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47

Contrarian Investment Strategies 143 Figure 7-1

Francis Nicholsons Pioneer Study

Percentage Gains, 1937-62

Average Price Appreciation Percentages Over Total Period

160%

1 Yr

2Yrs

3Yrs

4Yrs

5 Yrs

6Yrs

7 Yrs

Source: Adapted from Francis Nicholson, "Price-Earnings Ratios in Relation to Investment Results," Financial Analysts Journal (January-February 1968).

companies of trust company quality in 18 industries over the 25 years between 1937 and 1962. The results are given in Figure 7-1.

Nicholson divided the stocks into five equal groups solely according to their P/E rankings. These quintiles were rearranged by their P/E rankings for periods of one to seven years. Recasting the quintiles annually on the basis of new P/E information resulted in the stocks most out of favor showing a 16% annual rate of appreciation over the total time span. Conversely, switching in the highest P/Es on the same basis resulted in only 3% annual appreciation over the period. Although the performance discrepancies were reduced with longer holding periods, even after the original portfolios were held for seven years the lowest 20% did almost twice as well as the highest.

Similar results were tumed up by Paul Miller, Jr., who used as his database the companies on the Compustat 1800 Industrial Tapes with



P/E Quintile Price Increase

1st (highest P/E) 7.7%

2nd 9.2%

3rd 12.0%

4th 12.8%

5th (lowest P/E) 18.4%

Source: Drexel & Co., Philadelphia, monthly review, 1966.

sales of over $150 million between 1948 and 1964. Like Nicholson, Miller divided the stocks into quintiles according to their P/Es. The findings are displayed in Table 7-1.

With remarkable consistency, investors misjudged subsequent performance. In both studies, the results are completely uniform. The most favored stocks (quintile 1) sharply unde erformed the other groups, while the least popular group (quintile 5), showed the best results. The second most popular quintile had the second worst performance, while the second most unpopular quintile had the second best results.

Miller also found that the lowest 20% of stocks, ranked according to P/Es, did best in 12 of the next 17 years. The highest 20%, by comparison, did best in only 1 subsequent year and worst in 8.

Benjamin Grahams The Intelligent Investor cites a third study, this one involving the 30 stocks in the Dow Jones Industrial Average itself (Table 7-2). The performance of the 10 lowest and the 10 highest P/Es in the group, and of the combined 30 stocks in the industrial average.

Table 7-2

Average Annual Percentage Gain or Loss on the Dow Jones

Industrial Average

1937-1969

10 Low-Multiple

10 High-Multiple

30 DJIA

Period

Issues

Issues

Stocks

1937-42

- 2.2%

- 10.0%

- 6.3%

1943-47

17.3%

8.3%

14.9%

1948-52

16.4%

4.6%

9.9%

1953-57

20.9%

10.0%

13.7%

1958-62

10.2%

- 3.3%

3.6%

1963-69

8.0%

4.6%

4.0%

Source: Benjamin Graham, The Intelucent Investor, 4th ed., p. 80. Copyright © 1973 by Harper & Row Publishers, Inc. Reprinted by permission of HarperCollins Publishers, Inc.

Table 7-1

Average Price Increase per Year, 1948-1964



More Nasty, Ugly Little Facts

If the low P/E results were analyzed at all, they were criticized. For one thing, the growth school has always had a major following among investors. Many institutional investors could not bring themselves to believe the efficacy of the findings. After all, like the studies that discredited eamings forecasts, these findings did seem cavalierly to toss aside our years of practice (or perhaps brainwashing) to the contrary. When I published a paper in early 1976 summarizing some of the previous research, a number of professionals told me that such information was only history: "Markets of the 1970s are very different."

The evidence, of course, was a transitory enigma to our financial friends in academe who, in the late 1960s, were tightening the final nuts and bolts of the formidable efficient market hypothesis. According to this academic-launched dreadnought, such results simply could not exist. Why? Because rational, profit-seeking investors would not allow them. Clever investors would immediately jump into the better performing, lower P/E stocks, and stay clear of the triclder high P/E multiples until all the extra profits were extracted.

Further EMH criticism asserted that low-P/E stocks were systematically riskier (in the parlance, had higher betas) and therefore ought to provide higher retums. For the coup de grace, methodological criticisms of the studies were wheeled into action. They were mosdy hairsplitting

was measured over set periods between 1937 and 1969. In each time span, the low P/Es did better than the market and the high P/Es did worse.

The study also calculated the results of investing $10,000 in either the high- or low-multiple groups in the Industrial Average in 1937 and switching every 5 years into the highest P/Es (in the first case) and the lowest P/Es (in the latter). Ten thousand dollars invested in the lowest P/Es this way in 1937 would have increased to $66,866 by the end of 1962. Invested in the highest P/Es, die $10,000 would have appreciated to only $25,437. Finally, $10,000 in die Dow Jones Average itself would have grown to $35,600 by 1962. (Grahams findings have recendy been recycled into a hot new investment strategy, "The Dogs of the Dow.")

A number of other studies in the 1960s came up with similar findings. The conclusion of these studies, of course, is that low-P/E stocks were distinctly superior investments over an almost 30-year period. But theories, like sacred cows, die hard. The findings created little stir at the time.



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