The Low P/E Effect and Abnormal Returns for Australian Industrial Firms

Abstract

While the low P/E effect has been examined rather extensively in international markets particularly in the US, there is a notable absence of Australian market-based P/E studies. This research examines the relationship between the investment performance of Australian Industrial common stock and their P/E ratios in an attempt to uncover potential for a P/E based trading strategy. The excess and differential returns of P/E ranked portfolios containing 1310 Industrial firms over a 9 year period (January 1998 to December 2006) are examined. The results show the existence of a low P/E effect in the Australian capital market. Furthermore, the superior returns of low P/E stocks increase when a consensus of two business failure prediction models is applied to the portfolio of low P/E stocks. The statistically significant risk-adjusted returns afforded to hypothetical investors over the sample period (up to 12¿% per annum), not only provide support for a P/E based trading strategy, but also suggest a violation of the semi-strong form of the Efficient Market Hypothesis.

Keywords: efficient market hypothesis, price earnings ratio, P/E, trading strategy, equity valuations

JEL Classification: G11 G14