The Essential P/E. Keith Anderson
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HARRIMAN HOUSE LTD
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Petersfield
Hampshire
GU32 2EW
GREAT BRITAIN
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Website: www.harriman-house.com
First published in Great Britain in 2012
Copyright © Harriman House Ltd
The right of Keith Anderson to be identified as the author has been asserted in accordance with the Copyright, Designs and Patents Act 1988.
978-0-85719-244-8
British Library Cataloguing in Publication Data
A CIP catalogue record for this book can be obtained from the British Library.
All rights reserved; no part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise without the prior written permission of the Publisher. This book may not be lent, resold, hired out or otherwise disposed of by way of trade in any form of binding or cover other than that in which it is published without the prior written consent of the Publisher.
No responsibility for loss occasioned to any person or corporate body acting or refraining to act as a result of reading material in this book can be accepted by the Publisher, by the Author, or by the employer of the Author.
About the Author
After completing his BSc in Mathematical Statistics and Operational Research at Exeter, Keith Anderson worked for some years as a systems developer, most recently at Deutsche Bank in Frankfurt. He then did an MSc in Investment Analysis at Stirling, where he won the Morley Prize as the top academically in his year. For his PhD at the ICMA Centre, Reading University, Keith showed that different ways of calculating the Price–Earnings ratio could significantly improve investor returns.
He worked as a lecturer at Durham University Business School for two years before moving to York in 2008. Keith has written a number of books, papers and articles.
Foreword
Hardly any topic in finance has been explored as much as the relationship between value and price. One way is to examine the ratio of the share price of a company to its annual earnings per share, called the P/E ratio. Data from several markets indicate that stocks with low P/E ratios (so-called value firms) earn significantly higher returns than high P/E stocks (i.e., growth or glamour companies). This book joins the discussion about why this happens.
Many observers would agree that every so often investors go mad and that asset prices overshoot. Stock prices are regularly either too high or too low relative to what can be justified by business fundamentals (say, the company's earning power). The breakdown occurs both at the market level and at the level of individual securities. The experience of the last few years leaves no doubt that speculative bubbles in equity, debt, real estate, and other markets may cause immense harm to the world economy. Irrational exuberance has proven to be extremely disruptive. Nonetheless, routine everyday mis-pricing in the cross-section of securities also offers interesting profit opportunities for stock market investors.
In this volume, Dr. Keith Anderson presents an expert summary of past research on P/E ratios and investment strategy. He also contributes to the existing literature in behavioral asset pricing with an array of statistical analyses that employ U.K. data. What’s more, Anderson’s book has practical use. He explains how traders can execute a winning P/E strategy.
In my view, there is no reason to worry that the success of P/E investing will diminish over time. Still, traditional P/E ratios do have limits. Anderson makes clear how one can adjust P/E ratios and turn them into even more powerful predictors of future returns, while controlling for risk. I am certain that many readers will benefit from this insightful book. I admire what the author has accomplished.
Anderson’s empirical analysis and practical advice extend a line of scientific investigation stretching back 80 years. For decades, it was thought that movements in stock prices are random. Paradoxically, most researchers interpreted the unpredictability of returns as proof of the rationality of Wall Street. In an efficient market, prices must reflect all information quickly and accurately. If the hypothesis is true, only news that takes people by surprise ---and that is as likely to be positive as negative--- can have an impact on prices.
Even so, most amateur and professional investors continued to study financial reports and relied on trading rules in hopes of attaining superior portfolio performance. Security Analysis, the investors’ bible co-authored by Benjamin Graham and David Dodd in 1934, spelled out some of the specific methods that could be used, including P/E ratios. Security Analysis sold nearly a million copies. Later, in 1949, Graham also published The Intelligent Investor, a more concise book that is still in print today and that reviews basic investment principles in a form suitable for laymen. It was The Intelligent Investor that introduced the P/E ratio to the public at large.
For a long time, Graham and his followers were unable to convince the academic world to abandon its efficient markets dogma and rational worldview. [1] Since the late 1970s, however, new statistical studies, meticulously executed, have found that there are definite patterns in stock prices and that price and value may drift apart. So, the efforts of investors do not have to be futile, as predicted by the theory of efficient markets. For instance, there are trends in equity returns after earnings announcements. Surely, the most prominent behavioral anomaly relative to the classical theory of finance is the P/E effect discussed here.
The predictability in returns is connected to the remarkable volatility of market prices, itself linked to rapid surges and sudden stops in trading volume. Major fluctuations in stock prices usually go together with broadly anticipated changes in corporate earnings that may or may not be realized a few years later. Thus, P/Es are indicators of expected future earnings growth. Alas, too many people wrongly assume short-term events to be of great consequence for the long-term outlook of individual firms and the economy as a whole. (Hence, the earnings forecasts of financial analysts tend to be too extreme.) This extrapolative bias is perhaps the main cause of market overreaction. Regardless of their objective lack of information about what will happen tomorrow, traders have strong views just the same. In addition, investor sentiment and risk perception are closely tied to recent price movements. Thus, many traders fall into the trap of buying at market high-points (an observation that suggests overconfidence and recklessness) and selling at market low-points (an observation that suggests panic).
When do exaggerated price movements reach their inevitable turning points? We do not know. Precise, well-timed forecasts are simply unattainable. Indeed, the upward or downward price momentum that is typically associated with growth and value stocks may well continue for some time. However, we do know that, once false beliefs about earnings, risk or the attitudes of other traders take hold, it usually takes a great deal of opposing news, unfolding over many months (say, a brutal string of earnings surprises), to defeat crowd sentiment. Still, in the end, more often than not, prices do turn around, and diversified portfolios of low P/E stocks earn higher returns and expose investors to less risk than portfolios of high P/E stocks.
It is a great challenge to try to improve one’s investment performance, and it is especially stressful to go against majority opinion, to be a contrarian investor ---even if it pays to be contrary! This book offers essential scientific reassurance, as well as practical tools, to triumph over misconceptions and behavioral errors that distort stock market prices. I recommend it to readers with great enthusiasm.
Werner De Bondt
Professor and Director