Cheap is Good

Money makes the world go round. So how do we make money?

Suppose we have company X with earnings per share of $20 cents and share price is trading at $1.20 each. Divide the share price by its earning to get a PE ratio of 6. This means we are paying $6 for every $1 dollar of earnings made. We can loosely translate this to taking 6 years of earnings to recoup our investment.

PE probably serves as the most widely used valuation indicator right now. By using earnings as the denominator, we set the E in PE as 1 and allow relative comparison to be done between companies, industry groups or even geographical locations.

Assume other variables constant, a company with $50 share price may not necessarily be deemed “more expensive” than a company with $10 share price if the former has $10 earnings compared to the latter with $0.50 earnings.

PE = $50/$10 = 5
PE = $10/$0.50 = 20

In the former’s case, you are paying $5 for every $1 dollar of earnings generated by the company compared to paying $20 in the latter’s case.

Why will you want to pay $20 to claim $1 of earnings?

Higher PE stocks suggest higher growth potential. Investors are willing to pay a higher price now and expect earnings will grow in the future. Forecasting earnings is a notoriously difficult proposition as many different variables are involved and different assumptions are made. The lower we look in the income statement, the “dirtier” the numbers may become. Earnings happen to be right at the very bottom!

Sample Income Statement:

To accurately forecast earnings, you will need to have a good sensing of all the figures preceding it and how they evolve into the future.

Myself, I am not a very clever person and also. Remembering the margin of safety principle, I apply huge discounts to the price paid per dollar earnings, hover around low PE companies, classified as value stocks.

So why is cheap good?

Here’s some proof. I’ve created ten model portfolios by arranging and purchasing stocks according to their PE ratios. Let’s say if SGX has 700 companies listed, I’ll place the cheapest 10% (70 stocks according to PE ratio) of SGX into Decile 1, next 10% into Decile 2 until every company is accounted for and placed somewhere.

The holding period is one year. At the end of year, everything is sold off and stocks ranked according to their PE ratio again. Sales proceeds from Decile 1 will be used to purchase the new cheapest 10%, Decile 2 to purchase next 10% etc.

All data from Bloomberg. Assume no transaction cost and all dividend received will be reinvested into the respective deciles.

Here are the compounded returns over a period of 10 years (2008 to 2017)

Capture-blackwhite

I sleep in the day and head the dealing desk at night.

In my nightly work, I attempt to do analysis and scout around for trading ideas. The work I do tend to lean towards maths and science as I’m not a very artistic person.

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PE-10-yr-CAGR

Results are rather obvious. Cheap earnings outperform expensive ones!

If we go one step further..

What if we buy the cheap deciles (1 & 2) and short the expensive deciles (9 & 10)?

This way we (in theory):

  1. Earn from the winners & losers
  2. Isolate the value premium (buy only the outperformance)
  3. Hedge against systematic risk (think 2008 etc)
  4. (I can) soft sell CFD a bit

We will be profit making almost all the years! (at least on excel)

PE 15 yr value premium

So now what?

It will appear that cheap earnings does make money! Maybe next time we can pay more attention to PE ratio before placing our trades.

Thats all I have for now. Thank you for reading and join me again next time!