Last Updated on Feb 20, 2023 by Anshiya Tabassum
“The intelligent investor is a realist who sells to optimists and buys from pessimists.” – Benjamin Graham, Warren Buffett’s Guru.
Research by Nobel prize winner Eugene Fama confirmed in 1992 what was known for a long time from Benjamin Graham’s research and investment operations in the 1930s itself, that low PE stocks deliver high returns, meaning returns that beat the markets.
David Dreman, a highly research-oriented fund manager, has written several books on Psychology, stock markets, and contrarian investing. He shows that low price-multiple stocks can deliver higher returns.
In fact, stocks with any of the following low price-multiples are likely to deliver higher returns: low price-to-earnings (Low PE), low price-to-book(Low PBV), low price-to-cash flow (Low PCF), and low price-to-dividends (High Dividend Yield).
Filtering low PE stocks using Tickertape Stock Screener
Let us use the Tickertape Stock Screener and see what comes up. Without any filter, there are 4,524 companies. Now, on the Stock Screener, choose the PE ratio (low), all stocks below the PE of 20. Now there are around 2,500 companies left.
Now add the filter “long-term debt-to-equity ratio” and sort by long-term debt-to-equity ratio. You will see that a lot of companies have very high debt-to-equity. Except for banks, other financial companies, and infrastructure companies, a debt-to-equity of 0.5 is the limit. Anything higher than that can be considered a highly leveraged company. Ideally, you remove those companies from the search.
Go to the Stock Screener, and in the long-term debt-to-equity, choose 50%. Now around 1,700 companies are left.
Now add “interest coverage” as a filter. Ideally, this should be 4 or higher. Now ~700 companies are left.
Now go to the Market Cap filter and choose Rs. 1,000 cr. or higher; this filters out a lot of small companies where you might not get too much information about the company beyond the financials. Now only ~214 companies are left.
These 200 are large companies with strong balance sheets, low debt, and strong operating metrics in terms of interest coverage and are also available at a low price to earnings.
Are low PE stocks highly risky?
Typically, low PE companies are highly risky. Eugene Fama School of Academic research thinks these companies deliver higher returns because they are risky. They think, “high risk, high returns”. However, we have used the Stock Screener to screen out the highly leveraged companies with low-interest coverage. Most of the risky companies are now out of the universe. We have further reduced risk by screening out smaller companies using the Market Cap criteria.
An additional risk comes from investing in overvalued companies. This was already reduced by choosing a PE ratio of 20 or less.
Thus this remaining universe is relatively safer compared to a typical market portfolio. It is also likely to deliver higher returns, as per academic research.
However, for a typical investor, 214 companies are still a lot to choose from.
If one chooses the large-cap option in the Market Cap filter, then only 11 companies are left. One could look at these individually and decide what they like based on sectors and other characteristics of these companies. Many of these companies are from Oil & Gas and other Natural Resources, such as coal or metals. One should remember that these sectors are cyclical in nature.
Cyclical companies typically have high profits near the cycle’s peak and could have very low profits or even losses at the bottom of the cycle. These cycles could last from around 5 to 7 yrs. Thus, while investing in natural resource companies or commodity-oriented companies, one should be careful not to invest in them when they are at peak earnings. What looks like a low PE ratio today when the earnings are high might look like a very high PE ratio when the earnings are low in a year or two. Ideally, one can filter out these companies.
The best way to do that would be to go to the sector filter and remove Energy, Financials, Materials, Real Estate and Utilities. Very few companies will be left within the large and midcap universe. One can deeply dive into these companies’ financials by going to their specific pages on Tickertape. You can click on any name you like and see a page and link leading to the full detailed page for that company.
It is recommended that one should buy a portfolio of around 20-30 such stocks. One could choose sub-sectors from the filter and then from each remaining sub-sectors, except those already filtered out in the earlier para, one can choose 1-5 companies each and create a sector-diversified portfolio of around 25 companies.
Invest in a company only when you understand its business, financials, competitive advantages, growth potential, and valuation. Invest only if the company has a strong, well-entrenched business model, a strong, cash-rich balance sheet with low liabilities, a medium to high growth potential, and is available at a large discount to intrinsic value.
Review the portfolio every quarter. If a company no longer meets the above criteria, it might be time to sell and add a new company that fits the criteria. Over a period of time, one should be able to build wealth using this method.
As Graham says, buy from the pessimist and sell to the optimist. If you find it difficult to do this, we have already made a portfolio, Omni SuperStox, for you with a more sophisticated application of the Scientific Investing Framework of OmniScience Capital.
This article is written by Dr. Vikas V Gupta, CEO and Chief Investment Strategist at OmniScience Capital. He believes that “Chasing Alpha leads to Risks and Chasing Safety leads to Alpha”. Check out smallcases created by OmniScience Capital.
Disclaimer: Please note that any mention of company names is not a recommendation to buy, sell or hold. Equity investments are subject to market risks. Past performance is no guarantee of future performance. Global Investing has additional risks. One should invest based on the advice of their financial advisor based on their investment objectives, financial situation, and risk profile. OmniScience Capital, its management and employees, and its clients might be buying, selling, or holding the mentioned companies.
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