Buy low, sell high

Understanding the price-to-earnings (P/E) ratio can help you buy in the troughs and sell on the peaks, says Mike Deverell of Equilibrium Asset Management.

Back to basics

It’s the most basic principle in investing: 'buy low, sell high'.

Few people would disagree with this simple rule. Unfortunately, it isn’t that easy to apply as it’s impossible to say when markets are going to peak or bottom out. However, it is possible to implement a strategy that's a subtle variation on 'buy low, sell high'. Put simply, by buying when cheap and selling when expensive you will enhance your returns.

Sounds obvious, but how do you determine whether shares are cheap?

What is the P/E ratio?

The price/earnings (P/E) ratio is a great starting point. This is simply the price of a stock divided by its earnings per share. From this, a market average is calculated. If we compare this with other markets and historic averages, we can assess how cheap the market seems to be.

Research shows that if you buy equities when the P/E ratio is low, you are likely to end up with a much greater return than if you buy when P/E ratios are high. There is a strong correlation between the P/E ratio at the time of investment and the returns over the next 10 years.

This only really works at market level, where there is a wide enough spread to diversify away stock- or sector-specific risks. This helps to avoid 'value traps'.

Putting the theory to the test

It may seem intuitive, but it always surprises me how many investors ignore the simple principle of buying when 'cheap'. We recently carried out research to prove that returns can be enhanced using a P/E ratio strategy.

We back-tested a simple portfolio with a base allocation of 50% cash and 50% equities. We created a model to tell us whether we should over- or underweight equities at any time, and how to allocate between the different equity regions.

Our model said that if the P/E ratio was 50% below the long-term average, we should overweight equity by 50%. If it was 10% below average, we should overweight by 10%. If the P/E was 50% higher than average, we should underweight by 50% and so on.

This means equity could range from 25% to 75% of a portfolio. The portfolio was just changed once a year, in January. Just to be clear, this is not a system we blindly follow – just the model we tested in our research.

We then compared how the model portfolio would compare with a 'buy and hold' strategy, where we simply invested 50% in equity, held the rest in cash, and did not change it. We also compared our model against an annually rebalancing strategy, where each January we simply rebalanced back to 50/50.