RELATED TOPICS --> | Relationship between JSE ALSH Index P/E and its returns |
                               | Best performing P/E ratios since the 2003 Crash |


We aim to discover just how much the Price/Earnings, or PE ratio of a JSE share has a correlation to future growth. We will show, as with research done on international markets, that portfolios created from low Price/Book shares significantly out-perform all other shares and the indices over 1, 3 and 5 year periods.

We will test multiple periods commencing in 2000
(we are busy working on additional analysis back to 1990 for our subscribers only.) In each period we will sort the JSE by PE ratio as at 30 March, based on the most recent financials of each company at that date, be they finals or interims (this ensures fresh fundamental data is used in deriving the PE ratio). We then divide the sorted list into 10 sets of equal deciles, with Decile-1 containing shares with the highest 10% of Price/Book ratios (expensive shares) and Decile-10 containing the lowest ("value shares".) Decile 1 and 2 contain shares ranked by negative PE's (since we consider them to be "expensive"). We create portfolios from each decile and then measure each portfolios' 1, 3 and 5 year subsequent growth. Growth is measured using the last day in March of each year as start and end dates.

We created five sets of deciles to measure average 5 year growth, namely 2000-2005, 2001-2006, 2002-2007, 2003-2008 and 2004-2009. There are 2 additional sets of deciles for the 1 and 3 year growths, namely 2005-2008 and 2006-2009. There is also one extra decile set for the 1 year growth, namely 2007-2008. So there are 5 sets of 5-year deciles, 7 sets of 3 year deciles and 8 sets of 1 year deciles. Decile sizes ranged from 23-30 shares depending on year. The tests have thus exposed the 1,3 and 5 year periods to the latest 2009 crash as well as the 2000 meltdown. Since there are two full boom and bust cycles in this test period it is a good indicator of strategy performance.

Finally we averaged the results for each decile (5 sets of results averaged for 5 year growth, 7 sets of results averaged for 3 year  and 8 sets averaged for 1 year growths), and produce summary findings together with analysis of decile portfolio characteristics such as risk adjusted return, volatility, base rates and total return. This ensures a holistic method of evaluating a strategies performance instead of chasing strategies with seemingly the highest growth rates.

This set of tests represents the entire JSE universe ("ALL STOCKS"). We will also shortly publish the same tests conducted on universes that for each period eliminates the bottom 25% (to create a "LIQUID STOCKS") and bottom 50% ( creates a "LARGE STOCKS" universe) of the JSE by market capitalisation, to look at how the strategy performs with the "micro-cap" shares excluded, and how it performs on larger issues more common with fund managers/unit trusts. This data will be for subscribers only.


We see confirmation of international tests, for all of 1, 3 and 5 year portfolio holding periods, for PE > 0 (Deciles 3-10). On average, during the period 2000 to 2008, creating a portfolio of the lowest positive P/E shares on the last day in March in any year would have yielded a 43.5% CAGR if you held those shares for 5 years, 43.1% if you held onto them for 3 years, and 39.4% if you just hung onto them for 12 months. Low PE deciles (9 and 10) more than doubled performance of high PE deciles (3,4 & 5.) The average PE range in Decile 10 was 0-4.5 and the range for Decile 9 was 4.5-6.35 (meaning 9 & 10 covered PE's of 0-6.35)

We note that while PE is a good correlator of future growth, it does not appear as emphatic as those tests we conducted with the Price/Book ratio. This does differ from international tests.

We note with some interest the strong performance of Deciles 1 and 2. In every one of the 8 years tested, these deciles were made up 95% or more of the negative PE shares (since we treated a negative PE as an "expensive share" in the sorting process, the higher the negative number the more expensive). It would seem that a strategy of investing in shares with negative PE ratios could be quite a good one, although investing in the most negative PE shares in Decile 1 under performs those in Decile 2 by quite a bit. We suspect that investing in negative PE shares is a great example of a contrarian investing strategy. Negative PE's, which imply negative earnings, put the general investing public off and once the decile 2 shares (which are not overly negative), turn into positive earnings territory, everyone piles in and drives up the prices.

It is one thing having impressive average growth rates, but quite another if volatility is through the roof. Here we will examine PE decile-portfolio growth, versus standard deviation of underlying shares growth together with an averaged risk adjusted return ratio (Sharpe ratio=growth divided by standard deviation).

We see that Decile-9 provides, on average, a superior risk adjusted return by deviation of portfolio constituency (as indicated by the Sharpe ratio). This is confirmation of the literature that although low PE indicates good value, it mustn't be too low! The above tells us that on average shares with PE between 4.5 and 6.5 provided better risk adjusted returns than those with PE of 0-4.5 We see the risk adjusted returns steadily declining as PE ratio increases, confirmation of the old wisdom that with higher PE comes higher risk.

Now look at the gut-wrenching volatility of the decile 1 and 2 portfolios which are ranked by the negative PE shares. Although the returns on these 2 strategies were surprisingly high, you paid for it in the standard deviation of the growths of the underlying shares of each portfolio. These portfolios were characterised by shares going through the roof and others falling through the floor. Fortunately the high-risers made up for the laggards, but not everyone has the stomach for this sort of investing strategy.

As with the Price/Book backtests, these graphs dispel the myths that expensive (high PE) shares are "safe", as the lower decile shares have much lower Sharpe ratios than the higher ones. In the 1-year example, Decile-3 not only underperformed but the standard deviation of the growths of the expensive shares that it was holding gyrated resulted in a much lower Sharpe ratio.

We now evaluate total return delivered by a 1-year holding period strategy over the 2008-2008 period. We start in March 2000 and for each PE Decile, we take a hypothetical R1.00 and use it to buy equal rand amounts among the underlying shares of  the portfolio. We hold the portfolio for a year, after which we rebalance it (sell everything) and repeat the process (8 times) with the funds we have over. We exclude broker fees etc. (which will be about 2% each year per portfolio, 1% for the buying and 1% for the selling.)

We see that for positive PE's (Deciles 3 to 10), deciles 10 and 9 provided the best strategy absolute returns (R12.12 and R11.69 respectively.) Decile-2, with the lower 50% of negative PE shares returned an astonishing R18.64. However ALL these strategies fell far short of the R33.71 delivered by the Price/Book Decile-10 (lowest 10% of shares ranked by Price/Book.) We did not assume average growths in this exercise, we used the exact achievements for each share for each of the 8 years when simulating the investment period.

Here we examine another important characteristic of the above 1-year holding strategy, namely its historical tendency to outperform the market as a whole. This is very important as very few investors can stand by and be patient with a strategy whilst it is under performing the market for extended periods (even if its known to be a superior strategy over time). For our base rates, for each of the 8 years under comparison in the previous section, we created two portfolios called GRP (an equal weighted index of the JSE universe) and ALSI which is the standard JSE index with market-cap weighting. We feel it is important for a strategy to beat BOTH these peer groups at least 66% of the time to not deter the average investor. The below table shows what % of the time during the whole 8 year test period, each PE decile portfolio beat these two benchmark indices:

We see that the Decile-10 PE strategy out-performed both indices 75% of the time (6 years out of 8). Expensive "glamour" high PE shares constituted by the Decile-3 strategy failed to beat the ALSI 50% of the time and failed to beat GRP 90% of the time. Decile-1 and 2 both beat the ALSI 75% of the time and GRP 62% (5 out of 8 years) of the time. The missing of the 67% minimum for beating GRP by these two strategies means you will need strength of character to sit out perhaps 2 perhaps even 3 years of non-performance in a row. In fact both these portfolios had 2 consecutive years of GRP under performance.

The extent of the out-performance of the benchmark indices by the Decile-10 PE portfolio is shown below:


Here we look at the average per-annum growth achieved by each decile over the 8 years, compared to the standard deviation of said growth to derive a risk-adjusted "Annual Growth" score. This examines volatility of the per-annum growth of the respective portfolios as opposed to the volatility of their underlying shares. It gives us a sense of the "consistency" of the strategy over the 8 year period.

We note with interest that for positive PE's Decile-10 has a ratio of 1.4, versus the Price/Book Decile-10's strategy's 1.7. This implies a book value strategy yields more consistent per annum growth than a PE strategy. We also see the impressive 1.5 ratio delivered by the Decile-2 strategy (the "emerging positive earners")

Whilst 8 years is by no means an exhaustive back-test, the performance of the low PE indexing strategy is still convincing, although not as impressive as the same tests done for the low Price/Book strategy. We continue to extend our back-tests all the way to 1990 for this strategy, but felt it prudent to publish our findings to date, since it is merely a confirmation of extensive international research anyway.

As with the international research, we conclude that the price you pay for a share has a significant bearing on ultimate returns. Cheap, out of favour stocks eventually come back in favour and reward the investor. The strategy of investing in the least negative 50% of shares ("emerging positive earners") yields surprising results, albeit with lower GRP base rates than Decile 10. Bear markets are the best times to execute this strategy as the under-pricing by the market on low PE stocks is even more extreme on the down and the overpricing more extreme on the up (see our 2003 Crash trough-to-peak PE back-tests)

You can do a lot worse in the market than by buying the 10 or 20 lowest PE stocks on the JSE. Later on, we publish in the subscribers section how combining PE with other factors significantly improves performance whilst increasing base rates, decreasing volatility and decreasing required portfolio sizes. A classic example of this is the combination of a Piotroski score with low price-book stocks, which yields tiny portfolios that deliver stunning long term performance. We have completed an extensive 14-year back-test on a Piotroski coupled with Price/Book which you can go see over here. 

RELATED TOPICS --> | Relationship between JSE ALSH Index P/E and its returns |
                               | Best performing P/E ratios since the 2003 Crash |
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