IN BRIEF

Could it be that the most basic investment advice that you’ve received is misguided? "Buy low, sell high" appears a pretty obvious, surefire way to make money. But following this advice may actually lead to all sorts of judgment errors and easily forgotten transaction costs, as well as raising the question of what to do with the proceeds once you’ve timed the top of the market and claimed your prize.

 

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

IncludedImage

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.

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