Asking the wrong question
Most market commentary about a stock focuses on whether or not its price is cheap or expensive based on its price-to-earnings ratio (P/E)—the multiple of the current share price compared to the next year’s estimated earnings per share. Commentators appear in the financial press to say a stock is “expensive” as it “trades on a high P/E”.
Analysis of typical trading patterns suggests that most investors in emerging markets buy and sell stocks based on a one-year time horizon (see Exhibit 1).
EXHIBIT 1: HOLDING PERIOD OF MSCI EM EQUITY INDEX CONSTITUENTS
Source: Bloomberg. Data from 2010-2019. The securities above are shown for illustrative purposes only. Their inclusion should not be interpreted as a recommendation to buy or sell.
*Notes companies where the sum of ADR and Local shares have been used for purposes of calculation.
Such a short time horizon prioritises valuation multiples and ignores the key attraction of equities as an asset class: the opportunity they offer investors to identify assets that can compound their earnings over decades.
Focusing on near-term P/E multiples might seem a convenient shortcut to assessing valuation, but it’s the wrong framework through which to assess the value of a long duration asset.