PE selections, that is add the component of "selectivity " to the portfolio, then you will expose yourself to the " risk of unreliable earnings ", unless you are experienced and knowledgable enough to pick up the anomalies via the 10-K.

The technical filter is added for chart based traders to identify a true high probability set-up, with a fundamental filter used as an indicator and remove the need assuming diversification is employed, any further involvement with either chart reading, or analysis of the 10-K

What is interesting is that a lot of the most successful strategies have both a high upside beta but also a high downside beta


This has been the subject of much debate and controversy, and Fama certainly had much to say regarding beta. I'll have a read through, and present some of the pertinent arguments.

And I would be particularly interested to see the returns for each of the years you have been implementing your hybrid strategy in order to judge the market risk, if you would be good enough to supply them?


I do not use charts at all.
I most certainly do buy low PE stocks. But I filter them via the 10-K reports. I will buy individual companies, diversified via selectivity, not via a general buy.

OS found that value strategies were invariably greatly improved by adding a momentum stategy to them--eg for low PEs he found using only those with the greatest yearly momentum produced a compound annual return of 18%. Have you ever used such a type of filter - eg to wait to go long until the low PEs break out of the consolidation pattern you describe?


No. That way leads you back to the charts. Charts do not interest me at all. But if the results are improved, and you feel that is valid, then thats your choice.

Lastly, do you know of any accesasible source for the F&F article- if not, any chance of uploading it or the relevant bits ?


I'll see what I can do.
cheers d998

Jul 09, 2005

Member (1196 posts)

Ducati

Thanks for publishing your strategy which I find very interesting.

Ive been looking for the article by F&F on the internet but no luck so far. Is it ' The Equity Premium' in which case I think it may only be available in the Journal of Finance of which Im not a member.?

Im interested in their results as the main work on PEs Im familiar with is O'shaughnessey's 'What Works On Wall Street ' in which he looked at numerous strategies for the period 1951 to 1996. He took common stocks with low current PEs and found them to have a compound annual return of around 12% together with a rather high standard deviation.
Could you say specifically how F&F's methodology differs from OS, as I take it from your article that it involved some form of diversification, but not I take it the technical filter you use?

I am particularly interested in how different strategies cope with market risk. In WWOWS OS provided the figures for each year for each strategy between 1951 and 1996; this enables one to assess how the strategy performs relative to the market in any particular year. What is interesting is that a lot of the most successful strategies have both a high upside beta but also a high downside beta
Id like to know if F&F supply these annual figures so that one could make the same assessment?
And I would be particularly interested to see the returns for each of the years you have been implementing your hybrid strategy in order to judge the market risk, if you would be good enough to supply them?

OS found that value strategies were invariably greatly improved by adding a momentum stategy to them--eg for low PEs he found using only those with the greatest yearly momentum produced a compound annual return of 18%. Have you ever used such a type of filter - eg to wait to go long until the low PEs break out of the consolidation pattern you describe?

Lastly, do you know of any accesasible source for the F&F article- if not, any chance of uploading it or the relevant bits ?


Thanks again

Blipper

Jul 08, 2005

Member (8 posts)

LION

No, I realised you were referring to ttm earnings, I prefer Current earnings, or in your example the last full years earnings.

So Dec 31 2004 Annual report, if looking at a company for analysis today.

The reason that I am not terribly interested in Quarterly results are for the distortions that are manifest within the Income Tax, Working Capital, Surplus, Interest, Subsidiaries, and potential Off Balance sheet entities and Writedowns. These will all be disclosed in much greater detail in the 10-K report.

The reason for the price chart as a filter is to avoid the need to look at or understand the implications involved.

This is because the "Price" in consolidation will represent the activities of value hounds as myself who will break each company down, therefore the price chart represents the class of investor that is looking at SAFETY first, and returns as a SECONDARY.

cheers d998

Jun 29, 2005

Member (1196 posts)

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