The percentage of S&P 500 stocks with P/E ratios within 20 percent of the index is at a twenty year high, and there is evidence that investors are relying too heavily on benchmarking and ETFs, argues BMO Chief Investment Strategist Brian G. Belski in a recent report. He thinks this gives more active investors an opportunity to incorporate fundamentals into their investment decisions and find deals that other people overlook.
S&P 500 stock performance
“The year-to-date performance of stocks with the lowest price multiples has dramatically outperformed the overall market,” writes Belski. “As QE has driven stock prices higher, investors have sought out more attractively priced areas of the market. The result has been a surge in price multiples for areas at the lower end of the valuation spectrum making market valuation more homogeneous.”
He says that value investments have been strong when EPS growth rates are differentiated, but that GARP (growth at a reasonable price) strategies are even better, and “average returns for GARP strategies not only exceed traditional value strategies, but are almost double the S&P 500’s return.” He also says that GARP has a better risk profile than other strategies during periods of differentiated EPS growth.
Belski on investment strategies
Belski isn’t criticizing the strategies that brought the market to this place. People who realized that sentiment was driving valuation and bought the companies with the lowest P/E ratios did well, but that strategy won’t work forever. “From our experience, coupled with common sense, these trends are not likely to continue,” he writes. Part of this has already been seen as the market has pulled back, with underperforming companies getting downward corrections. “Companies begin to perform at varying fundamental degrees the longer the market cycles, and their stock performance is typically rewarded or penalized accordingly,” he writes. “We would urge investors to avoid such singular investment approaches and instead incorporate other fundamental variables (such as earnings growth) when making decisions.”
Which is really the main point—realizing that companies with a low P/E ratio when this cycle began was the key to strong earnings before, and focusing on divergent EPS growth may be a key factor now, but investors who always look at the same few criteria would have missed both.