Fundamental AnalysisSwing & Position Trading

Price / Earnings Hybrid Strategy

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.

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)
Power 6.94 18.40
Steel 7.98 8.80
Homebuilding 9.64 40.40
Electric Utility 10.18 20.70
Auto-parts 10.75 33.00
Tobacco 10.82 15.40
Insurance 10.90 8.10
Apparel 11.18 19.70
Home Appliance 11.70 18.90
Thrift 11.97 20.80
     
Average 10.20 20.40
Average change   100%

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)
Newspaper 41.14 21.70
Entertainment 41.43 24.60
Telecomm 43.14 16.50
Precision Instruments 44.17 17.20
Semiconductor 47.10 43.50
Publishing 49.06 16.80
E-Commerce 50.32 ?
Cable TV 53.49 0.00
Wireless Networking 60.49 182.00
Chemical 60.76 17.70

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.

Grant Macdonald has been involved in the stock market for a number of years. Although  he has traded using purely technical criteria in the past, his personal doubts about the theoretical basis and intrinsic flaws of technical analysis have led him away from the technical arena, with the result that he now concentrates his efforts on analysing companies on a fundamental level, seeking long term value in stocks that are currently out of favour with the market while ensuring that he diversifies into a number of them in order to minimise portfolio risk.

Grant Macdonald has been involved in the stock market for a number of years. Although  he has traded using purely technical criteria in the past, his...

Simon Gordon

Active member
126 1
Interesting article and thank you.

I think this type of strategy should be deployed for wealthy private investors who are not keen on individual stocks and don't want to buy mutual funds because of the high charges that eat capital in a low return environment.

Many UK investors buy into mutual funds that charge a 5% entrance and 1% to 2% in annual fees.

ETF's are the perfect place for these investors.

Perfect for your auntie!
 

SOCRATES

Veteren member
4,966 134
Yes, perfect for your Auntie, not my Auntie. Very Good Advice. Very Wise. Good Luck.
 
Last edited:

ducati998

Experienced member
1,193 68
FC

You like the hat.
As regards long term, short term, some will work out quite quickly ( months ) some will take longer ( years )

However, the maximum seems to be about 2 yrs.
If you were just moderate in your expectation, and took a 50% return, thats still 25% / annum, which is ( 24% ) what the research found.

It is aimed at people who have tried the daytrading, tried the futures, etc, have not had the results that they expected or wanted, but still feel that they want to use the market to generate wealth.

Thus as a minimum risk, minimum level of knowledge required, minimum effort ( time ) this provides returns that will probably exceed the majority anyway.

cheers d998
 

ducati998

Experienced member
1,193 68
Simon G & the blades

Thanks chaps.
At least those who actually trade have found it interesting if nothing else.

cheers d998
 

LION63

Established member
746 33
Ducati,

You would have been better off telling us how to pick the next Google, that is what the people here want to know and hear about. What is the next sector that will provide 10 baggers to all and sundry regardless of how good they are at trading. Talk about fireworks and then you will have everyone's attention and praise and be considered an unadulterated genius. Instead of that, you have chosen to share a recipe for steady, consistent and virtually risk free profits. Shame on you.

That is a very good article and goes to show that there is money to be made in all types of markets (bull or bear) provided one is prepared to do some homework and be patient. What I find interesting is that a lot of people mock returns of 24% per annum on average, yet they confess to losing money. Unless I am missing something, the markets must be made up of a lot of dumb participants (I am not interested in doing a handful of trades a year and making 24% risk free as I can do 25 trades a week, sit in front of my computer all day long and lose a large percentage of my capital in the process).

The sad thing is that the message will be lost on most readers because it is too simple, many believe that the more complex a strategy/method the more money they make. Simple charts or analysis are not sufficient or engaging enough. The hare and the tortoise theory do not sit well in financial markets.

Keep up the good work.
 

barjon

Legendary member
10,311 1,566
Please excuse my fat moderating finger, but this thread is dedicated to discussing a Knowledge Lab article and will itself form part of that permanent archive. It is, therefore, more important than usual that it stays on topic and does not become yet another vehicle for jolly - and not so jolly - jousting. So I'm editing/deleting off-topic content and hope that you will respect the thread. Thanks.

jon
 

roguetrader

Senior member
2,062 49
Interesting and simple approach, nice to see the highlight of ETF's, they can be a great way to achieve diversification within a sector.
 

SOCRATES

Veteren member
4,966 134
I am very sorry Joules, I disagree with you completely, because what you are explaining is back to front.

Now, the first thing to do is to establish whether it is a bear market or a bull market, by examining the condition of the market from a technical viewpoint, with particular reference to what is in the background and the reasons why.

Having established this, now the direction is ascertained for the long pull, then stock selection is the next step.

The P/E ratios as printed in the newspapers are not reliable.

The P/E ratios have to be calculated by mining into the accounts and transposing this against the current market price of the stock. In this way a truly accurate figure can be achieved.

Only then can a proper assesment be made, but only if a proper chart is available, showing open, close, high, low and volume, on a daily basis and an hourly basis that captures the period of the range.

And then, finally, this scenario has to be carefully inspected to ascertain whether the given stock is in sync.
This means whether it is harmonius to the market as a whole or whether it is not, whether it is being accumulated or distributed, or just capped or supported.

So you see there is a lot of work to be done which is not mentioned, and in real practical terms not so simple.
 

Tuffty

Well-known member
442 8
There is no link of market P/Es to subsequent returns, no matter how you measure the ratio and no matter over how long (up to five years) you measure returns.

Not my words but from an article written by Ken Fisher, see link below.

For every view point there is an alternative.

www.forbes.com/global/2002/1111/074asia.html
 

SOCRATES

Veteren member
4,966 134
Tuffty said:
There is no link of market P/Es to subsequent returns, no matter how you measure the ratio and no matter over how long (up to five years) you measure returns.

Not my words but from an article written by Ken Fisher, see link below.

For every view point there is an alternative.

www.forbes.com/global/2002/1111/074asia.html
I have read it, and I concur with his viewpoint.

Prices are not driven by Fundamental forces, they are driven by Supply / Demand imbalances.

Now, the assesment of the extent and cause of these imbalances is what serves to baffle nearly everybody.

You put your finger on the button by saying that for every viewpoint there is an alternative.

This is why this topic attracts so much argument.

I look upon all this in quiet contemplation and with wry amusement because all of it is obvious, yet the majority overlook the significance of the patently transparent.
 

bracke

Experienced member
1,286 12
ducati998

Thank you for an interesting article.

Do you calculate the p/e ratio from company accounts, if not from where do you obtain it?

Trust this meets with approval from the fat moderator.

Regards

bracke
 

SOCRATES

Veteren member
4,966 134
bracke said:
ducati998

Thank you for an interesting article.

Do you calculate the p/e ratio from company accounts, if not from where do you obtain it?

Trust this meets with approval from the fat moderator.

Regards

bracke
Oh ! Hello Bracke ! There you are. Nice to see you posting again.

May I tactfully suggest you say fat finger instead of suggesting corpulence as this may unjustifiably offend.

Now carry on, we are interested to see what response your question will elicit.

Mind you, if you look at my post above, you will see how I have explained it.

Clear as mud it is, but I am certain you are able to clock it.

Kind Regards As Usual.
 

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