In his book, How to Make Money in Stocks, William J. O’Neil argues that, “What seems too high and risky to the majority generally goes higher, and what seems low and cheap generally goes lower.” Is this a basis for profitable investing?
What makes a stock cheap or expensive? The most commonly used metric is the stock price of the target company for each $1.00 of earnings of the same company. That is, how much do you have to pay for each dollar of earnings? For example, three years ago, June 2016, the median stock price to one dollar of earnings, referred to as the Price/Earnings (P/E) ratio of the Dow 30 stocks was 18.1. That is, of the 27 Dow 30 stocks with valid earnings data in June 2016, the mid-point P/E ratio was UnitedHealth Group (UNH) with a P/E of 18.1.
Of the 13 companies more pricey than UNH, the most expensive was Verizon (VZ) with a price of $74.80 for every dollar of earnings. Of the 13 low cost companies, the least costly was JP Morgan (JPM) with a price of $14.60 per dollar of earnings.
But more importantly, how did each group perform in terms of the growth in price adjusted for dividends and stock splits? The accompanying table summarizes the performance for the last three years.
Two potential limitations of applying the analysis in table 1 to the broader U.S. stock markets. First, it is based on the Dow 30 stocks and the time period June 2016 to June 2019. However, data in Table 1 support the hypothesis that buying high and selling higher works better the shorter the time period. For longer, time periods, returns are higher for a buy low, and sell high strategy.