Stocks with Low PE Multiples Outperform those with High Multiples
One approach of stock selection is to look for companies with good growth prospects that have yet to be discovered by the stock market and thus are selling at relatively low earnings multiple. This approach is often described as GARP, growth at a reasonable price.
Earnings growth is so hard to forecast, it's far better to be in low-multiple stocks; if growth does materialize, both the earnings and the earnings multiple will likely increase, giving the investor a double benefit. Buying a high-multiple stock whose earnings growth fails to materialize subjects investors to a double whammy. Both the earnings and the multiple can fall. Therefore investors are warned repeatedly about the dangers of very high-multiple stocks that are currently fashionable.
There is some evidence that a portfolio of stocks with relatively low earnings multiples (as well as low multiples of cash flow and of sales) produces above-average rates of return even after adjustment for risk. This strategy was tested and had been confirmed by several researchers who showed that as the PE of a group of stocks increased, the return decreased.
This "PE effect," however, appears to vary over time - it is not dependable over every investment period. And even if it does persist on average over a long period of time, one can never be sure whether the excess returns are due to increased risk or to market abnormalities.
And low PEs are often justified. Companies on the verge of some financial disaster will frequently sell at very low multiples of reported earnings. The low multiples might reflect not value but a profound concern about the viability of the companies.