Resilience in market downturns
We often emphasise the importance of a company's P/E (share Price divided by Earnings (i.e. profits)) in our investment discussions. P/E is a metric that provides an indication of value: the lower the P/E ratio, the 'cheaper' a stock is. It should be noted, however, that First Samuel is not a pure 'value investor'. More on value versus growth investing, and topics surrounding this, in an upcoming edition of W&D.
Generally, a lower P/E investment has the opportunity to revert back to a 'fair value', as the share price now increases at a faster rate than earnings and thus provide an associated capital return. This is in addition to returns associated with a company growing its earnings and providing a dividend return. Clients may remember from First Samuel's CIO Dinner presentations that: expected return = dividends + earnings growth + P/E re-rate.
Furthermore, lower P/E stocks generally have lower downside risk - the market is effectively already providing for risks eventuating. Therefore, if there is company specific negative news, usually the share price fall won't be as severe.
All things we have mentioned in the past, ad nauseum!
This week's W&D focuses on another reason why investing in low P/E stocks is attractive - they are generally more resilient during a market downturn.
Just as lower P/E companies are more resilient (i.e. lower downside risk) to negative company specific developments, they are also usually more resilient to market downturns. A portfolio with a lower average P/E than the market will be more resilient in a market downturn, than a growth (high P/E) portfolio, or even than a market average portfolio.
Case in point - this year's downturn
If we consider this year’s market downturn – the All Ordinaries (XAO) has fallen 9.7% from late Apr-15, to close-of-trading last Wednesday. First Samuel’s target equity portfolio has a lower average P/E than the market. Thus we would expect it to outperform the market over this period - and this was indeed the case. Sixty per cent of the companies First Samuel clients are invested in (excluding South32, which wasn’t listed in late April) outperformed the All Ordinaries index.
Longer term data
Really, however, we should consider longer term data, and a wider data set.
Researchers Fama and French are considered world-wide experts and thought leaders on value-versus-growth investing outcomes. Their comprehensive analysis established that value investments have outperformed growth investments around the world over the long-term .
In other words, in the short-term a lower P/E portfolio offers resilience. In the long-term, a lower P/E portfolio offers outperformance.
It should be noted that there are cycles - in shorter time periods, even say 10 years (if for instance a major event occurs in that period), a growth investment style can outperform.
First Samuel expects to generate good investment returns on your behalf by selecting a portfolio of companies that a) provide strong dividends, and b) are expected to increase their earnings over our 3-year investment horizon.
Investing in a portfolio of companies with a lower average P/E provides resilience in short term market downturns. In the long term, opportunity for capital return is provided as P/E’s normalise. Lower P/E investments are demonstrated to, over time, deliver a superior investment outcome, as compared to a growth investment style.