Are Expensive Shares Always Bad for Your Investing Health?

gold coins money grab“The Intelligent Investor”, a book written by Ben Graham in 1949, is often credited as the best book ever written for investing. Within it are suggestions for how defensive and enterprising investors can go about selecting shares.

For instance, in Chapter 14 of the book, Graham suggested that defensive investors should seek shares with the following criteria:

“[C]urrent price should not be more than 15 times average earnings of the past three years”.

A study on areas of market inefficiencies by Professor Aswath Damodaran of New York University suggests there is evidence that supports Graham’s view of choosing only shares with lower price/earnings (PE) ratios. From the study (summarized in the graph below), shares with lower PE ratios tend to provide excess returns when compared to shares with higher PEs. More specifically, for a time period from 1967 to 1988, shares with the lowest PEs returned about 16% on average annually while the highest PE shares floundered with a 6.6% average annual return.

In other words, the cheaper shares (ones with low PEs) outperformed the expensive shares (ones with high PEs).

However, is this suggestion – that of favouring low PE shares over high PE shares – always applicable in our search for the best shares in the Singapore market?

An alternate view

Take Dairy Farm International Holdings Ltd (SGX: D01) for instance. The quarterly average PE ratio for the pan-Asian retailer is shown below. When we observe the average PE levels for the company for the first five years – from 2004 to 2008 – it was above 15 for practically the entire period.

 Source: S&P Capital IQ

However, as shown in the price chart below, folks may be surprised to learn that the company’s share price rose by 144% from the end of 2008 to its closing price yesterday. During the same time, it also gave out a hefty total of S$1.26 in dividends (US$1.01).

The returns from Dairy Farm has beat the returns from the SPDR STI ETF (SGX: ES3), a proxy for the Straits Times Index (SGX: ^STI), which only managed a capital gain of less than 11% for the same duration.

Source: Google Finance

So, what actually made the returns of the past five plus years possible was not the fact that Dairy Farm’s shares had started with a lower PE ratio. Instead, it was the strong earnings-per-share (EPS) growth of the company from 2008 through today. The yearly EPS of the company by financial year is shown below.

Source: S&P Capital IQ

Foolish Bottom Line

There are times when investors may inadvertently put too much attention on one metric or reversely, fall in love with a single business characteristic. In the context of this article, ruling out all shares which were trading at a singular arbitrary PE level (15) had a side effect of also ruling out one of the strong performers over the last decade (Dairy Farm Holdings).

In all fairness, there were six other criteria which were suggested by Graham to be used in conjunction with the PE ratio. Just as it was written by Graham – almost 65 years ago – a Foolish investor might do well to consider it as a suggestion, not a hard rule.

It is more likely that Graham’s broader lesson on share selection was really to fish in less crowded ponds. As the example with Dairy Farm shows, it may turn out that those “ponds that are less crowded” may not defined by a low PE ratio alone.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Chin Hui Leong doesn’t own shares in any companies mentioned.