Shiller PE and Picking Stocks: Where it Works and Where it Struggles

Conclusions on the Quick

Conclusions:

Shiller P/E works well for stock selection within Large Cap. Mean reversion for earnings growth seems to happen much more within the Large Cap universe than within SMID. The improvement in earnings growth for the Large Cap cheap slow growers tends to lead to multiple expansion while the decline in earnings growth for the expensive fast growth stocks tends to lead to multiple contraction within Large Cap. We see more economic momentum than mean reversion within Small & Mid Cap as the fast growers continue to grow quickly.
In the Small & Mid Cap space we find that the Shiller P/E disappoints in aiding stock selection but find that substituting EV to 10 year inflation adjusted EBITDA is more effective. Unlike in Large Cap, the benefits of economic mean reversion are much less potent for Small & Mid Cap firms and, in the context of cyclically adjusted levels of valuation, economic momentum is actually helpful to future stock selection. This effect is particularly pronounced among potential shorts that have poor recent three year earnings growth and are in the most expensive quintile of cyclically adjusted EV/EBITDA.
Recent (3 year) earnings growth seems to be a significant driver of cyclically adjusted valuation metrics like Shiller P/E or EV/EBITDA as there is a strong correlation between recent earnings growth and valuation based on historical earnings. In other words, there are relatively few slow growing but expensive companies and few fast growing but cheap companies based on the cycle adj. metrics like P/E and EV/EBITDA.
Leveraging the cycle adj. valuation metrics, recent growth and our Core Models, we can create portfolios that can generate significant excess returns and other favorable metrics.

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Summary:

Soaring corporate margins have driven valuations higher in both the Large Cap and Small & Mid Cap universes.
With profits near record highs we investigated if valuation metrics that capture full cycle earnings might help us find both compelling short and long opportunities overlooked by more traditional value strategies. This proved productive as the firms with low cyclically adjusted valuation tend to be firms that have suffered recent economic headwinds while firms with high cyclically adjusted valuation tend to be firms that have experienced the fastest trailing earnings growth.
We found that the biggest opportunities came from very different sources depending on if we are working in the Large Cap or Small & Mid Cap universes. In Large Cap we find that Shiller P/E helps find firms likely to experience economic mean reversion. On the long side, investors benefit from multiple expansion as firms with the weakest historical earnings growth tend to recover. On the short side, investors should consider firms whose recent strong growth in profitability has been erroneously extrapolated by the market and are likely to disappoint.
In Small & Mid Cap we find the best results on the long side come from exploiting economic momentum shrouded in investor uncertainty. On the short side, firms that have negative recent earnings evolution but are still expensive on our cyclically adjusted metric tend to put up catastrophic returns as these “story stocks” prove to be poor speculations.

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ADDITIONAL READING

The topics discussed in this article are aimed at seasoned professionals, as such, we have included some extra reading for anyone seeking out more information related to the topics above.

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