- PE ratios in the S&P 500 are all over the place; 7 of the top 20 stocks have PE ratios below 15, 7 from 20 to 30, and 5 above 30.
- You can buy stable, growing businesses at PE ratios below 15, so why would you stick to passive investing and buying riskier stocks at PE ratios of above 20?
- Maybe you think passive investing meets the definition of “boring,” something investors such as Buffett advocated. I don’t wish you the excitement of watching your portfolio fall from a PE ratio of 24 to a PE ratio of 15. Therefore, think about rebalancing now before it’s too late.
Yesterday we discussed how the economy is doing well but that the market isn’t responding accordingly. This is because of the high valuations where only exceptional catalysts can push the market higher while any kind of negative news easily brings it into negative territory. However, by analyzing recent earnings, we have found large discrepancies among sectors in revenue and earnings growth. We understand this is normal for a well-diversified portfolio, but do we have to own more of the overvalued stocks and less of the undervalued stocks as a market capitalization weighted index fund does?
Given that the S&P 500 hasn’t moved much in the last two years, we’d argue that the bull market fueled by low interest rates and quantitative easing—where the majority of stock prices grew—is over. Rebalancing now to a more active approach is what can protect your portfolio better in the case of a bear market, and give you better yields in the long term.
Figure 1: S&P 500 in the last 10 years. Source: Yahoo Finance.
Why You Should Rebalance From Passive Investing
Divergences in revenue and earnings growth are reflected into valuations, but not very accurately. This mis-pricing is a great opportunity for investors who want to lower their risk exposure for similar, if not better, returns.
A look at the top 20 S&P 500 holdings and their respective PE ratios proves the point. As the top 20 companies make 28.92% of the total S&P 500 index, we can look at them as a good representation of the whole index.
Figure 2: Top S&P 500 positions – PE below 20 (green), between 20 and 30 (yellow), above 30 (red). Source: iShares.
In the top 20, there are seven companies with PE ratios below 20. To be more precise, the PE ratios are below 15 for an average of 13.27. Seven companies have PE ratios between 20 and 30 with an average of 25.16. And five companies have PE ratios above 30 for an average of 63.78.
As in the long-term stock returns are perfectly correlated to underlying earnings and most passive index investors are in it for the long term, we’d argue that the same or better return on investment can be reached by buying stocks with better earnings. However, by eliminating stocks with high valuations you will not own Amazon (NASDAQ: AMZN) or Facebook (NASDAQ: FB). While you renounce an immense potential growth opportunity, you also keep high levels of volatility away from your portfolio. Also by selling the S&P 500 now, you sell such stocks at their historical peaks.
Figure 3: AMZN and FB in the last 3 years. Source: Yahoo Finance.
The above charts look great, but they are not so great for passive investors, who by owning the S&P 500, have been holding and buying an increasing percentage of those stocks as their stock prices have surged. FB was included in the S&P 500 on December 20, 2015 when its price was around $55 with a market capitalization of around $135 billion. FB now has a market cap of $348 billion and a much larger weight in the S&P 500.
In order to avoid buying more of the overvalued companies and less of the cheap ones, you can simply apply an active strategy to the S&P 500. The large number of low PE ratio companies in various sectors and different growth paths gives you the opportunity to build a portfolio with similar average growth prospects to the S&P 500, with higher current earnings and dividends and with less downside risk.
You can also diversify your portfolio by owning only one stock. We are talking about Berkshire Hathaway (NYSE: BRK.A, BRK.B). With its large portfolio of subsidiaries and holdings spread around various industry sectors, you get a well-diversified portfolio for almost half the price of the current S&P 500 as the PE ratio for the S&P 500 is 23.99, and it’s at 13.82 for Berkshire.
Figure 4: BRK’s portfolio. Source: T2.
Berkshire is a complicated company and a much deeper analysis is necessary before making an investment, but it is a great example of how rational diversification is better than passive market diversification. In the above BRK portfolio, no company has been bought where the business model still needs validation to come in the form of future earnings, expected growth or traffic monetization. All have been bought at a point where the business was stable, making money and expected to grow at the rate of the economy aided by some additional leverage in the form of normal corporate debt. In lack of better words, it is a bunch of boring, cheap investments.
Going back to figure 2, we can see that many boring investments in the S&P 500 are cheap when compared to more exciting ones like FB or AMZN. Although the exciting investments almost always come with greater volatility. If high volatility is stressful for you as an investor, you should also switch to less exciting, money making, boring, low PE, good old fashion business stocks.
By looking at stocks outside of the S&P 500, real gems can be found that have both a validated business model at low PE ratios and huge growth opportunities. Other strategies, like selling put options and specialized trading, can give you additional returns.