P/E Quintiles

High

Market

□ Dividend Retum □ Appreciation Total Retum

Figure 8-1 shows the retums of the low P/E strategy for the 27 years ending December 31,1996, using the largest 1,500 companies on the Compustat tapes. The retum the investor receives each year is brolcen down into its two basic components-capital appreciation and dividends.

The stocks are sorted in the usual manner into five equal groups in each quarter of the study, strictly according to their P/E rankings, and the retums are annualized.

Figure 8-1 once again demonstrates the superior performance of the low P/E group. Over the 27 years of the study, the bottom group averaged a retum of 19.0% annually, compared to 15.3% for the market (the last set of bars on the right) and 12.3% for the highest P/E group. The lowest P/Es beat the highest P/Es by 6.7% a year. If youre putting money away for your retirement fund, diis performance differential becomes enormous over time, as Figure 7-4 indicated.

Looking at die chart again, youll see that these cheap stocks also provide higher dividend yields. As Figure 8-1 also reveals, the low-P/E

Figure 8-1

Price/Earnings

Dividends, Appreciation & Total Retums January 1, 1970 - December 31, 1996

group yields 6.0% over the life of the study compared to 4.3% for the market, and only 1.9% for the highest P/E group. The return advantage of "worst" over "best" stocks is 4.1% annually, which on $10,000 over 27 years is $438,000.

Still, according to conventional investment theory, low P/E stocks 5/ / provide higher yields. These "uglies" are going nowhere, so their requirements for additional plant and capital equipment to foster expansion are much lower than for the highest P/E group. Therefore, they can afford to pay out more.

What is not as it should be is shown in the appreciation column in Figure 8-1. Here we see the low P/E stocks also have far better appreciation than either the high P/E group or the market. All the money that goes into capital expansion for the "best" stocks does not reflect itself in top-gun performance. The "down and outers" outstrip the top tier once again. Low P/E stocks provide the best of both worlds: higher yield and better appreciation, something that conventional wisdom states shouldnt happen.

The higher dividend returns, incidentally, help prop up the prices of cheap stocks in bear markets, one of the important reasons why low P/E and other contrarian strategies outperform in bad times.

Table 8-1 shows how buying the lowest P/E quintile and holding it unchanged for periods of 2 to 8 years over the 1970-1996 period would have done. As a glance at the table shows, the results are rather remarkable. The low P/E portfolios still provide by far the highest annual returns in the second year (18.7%), sharply out-distancing the highest P/E group (11.9%), and the market (15.3%). Low P/E returns stay well above market and high P/E stocks, for both the 3- and the 5-year periods.

Its su rising that the returns stay as high as they do for so long. This indicates that the undervaluation of the low P/E stocks is very marked.

Table 8-1 Price/Earnings

buy-and-hold returns January 1, 1970-December 31, 1996

P/E Quintiles 2 Years 3 Years 5 Years 8 Years

Strategies #2 and #3: Price-to-Cash Flow and Price-to-Book Value

Lets now look more specifically at two other important contrarian strategies, selecting stocks by price-to-cash flow or by price-to-book value. Cash flow, as you may remember from chapter 3, is normally defined as after-tax earnings, adding back depreciation and other noncash charges. Cash flow is regarded by many analysts as more important than earnings in evaluating a company, for the reasons oudined in that chapter.

As was also discussed in chapter 3, price-to-book value was a favorite tool of Benjamin Graham and other earlier value analysts.

Figures 8-2 and 8-3 give the results of each. The sample, the time period, and the methodology are identical to those used for price-to-earnings. Again, glancing at Figures 8-2 and 8-3, you can see the superior performance of the worst stocks, the lowest 20% of price-to-book value

For high P/E stocks, the overvaluation is just as significant. Even after 5 years, they continue to display much lower returns than the market. Holding the lowest 20% of stocks for 8 and even 9 years (not shown) still provides well-above-market returns for the low P/E group, with virtually no deterioration of performance from year one.

Another advantage of low P/E and other contrarian strategies is that they dont require a lot of work to be effective. As we just saw, rebalancing low P/E portfolios annually with large-size companies resulted in far above-market returns. However, you could rebalance far less frequently. This is a low intensity strategy with high-intensity results. You dont have to spend much time agonizing over the stocks you pick and constantly monitoring or inte reting every company, industry, or economic squiggle to divine all-important information. No, just select your portfolio (well look at how to do this shortly) and put it on automatic pilot. Youll save aggravation, not to mention commission and transaction costs this way.

At the same time, youll outdistance the market by a comfortable margin, which, as you know, few money managers can do. The point of the chart is not to get you to hold a portfolio intact into eternity, but to show that our normal work ethic of constantly being busy to be successful is not useful but often counte roductive in investing.

While I wouldnt buy a portfolio and hold it sight unseen for eight years. Table 8-1 (a large sample of stocks over the last 27 years) demonstrates you can make big bucks in the market by positioning yourself carefully at the beginning and fine-tuning moderately thereafter.