The conventional wisdom is that low PE stocks are cheap and represent good value. That is backed up by empirical evidence that shows low PE stocks earning healthy premiums over high PE stocks. If you relate price-earnings ratios back to fundamentals, however, low PE ratios can also be indicative of high risk and low future growth rates. In this chapter, we made this linkage explicit by creating a portfolio of low PE stocks and eliminating those stocks that fail the risk and growth tests. Of the 115 stocks that had trailing, current and forward PE ratios that were less than 10, more than 60% of the sample would have been removed because they had above-average risk or below-average growth.
In summary, a strategy of investing in stocks just based upon their low price-earnings ratios can be dangerous. A more nuanced strategy of investing in low PE ratio stocks with reasonable growth and below-average risk offers more promise, but only if you are a long-term investor.