Investing Using PE Mean Reversion

Every fund manager and investor wishes to earn more than the BSE Sensex return, which in technical parlance is referred to as generating alpha. There are many investing techniques using which investors try to earn excess return – one such technique is ‘mean reversion’. This technique of investing believes that every stock reverts to its long-term mean PE ratio and by selecting stocks which are trading below their long-term average PE ratio we can maximise our returns. The PE multiple (price to earnings ratio) has been one of the most popular approaches to equity valuation. The PE ratio of a company is calculated by dividing the current market price of the share with its earnings per share (EPS). 

In order to do so we need to observe the historical PE ratio and invest in shares which are trading below their long-term average PE. If the company is good on financial parameters and the management of the company is sound, the PE ratio will increase and definitely cross its long-term PE ratio, thereby generating higher returns for the investor. Many a times, we hear investors talking about Nifty and Sensex touching their all-time highs which is very similar to someone comparing the housing price of today with the price of a house in 2001 and realising that to buy a house as of now is much more expensive. 

These investors forget that prices should never be compared in absolute terms and if we are making this mistake then we will never be able to invest. Under normal circumstances, the price of the house today will never come down to the value that existed in 2001. Investors should not be concerned with the Sensex or Nifty index levels but should be more alert to the PE level of the index. Thus, the PE ratio indicates a number which is a unit of a company earnings’ that an investor is willing to pay. Hence, it could be used to compare and see if the stock is cheap or expensive as against other stocks in the same industry. 

Or it can be used in relative terms to see if the stock is cheap or expensive as compared to the values it has historically traded. Just as we can calculate the PE of a share, we can calculate the PE of an index and we can use the index PE to determine if the capitalisation in excess of `1,000 crore as this ensures liquidity and tradability of the selected stocks. Furthermore, the selected companies have ROE greater than 10 per cent, ensuring the generation of decent profits for the shareholder. 

For every year, starting 2011, we constructed a portfolio of those stocks where the PE of the current year is lower than the PE of the preceding 10 years. In simple terms, a company will qualify if the PE in 2011 is lower than the average PE from 2002-2010 and the company has maintained ROE of 10 per cent in all the years. The portfolio thus formed will be liquidated after one year and using similar logic we have constructed another portfolio every year till 2021. The results obtained from this study are enumerated in the table below. 

Indian equity market is relatively cheap or expensive. From 2001-2022 the average PE of the BSE Sensex was 18.55 and today it is around 23. We can therefore conclude that it is relatively overvalued. An investor who believes in PE mean reversion would like to wait before the index values go below 18.55. The PE mean reversion theory suggests that sooner or later the PE will return to its long-term average. 

The Study

In this article we are trying to back-test and check our hypothesis if investing in stocks using the mean reversion theory can generate higher returns. This study consists of the top 1,000 companies sorted on the basis of market capitalisation in 2022. From this set of companies we have selected only non-banking companies with a market As seen from the data, the portfolio invested with shares trading at lower PE generated double the Sensex benchmark returns. 

While the Sensex returns have outperformed the portfolio return in certain years, the portfolio returns outperformed the Sensex returns to a much greater extent. If an investor invests in shares trading at PE lower than the average PE ratio, he would be able to earn cumulative returns of 16 per cent as against the BSE benchmark of 8 per cent returns. Hence, the theory of PE mean reversion holds as long as the company is financially sound. Retail investors who passively manage their portfolios should buy shares of companies with sufficient profitability, tradability and liquidity. These should be trading at a PE ratio lower than their longer-term PE to generate better returns. 

Prof. Ruzbeh Bodhanwala, Prof. Shernaz Bodhanwala, Ms. Valki Korra, FLAME University, Pune