Stocks with Low PE Multiples Outperform those with High Multiples. Investors are warned repeatedly about the dangers of very high-multiple stocks that are currently fashionable.

In 1934, Dodd and Graham argued that "value" wins over time for investors.  To find value, investors should look for stocks with low PE ratios and low prices relative to book value, P/BV.  Value is based on current realities rather than on projections of future growth.  This is consistent with the views that investors tend to be overconfident in their ability to project high earnings growth and thus overpay for "growth" stocks.

Stocks with Low PE Multiples Outperform those with High Multiples
One approach of stock selection is to look for companies with good growth prospects that have yet to be discovered by the stock market and thus are selling at relatively low earnings multiple.  This approach is often described as GARP, growth at a reasonable price.  

Earnings growth is so hard to forecast, it's far better to be in low-multiple stocks; if growth does materialize, both the earnings and the earnings multiple will likely increase, giving the investor a double benefit.  Buying a high-multiple stock whose earnings growth fails to materialize subjects investors to a double whammy.  Both the earnings and the multiple can fall.  Therefore investors are warned repeatedly about the dangers of very high-multiple stocks that are currently fashionable.

There is some evidence that a portfolio of stocks with relatively low earnings multiples (as well as low multiples of cash flow and of sales) produces above-average rates of return even after adjustment for risk.  This strategy was tested and had been confirmed by several researchers who showed that as the PE of a group of stocks increased, the return decreased.

This "PE effect," however, appears to vary over time - it is not dependable over every investment period.  And even if it does persist on average over a long period of time, one can never be sure whether the excess returns are due to increased risk or to market abnormalities.

And low PEs are often justified.  Companies on the verge of some financial disaster will frequently sell at very low multiples of reported earnings.  The low multiples might reflect not value but a profound concern about the viability of the companies.  

What should you do if you find that the price or P/E is significantly above or below the historically fair price or fair P/E mark?

"It is better to buy a wonderful company at fair price than a fair company at wonderful price."

In general, if you can buy a quality stock today for a historically fair price or fair P/E, you should probably do so, provided the reward and risk are attractive.

However, what should you do if you find that the price or P/E is significantly above or below the historically fair price or fair P/E mark?

A low price or low P/E is probably your biggest concern, because it suggests that people who are buying the stock today might know something negative about the company that you don't know.

Think about it.  Why would investors pay less for the stock than it has typically sold for?

• Is there something in the news that you haven't heard about?  
• Has an analyst - or have a number of analysts - announced a reduced expectation of future earnings based upon something they know that you don't know?  
• Have you missed something in your quality analysis - or (shame on you!) recklessly jumped over that barbed-wire fence, failing to evaluate quality deliberately enough before moving on to look at the value considerations? 

(E.g. Transmile, KNM).

If the price or P/E is too low - move on to another company and forget about looking at the risk and reward.  You may miss a few good stocks, but you won't have to lose any sleep worrying about being wrong.



If the price or P/E ratio is too high, this tells you two things.

1. The first is that other investors appear to agree with you about the quality issues, because they are paying a healthy price for the stock.  
2. The second is that it may be too healthy a price.  

• You may want to put off buying it until the price becomes more reasonable.  
• Or, it may be worth the premium if the risk and reward are satisfactory.

(E.g. _____________)

Just know that, if you buy a stock whose price or P/E is too far above the fair price or fair P/E, when it later comes back down - which it usually will - the decrease in P/E can reduce your gain considerably.  Your chances of having a superior portfolio are far better if you select stocks for which you don't have to make any allowances.  


As you gain more experience, you'll find that you can make some intelligent exceptions in cases of high or low price or P/E, but for now, the advice for those who are just starting out, don't.