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WHAT HAS WORKED IN INVESTINGTable 18: Small is Better: Annual Investment Returns for Low Versus High Price/EarningsRatio Stocks within Market Capitalization Categories for the 20½-Year PeriodEnded October 31, 1989MarketCapitalizationCategoryAverageMarket CapOctober 31, 1989(Millions)Price/Earnings Ratio Category(Lowest P/E)1 2 3 4(Highest P/E)51 (Smallest) $46 18.0% 15.3% 10.2% 7.0% 4.1%2 127 15.7 13.7 10.0 6.5 7.43 360 17.0 15.1 10.6 7.4 8.24 1,031 13.8 12.9 10.3 8.5 7.15 (Largest) 5,974 13.0 12.4 9.1 10.5 8.7One million dollars invested in the lowest price/earnings ratio companies within the lowestmarket capitalization group in 1969 would have increased to $29,756,500 on October 31,1989. By comparison, $1,000,000 invested in the highest price/earnings ratio companieswithin the smallest market capitalization group would have increased to $2,279,000 overthis 20½-year period. One million dollars invested in the largest market capitalization,lowest price/earnings ratio group over this period would have increased to $12,272,000.Five-Year Holding Period Year-by-Year Investment Returns for LowPrice-to-Earnings Companies as Compared to High Price-to-Earnings CompaniesJosef Lakonishok, Robert W. Vishny and Andrei Shleifer examined the effect ofprice/earnings ratios on investment returns in “Contrarian Investment, Extrapolation andRisk,” Working Paper No. 4360, National Bureau of Economic Research, May 1993.The professors ranked all companies listed on the NYSE and the AMEX according tostock price/earnings ratios and sorted the companies into deciles. Portfolios were initiallyformed on April 30, 1968, and new portfolios were formed on each subsequent April 30.The study period ended on April 30, 1990. The decile portfolios were held for five years,and the average annual year-by-year investment returns, the average annual five-year returnsand the average cumulative total five-year returns were calculated. The investment returnswere equal-weighted. Table 19, on the following page, shows the results of the study.20
WHAT HAS WORKED IN INVESTINGTable 19: Investment Returns in Relation to Price/Earnings Ratios for All New YorkStock Exchange and American Stock Exchange Listed Companies,April 1968 – April 1990Holding Period FollowingPortfolio Formation(Highest Price/Earnings Ratio)Price/Earnings Ratio Decile(Lowest Price/Earnings Ratio)1 2 3 4 5 6 7 8 9 101 st Year 12.3% 12.5% 14.0% 13.0% 13.5% 15.6% 17.0% 18.0% 19.3% 16.2%2 nd Year 10.1 11.3 12.4 14.3 16.7 16.4 18.0 18.5 18. 3 17.43 rd Year 11.8 13.8 15.7 17.1 17.1 19.1 19.8 18.8 18.8 19.54 th Year 11.1 12.4 14.5 15.1 15.7 15.9 19.8 19.9 20.5 21.45 th Year 11.9 12.9 15.1 16.7 17.1 16.8 19.6 20.1 21.1 20.7Average annual returnover the 5-year periodCumulative 5-yeartotal return11.4 12.6 14.3 15.2 16.0 16.7 18.8 19.1 19.6 19.071.7 80.8 95.3 103.1 110.2 116.8 137.0 139.3 144.6 138.8Low Price/Earnings Ratio Stocks Yield Sizeable Excess ReturnsNet of Transaction ExpensesIn a study published in The Journal of Economics and Statistics (May 1997) entitled, “ThePredictability of Stock Returns: A Cross-Sectional Simulation,” Zsuzsanna Fluck (New YorkUniversity), Burton G. Malkiel (Princeton) and Richard E. Quandt (Princeton) examined theperformance of 1,000 large-company stocks ranked by price/earnings and price-to-book valueratios from 1979 through 1995, and confirmed the findings of the previous Lakonishok, Shleiferand Vishny study, “Contrarian Investment, Extrapolation and Risk,” finding that lowprice/earnings and low price-to-book value strategies yield sizeable excess returns net oftransaction costs and after adjusting for risk.As shown in Table 20, Fluck, Malkiel and Quandt constructed a data sample from Compustatfor the period mid-1979 through 1988 and for the period between 1989 through mid-1995consisting of the 1,000 largest U.S. companies sorted and ranked into deciles based on theirprices in relation to earnings. They found for the period mid-1979 through 1988 that thelowest price/earnings ratio decile, which was rebalanced quarterly, produced 1.82% of excessreturn quarterly, or 7.28% annualized, over the average return of the entire data sample. Thistranslated into an annual return for the low price/earnings ratio decile of 25.28% versus18.00% for the Compustat sample. Conducting the same study for the period 1989 throughmid-1995 produced similar results with the low price/earnings ratio decile producing returnsthat were 1% better than the sample per quarter, or 4% annualized, for an annual return of21
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