[UPDATED 31 dec ’13

Now that I have some data for the 5 year CAGR returns for the months of Oct ’08 through to Jan ’09, where the STI’s PE10 fell into the cheapest decile, let’s see what the evidence shows.

Oct ’08- 11.8%
Nov ’08- 13.1%
Dec ’08- 12.5%
Jan ’09- 12.6%

That’s pretty darn good to me. Using the lowest rate of return, $1,000 would have become $1,746.66. Not bad for a relatively passive strategy.

note: returns are based on capital gains only, do not include dividends which would boost returns and exclude transaction costs which would depress returns]

Original post starts here.

This is the start of a monthly post. Background info below.

5 Sep 12 PE10: 14.77x

I’m a fan of what James Montier calls the ‘Graham and Dodd PE’ (G&D PE)*. Essentially, it is the Price-to-Earnings ratio for a firm calculated using the moving average of the firm’s past 10 years of earnings. The reason for this is to smooth out earnings. After all, most businesses experience good and bad times and therefore buying based on just the last one year’s or even a quarter’s worth of earnings may not reflect the true earnings power of a firm. Averaging out earnings gives a more conservative picture where valuation is concerned.

For those that need data to believe, I point you to James Montier’s work titled ‘Better Value (Or The Dean Was Right!)’. This is a paper he wrote together with Rui Antune when he was at Drk Macro Research. I can’t find an exact copy of the paper online but this was compiled as Chapter 27 in Montier’s book, ‘Behavioural Investing: A Practitioner’s Guide to Applying Behavioural Finance’. Otherwise, there is a good summary of the results of that paper here. Of course, Montier and Antune’s work is about valuing stocks but I can’t think of any reason why it should not apply to indexes as well.

I’ve been tracking the STI’s PE10 using some data I found online and updated thereafter using data from Bloomberg. Unfortunately, I have way too little data (only way back to 1993) but from my own brief analysis, valuation does matter.

I’ve tabulated the PE10 for each month beginning in April 2003 and divided it into deciles. The two most expensive deciles (not surprisingly, Jan-Dec 2007) had negative p.a returns over a five year period while the two cheapest deciles (Apr-Jun ’03) posted returns of 19% p.a. over a five year period. All returns are based on closing prices of the index and do not include dividends. The average and median PE10 over the last 9 years are 20.8x and 20x respectively but use the average and median as a guide at your own risk. After all, the Dean recommended purchasing stocks at no more than 16x PE10.

Not surprisingly, Oct ’08 to Apr ’09 fell into the cheapest decile so let’s wait to see the returns from that one. So far, things look pretty good if you use that model.

*A more familiar version of this term may be Cyclically Adjusted Price-to-Earnings Ratio (CAPE) for those who follow the Robert Shiller’s work and the US markets.

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