Norman Rothery, PhD, CFA, is the founder of StingyInvestor.com.
It’s easy to find simple stock-picking strategies that have outperformed the market for decades. One of the very simplest was highlighted way back in 1973 and has continued to trounce the market since then.
The idea is to buy a handful of big blue-chip stocks in the venerable Dow Jones Industrial Average that have the lowest price-to-earnings (P/E) ratios each year. Picking stocks that trade at low prices relative to their earnings is a classic value investing technique. It’s one that has worked well across the broad market and in specific indexes and averages like the DJIA.
I first learned of the approach in the fourth edition of Benjamin Graham’s influential book The Intelligent Investor, which was published in 1973. Mr. Graham highlighted an early numerical study, which looked at buying stocks in the DJIA based on their P/E ratios. More specifically, it tracked a portfolio composed of the 10 stocks with the lowest ratios in the DJIA and another portfolio that held the 10 stocks with the highest ratios. (Both portfolios were rebalanced each year.)
The portfolio composed of the 10 stocks with the lowest P/E ratios climbed at an average annual rate of 7.9 per cent from 1937 to 1962. It beat the DJIA itself, which advanced at an average of 6.1 per cent annually over the same period. On the other hand, the 10 stocks with the highest ratios plodded along with average annual returns of just 3.8 per cent.
My memory of the study was triggered recently by a tweet from money manager James O’Shaughnessy, who essentially replicated and updated the study just after the turn of the century. (Mr. O’Shaughnessy examines a variety of quantitative stock-picking methods in his excellent book What Works on Wall Street.) His figures show that picking low-P/E stocks was a winning strategy in the decades following Mr. Graham’s book.
Based on Mr. O’Shaughnessy’s calculations, the 10 stocks with the lowest P/Es in the DJIA climbed at an average annual rate of 9.2 per cent from June 30, 1937, to June 30, 2004. By way of comparison, the DJIA itself moved up 7 per cent annually over the same period. The 10 stocks with the highest P/E ratios lagged far behind with a tepid annual growth rate of just 3.2 per cent.
As it happens, I have even more recent data. Earlier this year, I used Bloomberg’s back-testing tool to track a portfolio of six (rather than 10) stocks with the lowest P/E ratios in the DJIA over the 18 years to the end of 2017. (The portfolio was rebalanced at the end of each calendar year.) The low-P/E portfolio gained an average of 13.8 per cent annually over the 18 years while the DJIA climbed at an average of 6.9 per cent annually. The low-P/E stocks beat the market once again.
While the long-term results are interesting, if you’re like me, you probably want to examine the stocks that currently qualify. The six stocks in the DJIA with the lowest P/E ratios as of mid-September are: Goldman Sachs Inc., International Business Machines Corp., Intel Corp., Walgreens Boots Alliance Inc., Verizon Communications Inc. and JPMorgan Chase & Co.
They all trade for less than 14 times earnings. Income investors will also note that telecommunications giant Verizon and computer services behemoth IBM both offer dividend yields in excess of 4 per cent.
If history proves to be a good guide, the low-P/E darlings stand a solid chance of outperforming their peers. Mind you, it would be unwise to expect the method to beat the market each and every year because it hasn’t in the past. Investors have to expect ups and downs along the way.