Buy Low, Sell High – How to use market’s P/E ratio to profit from this strategy

In our previous post Do Indian stock markets bounce off PE levels of 12 & 24?, we found that there was some degree of truth in this statement. Indian markets do seem to bounce off PE levels of 12 and 24. And we also found that an average investor can use this information to make money (read more than 25% pa) by buying at low PEs and selling at high PEs (click hereto see summarized results). As already mentioned towards the end of that post, we decided to check market returns for other PE combinations as well. The reason for choosing multiple bands will be given later. We eventually selected 5 different sets of PEs –
  • Buy at PE12 & Sell at PE24
  • Buy at PE13 & Sell at PE23
  • Buy at PE14 & Sell at PE22
  • Buy at PE15 & Sell at PE21
  • Buy at PE16 & Sell at PE20

Before we give the results, we would like to share the methodology we used for our calculations. In first case, starting with Rs 10,000, we invested in index when it first touched PE12 and sold out completely when it first touched PE24. Now we waited for markets to once again correct to levels of PE12 and invested all proceeds from our previous sale. Again we sold off completely at PE24. The process was repeated as long as possible. And this process was repeated for all the above mentioned PE combinations. The results are as follows –

As you can see, the returns are somewhat above average. 🙂 The lower you buy and higher you sell, better are the returns. We also did not feel that it was a good idea to keep PE bands smaller than 4 (PE16-PE20 range). It would have only resulted in an increase in number of buy-sell transactions (and reduction in returns).

It should also be noted that though highest returns are achieved in band 12-24, the markets are generally not available in those ranges for long periods. For example, markets spent less than 5% of the time below PE levels of 13 in last 13 years. An investor may not get ample opportunity to invest at such low valuations. Also seen from graph below, markets do not spend too much time in the extreme areas. They correct themselves. Indian markets spend most of their time in PEs ranging from 17-21. This is the reason we decided to use PE bands which provide an investor with more opportunities to enter and exit the markets.

Percentage of time spent by Indian markets at various PE levels – Last 13 years
We had also planned to assign lesser weightage to returns earned in 2003-2008 bull phase as we believed that same irrational momentum may not be repeated in future. But we decided otherwise. The reason is that whatever weight (less than 1) we would have attached to this period, it would have been based on assumptions, which in turn would have been biased and subjective. It would have resulted in reduction of returns to more normal levels and would have also increased the mathematical complexities of these results. You can very well reduce these results by 50% and still get market equaling returns. But purpose of this post is not to give the exact returns upto two decimal places but to prove that buying at lower PEs and selling at higher PEs is a (once again) proven approach of earning good (if not market beating) returns.

Caution – The results may look amazing but beware that these are theoretical results. They may differ significantly from real world results.

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Do Indian stock markets bounce off PE levels of 12 & 24?

Confession time… We are obsessed with P/E Ratios. Now this statement itself would shoo away a lot of intelligent readers. As a reader, you should understand that we have a bias for simple tools/ratios like PEs, PBVs & Dividend Yields. But if you are still reading this sentence, we assume that you too are interested in simplicities of stock investing.

In a post done in May 2012 about PE, PBV & DY Analysis of Indian stock markets and how you can benefit from them, we found that investing in markets trading at low PE multiples resulted in increased probability of higher than average returns (Click hereto see how).

Just to re-check this conclusion, we decided to re-evaluate Market Movement in relation to PE levels of 12 and 24. We plotted the data on a chart (below) and were pleasantly surprised!

Click to enlarge
Though above chart looks like a screen from trader’s terminal, it’s actually a rawdisplay of benefits of fundamental law – Buy low (PE). Sell high (PE).

The blue line is actual index’s (Nifty50) movement during last 13 years

The red line is theoretical index levels at a PE = 24

The green line is theoretical index levels at a PE = 12

Assumption – We believe that a growing economy like India is undervalued at PE=12 and overvalued at PE=24. (You may differ on this).

As we can see, whenever the actual index touched the green line (PE12), shown by green bubbles, it bounced off considerably (Major Gains were recorded).

Similarly, when the index touched the red line (PE24), marked by red bubbles, it generally resulted in actual index falling considerably (Major losses were recorded).

So would it be safe to say that index bounces off PE levels of 12 and 24?

The author discussed this conclusion with a close friend and was well advised to look for other combinations of high and low PEs as well. We reserve the analysis of other PE combinations for our next post. In this post, we would do some further calculations using just two combinations PE12_&_PE24 & its more conservative subset PE14_&_PE22. Instead of just keeping our calculations limited to 12-24 zone, we chose 14-22 as an additional level. The reason is that levels of 12 & 24 are rarely achieved. They are very rare. So an investor may not get many opportunities to take his calls at these levels. In comparison, levels of 14 and 22 are more frequently seen in the markets, giving ample decision points to an investor. So here is what we found –

  • Starting with Rs 10,000, we invested in index when it first touched PE12 and sold out completely when it first touched PE24. Now we waited for markets to correct to levels of PE12 and invested all proceeds from our previous sale. Again we sold off completely at PE24. The process was repeated as long as possible.
  • We repeated similar exercise with PE levels of 14 and 22. We bought at PE14 and sold off at PE22. The resultant data is tabulated below.

  • As you can see, buying at PE12 and selling at PE24 resulted in just 6 transactions in last 13 years!! But returns have been a phenomenal 26% i.e. Initial amount of 10K has increased to 198K!!
  • Similarly, for PE14 & PE22, returns have been a great 18.8%
  • This type of investing may require a lot of patience as we only make 6 transactions in 13 years, i.e. one transaction every two years!!

We are pleasantly surprised by these results. Is it so easy to earn a 25% pa return for more than a decade?? Our answer would be a big NO. Reason, as already mentioned, is that we need to check the data for other PE combinations. We also need to assign a lesser weightage to the great Indian Bull Run of 2003-2008 (which may not be repeated in years to come). We also need to see if such trends are visible in other markets. But that part of discussion is reserved for another day. For the time being, enjoy the simplicity and so-called amazing returns of our proposed approach. 🙂

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