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Value investors love to pick stocks with low price-to-earnings ratios and a wealth of studies back them up. But recent research indicates there might be a devil hiding in the details.

Nicholas Anderson wrote a paper called The Performance of Relative-Value Equity Strategies that looks at different P/E-based methods while doing his MBA at the University of Chicago Booth School of Business. As it happens, he was a member of the team of students who won the Ben Graham Centre’s International Stock Picking Competition’s top prize in Toronto in 2016. (I highlighted his accomplishment and look forward to this year’s contest, which concludes in April.) He now works as an equity analyst at Thornburg Investment Management.

As part of his study, Mr. Anderson looked at buying stocks in the S&P 500 with low P/E ratios. He determined that an investor who had purchased an equal-dollar amount of the 10 per cent of stocks with the lowest ratios each year would have outperformed the equally weighted S&P 500 total return index by an average of 4.33 percentage points annually from June, 1990, to June, 2014. It’s just the sort of huge return boost that attracts people to value investing.

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I found similar results last year using Bloomberg’s backtesting facility. A portfolio composed of 10 stocks in the S&P 500 with the lowest positive P/E ratios, reformed each year, outperformed the regular S&P 500 total return index by an average of seven percentage points annually. It beat an equally weighted portfolio of all of the stocks in the index by an average of 4.2 percentage points per year. Here the period examined started at the end of 1996 and concluded at the end of 2016.

The devil was revealed when Mr. Anderson explored several closely related – and relatively popular – strategies that didn’t fare nearly as well.

The second method buys a stock when its P/E is low compared with its average over the prior 10 years. For instance, the accompanying graph shows how Viacom’s (VIAB) P/E ratio varied over the last decade based on data from S&P Capital IQ. The company currently has a P/E ratio of 6.1, which is one of the lowest ratios in the S&P 500 and would qualify it for Mr. Anderson’s first portfolio. It is also well below its 10-year average P/E of 12.7, which makes it a candidate for his second portfolio.

Each year the second portfolio buys an equal-dollar amount of the 10 per cent of stocks with the lowest P/E ratios compared with their historical averages. The portfolio beat the equally weighted S&P 500 total return index by an average of just 0.72 of a percentage point annually from June, 1990, to June, 2014. The result was much worse than simply buying the lowest ratio stocks in the index each year without regard to their past P/Es.

Problem is, P/E graphs are quite popular among portfolio managers and investors alike. Mr. Anderson’s study suggests that such graphs should be given a wide berth because their use may yield lower returns than simpler value techniques.

He also looked at more complicated variants that consider a stock’s market-relative P/E compared with its own past history. The idea being to look at the difference between the stock’s P/E and the market’s P/E and compare the difference to its 10-year average. But the extra complication wasn’t worth it because the results were slightly worse, with an average annual return advantage of just 0.66 of a percentage point versus the index.

Similarly, he considered using market-relative P/E scaled by its variability (standard deviation). The extra math provided an average annual return boost of just 0.7 of a percentage point versus the index, which is unfortunate because it was the method he had the most interest in exploring.

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When researchers encounter disappointing results they often throw them into a filing cabinet where they’re never seen again. But, much to Mr. Anderson’s credit, his were published and investors can benefit by knowing what not to do. For my part, I’ll never look at a P/E graph the same way again.

Norman Rothery, PhD, CFA, is the founder of StingyInvestor.com.

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