P/E Ratio Trading System & Strategy illustrates that low P/E stocks produce higher risk-adjusted returns than high P/E stocks. This is another classic value investing anomaly that has been supported by value investors such as Warren Buffett, Joel Greenblatt and Howard Marks and written about by researchers including Basu and Shiller.
A key insight concerning the P/E ratio is how it encapsulates investor sentiment.
If a stock has a high P/E ratio, its price is high relative to recent earnings. Investors are therefore expecting that stock to grow quicker and produce higher earnings in the future.
A stock with a low P/E ratio, meanwhile, is less expensive relative to recent earnings and investors are therefore less optimistic on growth.
Low expectations are more easily overcome and this is why a low P/E ratio can indicate an undervalued company and a good investment opportunity.
The P/E ratio is a noisy signal but there has been lots of research into its effectiveness.
Professor Shiller produced one of the most well known studies into the P/E ratio and showed a clear correlation between low P/E and forward returns. In the following chart you can clearly see the relationship:
P/E Ratio Trading System & Strategy:
According to this anomaly Trading Strategy, you should prefer low P/E stocks when constructing your portfolio in order to benefit from this value premium.