Investments

Topics: Stock market, Financial markets / Pages: 31 (7587 words) / Published: Sep 9th, 2013
initial position
Active management strategies can be broadly grouped into those applying: marketing timing, industry selection, security selection. Given the fact that that the investor already holds a well-diversified portfolio, it was decided that the most appropriate strategy was to purchase growth stocks which was considered to be undervalued by the market and can be bought cheaply today but has significant earnings upside to be able to outperform the market in capital terms in the future (Chahine (2009)). Chahine (2009) suggested that these stock may be identified using a combination of PE ratios and forecast earnings growth. The details of the initial position are shown in Appendix 1.
Price-Earnings Ratio
The Price-to-Earnings ratio is a measure of the share price of a company relative to its earnings. As such, a high PE ratio means that an investor is paying more for each unit of income compared to a company with a lower PE ratio. This valuation method has proven to be a useful analytical tool to identify desirable stocks as Campbell and Shiller (1989) showed that the ratio is a good predictor of future stock prices (See Graph 1). This conclusion is supported by Bhargava and Malhotra (2006) who showed that an increase in PE ratio brings about a decline in yields and inflated stock prices.

Graph 1: Source: Anderson and Brooks (2006)
An empirical study conducted by Basu (1977) concluded that portfolios formed with low PE ratio stocks outperformed portfolios formed by high PE stocks. This is confirmed by Graph 2 which shows that in the period from 1975 to 2003, low PE stocks have significantly higher Sharpe ratios than high PE stocks.

Graph 2: Source: Anderson and Brooks (2006)

Anderson and Brooks (2006) suggest that the main advantage of PE ratios is that they easily comparable with an unlimited number of stocks. However, it is limited by virtue of the fact that it is not stable over time and is partly determined by outside forces such the



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