Wall Street loves to complicate simple ideas. The efficient market hypothesis crowd will tell you that stocks trading at 5 times earnings must be broken, damaged goods that deserve their basement valuations. The momentum traders avoid them entirely, chasing whatever is moving up and to the right on their screens. Meanwhile, the academics buried in their ivory towers have been quietly documenting something rather extraordinary for nearly 50 years.
Sanjoy Basu published his seminal study on low price to earnings ratios back in 1977. His findings were straightforward and powerful. Stocks in the lowest PE quintile earned substantially higher risk-adjusted returns than high PE stocks. A modern replication covering 1989 through 2014 found that the low PE portfolio earned 3.46% monthly compared to just 0.88% monthly for the high PE portfolio. That translates to approximately 50% versus 11% annualized returns. The difference is not trivial.
