Using PE to improve your return on investment

Stair spiral

I recently read an article which stated that the best indicator for future performance is the Price to Earnings (PE) ratio of a market. I tried finding it again but to no avail. However, the gist of it is that when the PE ratio is low, the return on investment in the near future is increased. When the PE ratio is low, it means that the shares are selling at a discount to earnings. Similarly, when the PE ratio of a market is high, the shares are selling at a premium.

Analysing shares based on PE ratio

This made me wonder whether it might be worth investing only in a market when the PE ratio is low to increase your return on investment. I decided to test this theory. It also does not make sense to only invest when the PE ratio of the Johannesburg Stock Exchange (JSE) is low. So, the logical thing to do is to invest in different markets, but choose only the ones that are trading at a discount. As a start, I decided to define markets that are trading at a discount, as two PE points below the 20-year average.

Simulating this ended up being much easier than I anticipated. This was because the JSE and New York Stock Exchange (NYSE) is indirectly proportional. So when the JSE is expensive, the NYSE is cheap and vice versa. Below is a table of the JSE and NYSE’s PE ratios over the last 20 years. Then we compared average ratios for the same periods. Negative variance indicates a cheap market while positive variance shows an expensive market. These are also highlighted, with green being cheap and red being expensive.

There are only two years when the two markets were both cheap, namely 2011 and 2012. It is also evident that the NYSE is more expensive than the JSE on average. This is based on the average PE ratios of the two markets. This shows that the NYSE is more popular. Investors will rather invest in the expensive market as they have more faith in it.

Baseline investment

So as a baseline, let us consider a 20-year investment split 50/50 between the JSE and the NYSE. What would an investment of R20 000 per year in today’s money have made you if you invested in this way? This can be seen below.

Your return on investment on the NYSE would have been slightly better over this 20-year period, yielding R361 800. The performance used for this calculation is based on the average growth for the two markets per year. At the end of this period, your total investments are worth R693 700.

PE optimised investment

So now, based on the average PE ratio we choose only one market to invest in at a time. Additionally, we then invest in the cheapest market of the two. This allows the development of a PE optimised investment model. Based on this model, we would have invested in the JSE from 1998 to 2003 and from 2008 to 2009. Similarly, we would have invested in the NYSE from 2004 to 2007 and from 2010 to 2018. If we invested the same amount as during the baseline example, the results can be seen below.

Again, the return on investment was better on the NYSE, even though we only started investing in this market during 2004. However, this time we have saved a total amount of R756 100, which is 9% more than when using our baseline strategy. This is a simple way to increase the performance of your Exchange Traded Fund (ETF) portfolio. It does not in any way change the funds that you ultimately end up investing in. It only changes the time when you enter each fund. 

This is an investment strategy that I will be implementing. I can even do some cash investments (or store the money in my home loan) when none of the markets is cheap, and then transfer it to the first market that becomes under-priced.

Be safe out there,

Hendrik

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End note

Thank you for reading to the end. Apparently, the average person spends 8 seconds on a page, so you are special. If you have any suggestions, feel free to drop me a mail on the contact page. If I missed anything or you have questions, don’t hesitate to comment below. I might even notice it and respond.

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