Baron Von Rothschild “Invest when there is blood on the street.”
Sir John Templeton “Invest when pessimism is at its highest.”
The P/E ratio provides a good indicator to future potential performance of company equity prices if compared to the performance over the previous ten years.
The lower the P/E ratio the better for the next 10 year average performance.
The lost decade
The FTSE started on 3rd January 2000 at 6930.20 and on the 3rd October 2011 the index stood at 5128.50.
This means that in simple terms the index has fallen by 1801.70 or -26%.
This figure does not include dividends but including the dividend return over this period the return would have been -17.58%.
The average inflation rate over the same period was 2.38%.
So the adjusted return taking both of these into account, would be in excess of -35% over a period of 11.9 years.
Or a loss each year of about 3% p.a.
A value based investor will look continually at individual companies.
On an individual basis a company will have stock specific drivers:
- New products – good or not
- Market share – increasing or decreasing
- Accounting – problems ?
- Growing sector – new / markets / internet or renewable energy
These will move individual stocks on a per case basis.
There are also macro factors to consider, these overlay individual stock analysis by factoring in the positive or negative economic conditions.
So currently markets are volatile and fearful over macro issues.
It is fair to say that most things most of the time move in cycles:
So in 2000 with an average P/E (Price to Earnings) Ratio of 19 times this meant that on average a company share in the FTSE was being purchased at a price per share of 19 times its annual profits (i.e. if profits remained constant it would take 19 years for a company to earn what had been paid as a share price).
Now if we factor in that the highest P/E ratios are likely to be achieved at the time of highest confidence (because profits are strong and achieving new highs) this in most cases guarantees that the price being paid at the most optimistic point in the cycle will be the most expensive in real terms on both sides of the calculation are peaks.
This tends to be the period of highest activity however because of investors emotional bias towards consistency of positive results spurring their increase of comfort in investing.
Conversely when P/E ratios are low on average this will usually indicate that:
- There are macro concerns (as now the Banks / Sovereign debt and slow growth going forward)
- Company profits are lower / fallen from previous peaks
So a low P/E in a period of lower profits means that both sides of the equation are depressed.
Price – Low / Profit Low
So the cycle has moved this year from the phase of “problems to pessimism.”
If the graph of the P/E ratio for the following 10 years performance of shares is viewed then years of low P/E ratios are consistently and significantly the best times to invest, and are the most rewarding times to produce above average returns over the following ten years. This is the opposite for those years ending with high P/E ratios where the following 10 year returns are poorer.
Concerns / caveats
- Markets as now can be historically cheap, they can however get even cheaper
- The current concerns regarding Europe is SUPER MACRO, and can distort the market by quantumly increasing short term volatility
However the fear induced in markets currently by the possibility of bloody, pessimistic outcomes brings us back to the quotes at the start of from Messrs Rothschild and Templeton.
NOTE: This is written in a personal capacity and reflects the view of the author. It does not necessarily reflect the view of LWM Consultants. The post has been checked and approved to ensure that it is both accurate and not misleading. However, this is a blog and the reader should accept that by its very nature many of the points are subjective and opinions of the author. This is not a recommendation to buy any product or service including any share or fund mentioned. Individuals wishing to buy any product or service as a result of this blog must seek advice or carry out their own research before making any decision, the author will not be held liable for decisions made as a result of this blog (particularly where no advice has been sought). Investors should also note that past performance is not a guide to future performance and investments can fall as well as rise.