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
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" ) :
- "TTM", or trailing twelve months, i.e. the last four quarters? earnings.
- "Current", from the last "year?s" earnings as per the "Annual Report".
- "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.
The historical statistical research was completed by FAMA & FRENCH and the current research to the present by myself. From an equally weighted portfolio of common stocks, returns are as follows:
|1952 ? 2001||24.11%|
|1952 ? 1971||23%|
|1972 ? 1990||19%|
|1991 ? 2001||27%|
From an industry perspective (2001 ? 2005):
|Industry||P/E (’01)||P/E (’05)|
What we see is the law of large numbers. The returns from the industry far outstrip the aggregate return on individual stocks. For the P/E to double, the price must double, with earnings remaining static. Therefore we have an increased return, with increased safety due to the principle of diversification.
|Industry||P/E (’01)||P/E (’05)|
Now, we can see from the above results that in 4 years the leaders fell, and the laggards improved. This has been a consistent finding, statistically demonstrated by FAMA & FRENCH in their results that almost cover a 60 year period.
Diversification, as a way of reducing risk, was adopted from the insurance industry. Actuarial tables were compiled on mortality rates, incidence of fires per 100 households and weightings for ?moral hazard? calculated. The resulting calculation provided the premium that would need to be charged, to ensure an ?aggregate? profit for the insurance company. This methodology was successful, and has stood the test of time within the insurance industry. This principle has been almost universally accepted within the investment community for the management of risk. Today it is possible to buy ?ETFs?, or Exchange Traded Funds, for diverse industries. This is a cheap and very effective way of practicing diversification with absolutely no effort.
In summation: We buy an ETF for an entire industry. We buy a low P/E ratio industry ETF only. We can buy multiple low P/E ETFs, where "low" means a P/E of <10. We time said purchase using qualitative judgement of the chart pattern. No stop loss is required as we eliminate attrition of our capital immediately. We reduce trading costs substantially. No specialized trading platform is required.
When do I buy? Assuming the relevant P/E ratio is favourable, observe a weekly or monthly chart. If the chart shows consolidation, is in a trading range, is boring and doing nothing much then the crowd is absent and it is safe to enter because you have beaten the crowd to the entry. Now you just wait. No need for a stop loss (provided that you are diversified). No manic entries or exits, just sit there until up it goes, and you sell out to the arriving crowd.
When do I sell? If the research is correct, and at this point there is no evidence to contradict the findings, very aggressive traders will sell when they have a 100% improvement in the P/E on purchase price. Conservative traders or investors may settle for a 50% improvement in the P/E ratio. A third selling point would be a historically high P/E. If we bought at a P/E of 8, and historically the industry never went above a P/E of 15, we would not hang on waiting for a P/E of 16. We would sell at 14. Either way, the returns are satisfactory. Or, from a technical perspective, when you encounter a significant point of resistance, on a weekly or monthly chart.
What else is required? Patience!
Let?s take a chart example.
caption: XLF exchange traded fund
Here we have a monthly chart of a US banks ETF, and in late 2002 / early 2003, when banks were in the grip of the bear, the P/E (though not marked on the chart, unfortunately) was considerably <10, signalling a screaming buy. Does the chart agree? I would say that it does, as by early 2003 there is an obvious, albeit wide, trading range in play and there was plenty of time to buy in this range before the subsequent uptrend. Remember that with no stop loss in place, the gyrations within the range would not have shaken us out of position.
At the time of writing, the P/E ratio is >11 and thus no longer fulfils our buying criteria. However, around $28, the P/E just qualifies and this coincides well with the approximate bottom of the chart consolidation pattern between $27 and $30, thus presenting another buying opportunity.
Unfortunately this example does not appear in the industry sectors that were compared and contrasted previously. However, as this is a current example as of June 7 2005, it will be very easy to track and monitor the results going into the future.
Real time examples are much more interesting than historical and hindsight examples, although from a research perspective they are vital as a starting point. This strategy is suitable for the risk averse trader or investor who requires higher than average returns, but with minimal risk and effort. It provides enough intellectual stimulation to keep you engaged with the market, yet avoids the often stomach churning adrenaline of the short term trader. All that remains is for the individual to test it in real time for themselves.