How to earn High Returns at Low Risk – Invest in Low PE Stocks

Investing in low price to earnings ratio (PE ratio) stocks has been around for about a century now. Its most ardent proponent, Benjamin Graham, has been one of the best stock investors of all times. He introduced a low PE ratio as one of the founding principles of value investing school. Graham’s major focus was to find out stocks, which were selling at a discount to their fair value. Such stocks present an opportunity to earn good returns while exposing the investor to low risk. He pointed out that these stocks can be easily found among stocks trading at a low PE ratio.

I was introduced to value investing and low PE stocks in 2008 when I read The Intelligent Investor by Benjamin Graham. I was highly impressed with Graham’s teachings & the value investing approach to stock investing. I found a perfect match between my investing aspirations and the principles of value investing. Thereafter, I left technical analysis and started following the fundamental analysis of stock investing.

Graham stressed on two vital principles for stock investors:

1. never overpay for any stock and
2. always keep a sufficient margin of safety while investing.

Upon years of stock analysis, I realized that the stocks, which satisfy Graham’s two principles, offer great return potential to an investor along with a high margin of safety. I have been investing in low PE stocks for more than a decade and it has served me well. It has helped me get pleasant returns from my portfolio.

Low PE stocks have always been referred to as risky investments by investors and stock proponents. Their arguments are not entirely wrong because low PE ratio is the area, which in addition to exciting investment opportunities, also contains the entire junkyard of the stock market.

Low PE ratio segment contains stocks, which are excellent businesses, growing at a fast pace with good business advantage & efficient management but currently in the nascent stage of their life cycle. Such stocks are yet to be recognized by general market participants and therefore, available at low valuations. On the contrary, this segment also contains stocks that have poor business fundamentals, running in losses, have questionable management that has eroded the wealth of shareholders over the years.

Therefore, the key to benefiting from low PE ratio stocks is to separate the wheat from the chaff. Selecting good stocks in this segment is a treasure hunt where hard work spent is well rewarded.

Graham believed that the prevalent notion of undertaking higher risk being necessary for expecting higher returns is a myth. He believed that the expectation of returns depends upon the intelligent effort put in by the investors. Graham said that market inefficiencies provide many opportunities of earning high returns by taking minimal risk provided the investors do the hard work of identifying them.

I believe that low PE stocks if selected after detailed analysis offer a unique opportunity of high return with low risk for the investor.

Examples of investments in two companies: Mayur Uniquoters Ltd. & Vinati Organics Ltd.(Vinati), which I bought in January 2012 and February 2012 at low PE ratio, after my due diligence, are very pertinent here:

Both Mayur Uniquoters and Vinati have provided excellent returns in my portfolio till date (Jan 16, 2015):

Based on my experience in stock markets since 2006, I have realized that low PE stocks, if selected after proper due diligence, offer the much-aspired combination of high returns with low risk. Let us see which features of low PE stocks make it possible:

Low PE stocks offer High Margin of Safety

Graham introduced a novel concept of Margin of Safety (MoS) in his book The Intelligent Investor. The margin of safety compared the earnings yield (EY) of a stock with the yield on government securities (GSec) or treasury securities. Earnings Yield (EY) is calculated as the ratio of earnings per share (EPS) and the current market price (CMP) of any share.

EY=EPS/CMP

The margin of Safety implies that the higher the earnings yield from government securities (GSec)/Treasury Yield, the safer is the stock investment.

To illustrate, suppose the investor buys a stock of company ABC Ltd at INR 100. If EPS of ABC Ltd is INR 10 then PE ratio would be 10 and the EY would be 1/10 or 10%. As current GSec yield is about 8%, ABC Ltd is a good investment. Suppose, after the investor buys ABC stock, its price falls and becomes INR 50, then the PE ratio would become 5 and the EY would become 1/5 i.e. 20%. EY of 20% would attract more and more investors to shift money from bonds markets and use it to buy ABC stock as it yields 20% against GSec yield of 8%. This new demand for ABC stock will increase its stock price and limit the downfall. This forms the basis of Graham’s assumption that the higher the difference between EY and GSec/Treasury yield, higher is the Margin of Safety.

Mayur Uniquoters at PE ratio of 6.6, offered EY of 15%, which is significantly higher than prevalent GSec yield of about 8%. Similarly, Vinati at PE ratio of 7.7, offered EY of 13%, which again is higher than the GSec yield. Thus, both Mayur Uniquoters and Vinati offered very good margin of safety in terms of Benjamin Graham and thus, represented low-risk investment opportunities.

Low PE Stocks offer High Return Potential

Most of the low PE stocks are small to mid-cap companies that are yet to be recognized by market participants or large-cap companies that are facing trouble and hence, currently, out of favour.

I prefer finding small to mid-cap companies, which show good financial, business, valuation and management strengths and invest in them with a long-term horizon. Such companies have proved to be excellent investments because of many subsequent underlying developments, which work in the investor’s favour:

Increased Coverage by Market Participants: 

If the selected low PE companies have a sustainable business advantage and continue growing at a good pace, then these companies are recognized by other market participants like equity research firms. Stockbrokers put these companies in their coverage list and publish regular reports about them. Such coverage brings these companies in the notice of other investors and increases the demand for their shares.

Sustained good business performance of Mayur Uniquoters and Vinati Organics has been recognized by research firms. Both these companies are currently being tracked by research firms like HDFC Securities & Edelweiss among many others. Because of the reports of these firms, many investors now know about the good performance of these companies, which has led to increased demand for their shares.

Improvement of Credit Rating: 

Sustained good business performance by these companies is also recognized by credit rating agencies. Rating agencies upgrade the credit rating of their debt facilities, which leads to a lower cost of debt for these companies, which is good for their future business prospects. Apart from a lower cost of debt, improving credit ratings bring these companies under the radar of many institutional investors who start to look at these companies as potential investment opportunities.

 During 2012-2015, Mayur Uniquoters was upgraded twice by CARE Ltd from A to A+ (October 2012) and from A+ to AA- (October 2014). Similarly, Vinati Organics was upgraded by CARE Ltd from A- to A (August 2014). These rating upgrades have improved the business prospects for Mayur Uniquoters and Vinati Organics.

Increase in Stake by Institutional Investors: 

Increased coverage by research firms, upgrade of ratings by credit rating agencies are some of the factors that bring good performing low PE companies in the notice of institutional investors. Once convinced of the business advantage of such companies, some institutional investors buy shares of these companies. Once such a company features in the portfolio of one institutional investor, other big investors who track peer portfolios get enticed to these companies and a cycle of investments starts.

During 2012-2015, both Mayur Uniquoters and Vinati Organics witnessed increasing investments by institutional investors:

Expansion of PE Ratio:

Potential of PE expansion is the single most important factor that leads to good returns for investors in low PE stocks. Increased demand for their shares by institutional investors & other market participants increases the premium on their shares and thereby the PE ratio rises.

During 2012-2015, both Mayur Uniquoters and Vinati Organics witnessed a significant increase in their PE ratios. PE ratio of Mayur Uniquoters increased from 6.6 to 33.7 and Vinati Organics from 7.7 to 24.5.

PE expansion is the major factor resulting in significant returns for an investor, apart from continued earnings growth. The below table shows that out of the annualized returns (IRR) provided by Mayur Uniquoters and Vinati Organics, a huge portion is because of PE ratio expansion:

We can see that out of annualized returns (IRR) of 136% generated by Mayur Uniquoters, earnings growth contributed only 32% and PE expansion contributed a whopping 104%. Similarly, for Vinati Organics, out of annualized return (IRR) of 143%, earnings growth contributed only 27% and PE expansion contributed 116%.

For Mayur Uniquoters, PE expansion accounted for 75% (102/136) of total returns and for Vinati Organics, PE expansion accounted for 81% (116/143) of total returns. Therefore, we can see that more than 75% of the total returns generated by Mayur Uniquoters and Vinati Organics are due to PE expansion.

Limitation on Returns while buying High PE Stocks:

Capital gains from a stock investment come from the growth of the company’s earnings and expansion of PE ratio. If a company’s growth potential is well recognized in the stock market, then its share price already factors in future growth potential. Shares of such companies usually trade at high PE ratios (>20) and the scope of future PE expansion is minimal. If an investor, buys shares of such companies then the contribution from future PE expansion is very low or nil. On the contrary, if high PE ratio companies, due to any reason, are not able to match market’s expectation of growth rate, then their PE ratio decreases and the investor can suffer a greater risk of capital loss.

If an investor had invested in Mayur Uniquoters and Vinati Organics at PE ratio of 25-30, then she would have potentially, got the returns of 32% and 27% respectively, solely due to their earnings growth. She would have missed the contribution of PE expansion on her investments, which is a very significant component of overall return.

Moreover, according to Benjamin Graham, the stocks with high PE ratio have low earnings yield (EY), which is well below the GSec/Treasury Yield. Therefore, stocks with high PE ratio offer low Margin of Safety and in turn entail higher risk than stocks with low PE ratio.

Therefore, I believe that stocks with high PE ratio offer limited return with high risk. Stocks of companies with low PE ratio offer the potential of high returns at low risk.

• Read 3 Principles to Decide the Investable PE Ratio of a Stock for Value Investors
• Also Read: Hidden Risks of Investing in High PE Stocks

However, a low PE ratio should not be the only criteria for selecting a stock for buying. Investors should focus on finding a conservatively financed, fast-growing company available at low PE ratio. The company should be a fundamentally strong company, which is yet to be recognized by the market. It has to meet all the criteria of the checklist for buying a stock.

(Read: Final Checklist for Buying a Stock)

A Final Word of Caution

An investor has to tread very carefully while investing in low PE stocks. As mentioned earlier, this is the segment where the entire junk of stock market is present. If an investor were too enamoured by low PE as the only criteria, she may end up owning poor quality stocks that might lead to losing her entire capital.

However, if the investor applies all the criteria of financial, business & industry, management and valuation analysis on the shortlisted stocks and then selects the stock to buy, she would be able to find the winners. It is a treasure hunt!

Additionally, the investor must not forget the equally important process of regular monitoring of stocks in her portfolio.

(Read: How to Monitor Stocks in Your Portfolio)

The sequence of events of recognition by other market participants and PE expansion might not happen immediately after an investor buys a low PE stock. It might take years before the market responds to the good business performance of stocks. However, until then, an investor should show patience and enjoy the fruits of dividends.

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Your Turn:

I would be happy to know about your criteria for stock selection. Do you prefer investing in low PE or high PE stocks? What is your learning by investing in such stocks? You may provide your inputs in the comments below or contact me here.

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 P.S. I have used the data of different stocks from www.bseindia.com and annual report of Mayur Uniquoters Ltd and Vinati Organics Ltd in this article.

Disclaimer

Registration status with SEBI:

I am registered with SEBI as a research analyst under SEBI (Research Analyst) Regulations, 2014.

Details of financial interest in the Subject Company:

At the date of writing this article, I do not own stocks of the companies mentioned above except Vinati Organics Ltd in my portfolio.