Market Wizards – Interviews with Top Traders : [PDF Download]

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“To say that a stock is undervalued because it is selling at a low P/E ratio is nonsense. In our research, we found there was a very low correlation between the P/E ratio and the best-performing stocks. Some of these stocks had P/E ratios of 10 when they started their major advance; others had P/E ratios of 50.

During the thirty-three years in our survey period [1953-1985], the average P/E ratio for the best-performing stocks at their early emerging stage was 20, compared to an average P/E ratio of 15 for the Dow Jones Average during the same time. At the end of their expansion phase, these stocks had an average P/E ratio of approximately 45.

This means that if, in the past, you were not willing to buy stocks with above-average P/Es, you automatically eliminated most of the best-performing securities. A common mistake a lot of investors make is to buy a stock solely because the P/E ratio looks cheap.

There is usually a very good reason why a P/E ratio is low. Many years ago, when I was first beginning to study the market, I bought Northrop at four times earnings and watched in disbelief as the stock eventually declined to two times earnings. Another common mistake is selling stocks with high P/E ratios.

I still remember in 1962 when an investor barged into my friend’s brokerage office, declaring in a loud voice that Xerox was drastically overpriced because it was selling at fifty times earnings. He went short at $88. Xerox eventually went to $1,300, adjusting for stock splits”

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