WORLDVIEW: New study proves widely used investment tool damages wealth creation

Every investor seeks for an edge. Doubly so for those advising them – the notorious “helpers” and “super helpers” as Warren Buffett calls them. So it’s no surprise investment professionals enjoy creating new tools which they claim delivers an advantage (with the benefit of also helping justify their fees).

Buffett believes in keeping things simple, for instance by investing in a low-fee index tracker rather than actively managed unit trusts. His approach has a lot to recommend it: managing your own money delivers the peace of mind that always flows from better understanding. Also, sticking with the basics often delivers superior returns.

My Biznews colleague Jackie Cameron recently came across results of research supporting this keep-it-simple approach.

Jackie writes: “Among the first financial calculations drummed into my head by my accounting teacher was the price-to-earnings (PE) ratio. The PE ratio is regarded as a fairly easy tool to assess whether a company’s shares look cheap or expensive. It is the simple division of the share price (P) by the company’s earnings (E).

The PE ratio is widely referenced by investors everywhere, but with little thought to its potential shortcomings. The devil emerges in the detail. Benjamin Graham, the father of rational investing, pointed out some flaws in his seminal work, Security Analysis, co-authored with David Dodd.

Referring first to the P, almost a century ago Graham proposed the stock market is a “voting machine rather than a weighing machine”, with the price of a stock reflecting those votes. The PE “can scarcely be called a standard, since it is controlled by investment practice instead of controlling it”, he cautioned. Yet despite this criticism by a man so revered among investors that he earned monikers like Einstein of Money and Dean of Wall Street, the PE ratio has remained a staple.

Now, a respected figure in the UK investments has trained the spotlight back onto the ratio, in particular highlighting the weaknesses of widely used “prospective” PEs. This is the ratio that is based on projected or forecast earnings, rather than the published historic ones.

In a two decade study of stock market performance across four major markets, Joachim Klement of the CFA Institute investigated how accurately forward PE ratios predict of future performance. Klement has produced several important studies on finance and investing and has worked in senior roles in the investment industry, including head of equity for UBS Wealth Management. So knows his onions.

Klement noticed that studies on the value of PEs looked at trailing price-to-earnings ratios, not forward PE ratios. So, he investigated with a view to getting a definitive answer to which PE is best: trailing or forward? He crunched numbers for the S&P 500 (US); FTSE 350 (UK), Euro Stoxx 300 (eurozone) and Japan’s Nikkei 225 and compared returns by a fifth of stocks with the lowest PE ratios to the 20% with the highest PE ratios.

His monthly comparisons went back 20 years, first using trailing 12-month PE ratios for each stock and then switching to forward 12-month PE ratios. The results showed a decisive victory for history with the best returns achieved by using trailing PEs, with the cheapest outperforming the expensive by anything from 1.2% a year in the US to 10% in the UK. By contrast, using “prospective” PE ratios “destroyed performance” in US markets, with an only “not quite as bad” result from the UK, Europe and Japan.

Klement says his research demonstrates there is little value in projected PE ratios: “As I tell my colleagues at work: “Never ever use forward PE ratios. Ever.” If an investment analyst of the ilk of Klement has dumped the prospective PE ratio, maybe we should consider doing so too?”

Thanks Jackie. Proof that “new fangled” is not automatically better. And that, as ever, predicting the future is a challenge that’s littered with unimaginable pitfalls. Stay humble and keep it simple. With your money and your life.