- It is possible to build a well-diversified portfolio with low PE ratio stocks that have equal the growth of high PE ratio stocks.
- Short exposure and analysts’ targets indicate the market is in a very positive mode.
- The market is extremely short term focused. We’ll identify where to look to find the opportunities.
Using data from Quant, I’ve analyzed 1,626 U.S. stocks.
The factors I’ve analyzed are: market capitalization, current and forward PE ratios, price to book value, dividend yield, percentage short, analysts’ targets, 52-week highs and lows, and earnings per share growth.
The goal of this analysis is to provide insight into how to beat the market in 2017. I believe that research, thorough analysis, and patience will always outperform the market, especially because the distribution of the above-mentioned factors is all over the place as you will see below.
The Situation With Fundamentals
The average PE ratio of profitable stocks in 2016 is 26.09, but the distribution is pretty wide.
Figure 1: PE ratio distribution.
Theory would say that stocks with low PE ratios lack growth and stocks with high PE ratios are all about growth. In our case, the theory is mostly correct. A scatterplot shows it.
Figure 2: PE ratio and growth.
However, by eliminating the outliers and analyzing companies with PE ratios up to 30, there are significant insights to be had.
Figure 3: PE ratios up to 30 and growth.
The difference in growth is minimal and there are plenty of stocks with PE ratios below 15 that have equal the growth rates as stocks with PE ratios over 20. As in the long-term returns are perfectly correlated with earnings, I would prefer to own a well-diversified portfolio of stocks with PE ratios below 15 than the general market. The large quantity of stocks with lower PE ratios will make the diversification almost equal.
The distribution of dividend yields is wider with low PE ratio stocks, but again, the bulk of dividends is around 2% and evenly distributed between the 15 and 25 PE ratio range.
Figure 4: Dividend yields and PE ratios.
An important factor is that many stocks have payout ratios that are larger than their earnings. This is even more exacerbated by buybacks. So be careful to choose sustainable dividend and buyback yielders for your portfolio.
In the below figure, I have plotted the dividend yields and a 100% payout ratio for the respective stocks derived from their earnings.
Figure 5: Dividend yields and 100% payouts.
The sustainable dividend yielders will be easier to find with lower PE ratio stocks.
A look at what analysts have to say and the short exposure will give insight into market sentiment.
43% of the stocks are already above analysts’ price targets, while the average expected return stocks should have in order to reach analysts’ targets in aggregate is 3.8%.
Figure 6: Analysts’ price targets in relation to the current price (1 is where target and price are equal).
Analysts are usually very bullish, so a 3.8% discount on their price targets send a message that we could be close to the end of this bull market or in line for a sequence of upgrades.
The average short percentage is 5.45% with the large majority of stocks falling under that threshold.
Figure 7: Percentage short.
With a low short percentage and positive analysts’ targets, we can conclude that the general market is optimistic and that shorts don’t dare to bet against such a market. A positive market sentiment can easily lead to even higher than current market levels, but be aware that things can change very quickly.
The positive market sentiment has created a situation where the current price of the average stock is 55% higher than its 52-week low.
Figure 8: Current price return from 52-week low.
43% of analyzed stocks are up between 22.5% and 55.5% from their 52-week lows while 38% of them are up more than 55.5% from their 52-week lows. Only 17.5% of stocks are in the 22.5% range from their 52-week low.
For me, this is a clear indication of the myopic attitude the majority of investors have. Knowing that the market is myopic means we will continue to see high levels of volatility like that which is described above. Things may not look volatile when you look at the S&P 500 chart, but sectors are what are volatile. The aggregate of sectors makes the whole market look stable, but the situation underneath isn’t like that at all. The high sector volatility is something you should seize or at least understand the risks of.
In order to seize the opportunities, you have to understand the fundamentals of the sector and act when stock prices are far below the sector’s fundamental balance. A 2016 example is oil. In January 2016, the price of oil was below $30 per barrel.
Figure 9: Oil prices in the last 12 months. Source: Bloomberg.
As the majority of producers have production costs above the $30 level, it was a clear indication that the slump would be temporary and that there would be a rebound at some point in time. By finding a stock in the sector that won’t go bankrupt even if below cost oil prices persist, you are temporarily open to the downside but in the long term you should enjoy extremely positive returns. Even those who thought that oil couldn’t go below $40 and bought oil stocks when oil was at $40 are now in positive territory with their investments.
On the risk side, stocks can simply go down at the same speed or even faster than they went up, so be aware of that. I wouldn’t be surprised to see 80% of stocks close to their 52-week lows in 2017.
Stay tuned to Investiv Daily for up to the minute market and sector insights that will allow you to seize opportunities like those described above.