The Performance of SPI Stocks in Relation to their P/E Ratios
Creators: name: Thalmann, Gian-Luca
Publisher: name: ZHAW Zürcher Hochschule für Angewandte Wissenschaften
Year: 2016
Subjects: 332: Finanzwirtschaft

description: The efficient market hypothesis (EMH) asserts that stock markets are price efficient, meaning that in an efficient capital market, security prices fully reflect available information and no investor can make abnormal profit out of it. While there is substantial empirical evidence supporting the EMH, many still question its validity. Proponents of the price-earnings (P/E) ratio hypothesis claim that low P/E stocks tend to outperform high P/E stocks. Moreover, the returns of low P/E stocks tend to be larger than warranted by their underlying risks. This conclusion is difficult to reconcile with the efficient market hypothesis and is therefore often referred to as efficient market anomaly. The goal of this paper is to determine whether low P/E ratio stocks outperform high P/E ratio stocks (which is formally called the price/earnings ratio hypothesis) in the Swiss stock market by considering data spanning from 2005 to 2015. Moreover, this thesis intends to prove that low P/E portfolios are able to generate excess returns compared to the market and to investigate the extent to which an abnormal return can be generated by investing in the portfolio with the lowest price/earnings ratio (in terms of the CAPM). For any given year under consideration, four portfolios consisting of 25 stocks with similar P/E ratios were formed. Each of these portfolios can be seen as a mutual fund having a strategy of purchasing securities in the given P/E quartile on January 1, holding the portfolio for one year, and then liquidating and reinvesting the proceeds in the same quartile portfolio (on January 1) in the following year. The research is split into two parts: In a first step, the returns are compared on a absolute performance basis, whereas the second part adjusts the returns to their corresponding risks and subsequently splits the results into a pre- and post-financial crisis section. During the 11-year period under investigation (2005–2015) the low P/E portfolios earned higher average absolute and risk-adjusted rates of return (considering total- and systematic risk) than the high P/E portfolios. Furthermore, low P/E portfolios were able to generate significant excess returns compared to the market. While the price/earnings ratio hypothesis is not fully confirmed by the pre-financial crisis section, the post-financial crisis section does underline the higher absolute and risk-adjusted returns of the low P/E portfolios. Nonetheless, the low P/E portfolios managed to outperform the market significantly in both sections. In conclusion, the “P/E effect” seemed to exist for stocks within the Swiss Performance Index during the period 2005-2015, and therefore the price/earnings ratio hypothesis may be considered as validated. Furthermore, the findings of this paper suggest that P/E ratio information was not “fully reflected” in security prices as postulated by the efficient market hypothesis. Further research could apply other risk-based models, such as multifactor asset pricing models, to verify if the derivations from CAPM are truly due to mispriced securities or simply a result of a failed risk adjustment procedure of CAPM.