Many investors are surprised when they learn that focusing on the middle ground is a better way to make money than with high or low p/e stocks

The p/e ratio appears in the stock tables of just about every North American newspaper, and of course on the Internet, and is used by a great majority of investors. But although the p/e ratio seems easy to use, it’s much more complex than most investors realize.

And here are some questions for those investors to ask when looking at p/e’s:

Do low p/e stocks always outperform high p/e stocks? Should you sell a stock if its p/e ratio gets too high? If so, how do you decide what’s “too high”?

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Paradoxically, low p/e stocks are frequently among the most-risky ones you can buy

One of the biggest mistakes investors make is buying low p/e stocks, thinking that will ensure they’re getting a “bargain.” Sometimes that’s true, but sometimes a low p/e stock is a sign of danger. Here’s why.

When a profitable company is headed for a long period of losses, its share price usually drops far more quickly than its earnings. That’s because well-informed investors and insiders sell before the bad news becomes widely known.

So, before the “E” shrinks (i.e., before earnings disappear), the stock passes through a low p/e period. Buying at this point can be like getting on a train just before it derails.

Analyzing a company’s income statement is the key to determining the quality of its earnings.

Low p/e stocks or high p/e stocks? How Successful Investors can profit from p/e’s

Rather than focusing on low p/e stocks and avoiding high p/e stocks, you will generally make more money in the middle ground. That is, invest mainly in well-established stocks that have an appealing long-term growth record—and a moderate p/e. These are the stocks we favour in our Successful Investor approach. In our experience, they provide above-average returns in the long run. That’s because they provide nice gains in rising markets, and they also tend to hold up well when the market declines.

As for high-p/e stocks, we in general only recommend them as buys if we feel they have above-average investment appeal and deserve an above-average p/e.

Four tips for comparing low p/e stocks and high p/e stocks

• Most investment measures fall on a spectrum that ranges from suspiciously cheap to extraordinarily expensive.
• It’s a mistake to focus on stocks in the “suspiciously cheap” end of the p/e spectrum. It’s also a mistake to reject stocks of out hand just because their high p/e’s make them seem too expensive.
• Most investors, most of the time, will find their best opportunities in the middle of the spectrum, far from the extremes of suspiciously cheap to extraordinarily expensive.
• To get any real value out of any investment measure, p/e’s included, you need to look at them in the context of everything else that’s going on, in the market and in individual stocks.

Bonus Tip: Financial advisors and the “contrary opinion” approach

Today, we’re hearing about a number of advisors who are finding odd reasons to advise investors to sell or stay out of the market.

For instance, some advisors believe the great mass of investors are naïve and just don’t understand the market’s risks. These people believe the proverbial “little guy” is now buying against all reason, ignoring the economic negatives. So they feel the smart folks should sell, and only go back in the market when the outlook improves. This reflects a so-called “contrary-opinion” approach.

The contrary-opinion idea is based on a tiny grain of truth. One study calculated the correlation co-efficient over the past 20 years between the results of a yearly investor poll and the rise or fall of the Standard & Poor’s 500 index one year later.

If the correlation co-efficient was plus 1.0, it would mean that investor optimism and the stock market regularly rise and fall in tandem. This is the opposite of the contrary-opinion view. If the figure was minus 1.0, it would mean the study found the two move inversely—when one goes up, the other goes down. This would confirm the contrary-opinion theory.

If the study found a zero calculation, it would mean there is no correlation between investor optimism and the level of the stock market, and the two move independently of each other. In fact, the study found a correlation co-efficient for the 20 years of minus 0.17—much closer to zero than to plus 1.0.

In our experience, the contrary-opinion theory really only tells you much at market extremes. When the market plunges, investors are panicking and pessimism is rampant, that’s often a good time to buy. When prices are soaring, investors are giddy and it seems everyone you meet wants to talk about their stock market successes, that’s often a good time to sell. But these extremes are only obvious in hindsight. Investor sentiment and the stock market never get so high that they can’t go higher, nor so low that they can’t fall even more.

That’s why we see contrary-opinion as a little like p/e ratios—one of the multitude of things that Successful Investors consider when forming investment opinions.

Differing company accounting practices can lead to discrepancies in comparing stocks. Do you consider this while comparing p/e’s?

How much value to you place in p/e’s when you evaluate a stock?