Many investors think that low P/E ratio stocks are better investments than high P/E stocks, but the reality is that either one can benefit your portfolio—or harm it

Successful investors treat P/Es as just one of many tools for conducting stock research, not a deciding factor. That’s because by themselves, P/Es can steer you wrong on individual stocks, and on the market in general. As well, there are lots of stocks out there that are cheap on a P/E basis. But many will remain cheap—their share prices won’t be rising any time soon.

When conducting stock research, you need to ask yourself if a P/E is telling you something by being unusually high or low. In the worst cases, buying low P/E ratio stocks and thinking that alone means you’re buying value, is often like boarding a train before it derails.

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Low P/E ratio stocks or high P/E ratio stocks? How Successful Investors can profit from P/Es

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.

Here are 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 makes 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/Es included, you need to look at them in the context of everything else that’s going on, in the market and in the individual stocks.

 High P/E ratio stocks can be profitable, too

You should expect to pay a high P/E for a stock with lots of growth potential. As well, you may want to buy shares of high-P/E firms that continue to report positive earnings even in bad times. This shows a high-quality company. This is true even if a company stays marginally profitable, or at least avoids eye-catching losses, in bad times.

You’ll also pay more for companies with a long-term upward earnings pattern. However, few are worth more than 20 to 25 times normal earnings in the middle part of an economic cycle. So, you should avoid loading your portfolio up with high-P/E stocks. Should the market go into a broad setback, these stocks are particularly vulnerable.

Bonus tip: Low P/E ratio stocks in the auto industry

Some Inner Circle members have asked about low P/E ratio stocks of automakers (for example, General Motors has a P/E of just 7.0). They wonder if these low P/Es represent a warning sign, or a buying opportunity.

Investors see carmakers as highly cyclical businesses, and rightly so. First, they’re vulnerable to economic shocks; second, they’re considered “elastic” in relation to GDP/economic growth, meaning they move up and down with GDP/growth. Generally, when the economy prospers, people buy more cars, so carmakers’ earnings shoot up. That pushes up the “E,” or denominator, of the P/E ratio. However, investors have a natural skepticism about the staying power of a cyclical rise in car sales and those for other vehicles. As a result, prices of auto stocks rise at a slower pace than automaker profits. In other words, while the “P” of the P/E ratio does rise, the E rises faster and so the P/E ratio falls.

When automakers’ earnings shrink, the E drops, and this pushes up the P/E ratio. Historically, in fact, some of the best times to buy automaker stocks has been when they have traded at high P/E ratios, not low ones. That’s because P/E ratios often soar near a cyclical low in the auto industry, when earnings (the E) have evaporated but are headed for a rebound. A rise in the price of the stock is likely to follow.

All in all, the low P/Es of automakers stem mostly from widespread investor fears that auto sales have reached a cyclical peak, or are close to doing so.

Overall, it’s best to buy stocks for the desirability of the businesses they own and operate, rather than as a way of betting on the economic outlook. That’s especially true with automaker stocks, because those companies are so sensitive to economic cycles, not to mention changing government programs, trade disruptions and so on.

It can be dangerous to only rely on P/E ratios. What other tools and analysis points do you use while investing?

When have you bought a stock with a high P/E ratio that turned out to be a good addition to your portfolio?