Expensive Stocks May Be Good

Financial media often tout claims and concerns about various fundamental or technical market conditions. One of the most frequently discussed metrics is the valuation indicator known as the price-to-earnings (P/E) ratio. Should investors be concerned about high P/E ratios? Can investors add value using P/E ratios?

We explore two strategies using the S&P 500 equity basket:

1. Based on high P/E ratios compared to peers

2. Based on high P/E ratios relative to own history

In the first strategy, “S&P 500 High P/E Ratio vs. Peers Strategy”, we choose one hundred stocks with the highest twelve-month trailing P/E ratios¹. We rebalance our list at the start of each quarter and form a portfolio using market cap weights.

In the second strategy, “S&P 500 High P/E Ratio vs. Own History Strategy”, we select stocks if their twelve-month trailing P/E ratios are in the top ten percentile of their five-year history. Similarly, we rebalance our list at the start of each quarter and form a portfolio using market cap weights.

Using OdinUltra, the no-code specialized financial AI platform developed by Big Data Federation Inc., investors can quickly evaluate the two strategies performance with data-driven analytics support and decide for themselves.

Below are the NAV curves of these strategies versus the benchmark (S&P 500 Total Return Index):

10 Year Performance (2013-09-07 – 2023-09-07)

Interestingly, both strategies outperform the S&P 500 Total Return Index over the last ten years in terms of the Sharpe ratio and cumulative returns:

Strategies	Sharpe Ratio	Cumulative Return	Compound Annual Growth Rate	Standard Deviation	Maximum Drawdown
S&P 500 High P/E Ratio vs Peers	0.76	312.30%	15.25%	20.32%	37.48%
S&P 500 High P/E Ratio vs Own History	0.96	425.20%	18.08%	18.30%	33.29%
S&P 500 Total Return Index	0.70	219.50%	12.34%	17.70%	33.79%

^{_{Source: Big Data Federation, Inc.}}

 

We can also examine performance details of these strategies for specific periods, for example, during the 2022 bear market.
 

1 Year Bear Market Performance (2022)

 

In the bear market scenario, the basket consisting of stocks with high P/E ratios vs. peers underperformed the S&P 500 Total Return Index. On the other hand, the basket consisting of stocks with high P/E ratio vs. own history significantly outperformed the S&P 500 Total Return Index.
 

Backtesting these strategies requires our calculation engine to accurately trace the historical S&P 500 composition and identify the correct list of 100 stocks with the highest P/E ratios historically. Data cleansing, modeling, and validation are essential parts of the process. Generating the above results can take anywhere from a few days to several weeks for a typical researcher, depending on data availability and technology infrastructure. With OdinUltra, these tasks can be accomplished in just a few minutes. Users can also download position and NAV details for further study from OdinUltra if so desired.
 

In conclusion, high P/E ratio stocks – often regarded as expensive and inherently riskier by financial media – may be good investments. Especially, if we measure a stocks P/E ratio against its own five-year history. With OdinUltra, users can quickly establish this via a detailed backtest. OdinUltra empowers asset managers to leverage their domain expertise throughout the entire investment process to explore, construct, verify, and deploy investment ideas and theses quickly.