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While P/E ratios are useful metrics for securities,
the point of this article is to highlight some limitations.
We’ve seen a number of younger investors over emphasize P/E, as I did in my younger years.
Like me, they realized P/E was not perfect, yet they sometimes use it to make otherwise blind investment decisions.
The P/E tailwind fallacy
There’s a tendency to expect large P/E differences to diminish over time.
For example, let’s say we have two securities A and B.
A has a P/E of 20, and B has a P/E of 10.
If A and B are considered similar in some way,
it’s tempting to think that B will outperform as the P/E ratios become more similar in the future.
There are a couple problems with this.
First, and perhaps most obvious, is that even if the P/E becomes more
similar, it does not mean that B will earn a higher return.
For example, if A grows earnings faster than B, then A can earn a higher return and
simultaneously reduce its P/E.
What may be more overlooked is that, even if A and B grow earnings at the same rate,
B needn’t earn a higher return.
Perhaps this is the case with the
S&P 500, which has been at a very high P/E for quite a while.
It’s tempting to think its P/E will decrease closer to its longer-term average.
However, it’s very possible there’s a systematic cause of this higher P/E.
For example, perhaps many workers made a long-term commitment to invest
retirement savings in a S&P 500 index fund.
The constant demand could easily counter sellers trying to dodge the high P/E ratio.
Active investors could have even concluded that the S&P 500 deserves a higher P/E.
For example, risk/uncertainty with
international and
small-cap stocks may cause
investors to want to pay more for the S&P 500.
Or perhaps active investors believe the US government (including its military) will
help ensure these big businesses succeed.
The point here is that identifying a P/E difference is not enough.
You must also identify a reason why the P/E will become more similar in the future.
Analogy
Here’s an analogy I find useful.
Would you buy a house only knowing the price per square foot (PPSF) is low?
You can probably come up with a bunch of reasons why that would be insane.
If you think about it, many of those reasons apply analogously to buying stocks based on P/E.
Let’s pick a few.
At the highest level, you may realize that the house has been listed for sale publicly.
If it’s a great deal, someone has probably bought it already.
If no one bought it, people likely found reasons not to.
The only exception I can think of is if you’re the first to see the listing.
The same can be said for low P/E stocks listed publicly, and it’s unlikely you’re the first to notice the low P/E.
If others found the stock attractive, they would buy it and hence push the price up.
So why would a house sit on the market with a low PPSF?
Maybe the air conditioners, floors, and roof need replacing.
Likewise for a low P/E business–it could mean the business has upcoming expenditures.
A home with a low PPSF may be in a bad location with increasing crime.
Or maybe the house is out of style—the design and all the finishings are from a previous era.
Likewise a stock with low P/E may be in a bad industry that’s declining.
Perhaps the home is located in a flood zone or otherwise susceptible to natural disasters.
Likewise a low P/E stock may be unusually susceptible to small changes in laws or economics.
The intent of all this is not to dissuade you from looking at P/E ratios.
The point is to keep P/E in context, and consider it as one checkpoint
in a much larger evaluation (as you would with the PPSF of a home).
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