Investment Performance of Common Stocks in Relation to Their Price-Earnings Ratios
Source: Basu, S. (1977). Journal of Finance 32(3), 663–682.
TL;DR
One of the first documented contradictions of the efficient-market hypothesis: **low price-earnings
(P/E) stocks earn higher risk-adjusted returns** than high-P/E stocks. The "P/E effect" is an early
form of the value premium and a direct challenge to the CAPM and semi-strong efficiency.
What anomaly it documents
A negative relation between the P/E ratio and subsequent returns: cheap (low-P/E) stocks outperform
expensive (high-P/E) ones even after adjusting for CAPM risk, implying public valuation information was
not "fully reflected" in prices.
How it is constructed
Rank NYSE stocks into portfolios by trailing P/E ratio.
Compare returns and CAPM-adjusted performance across P/E quintiles over the holding period.
Evidence
Low-P/E portfolios earn higher absolute and risk-adjusted returns than high-P/E portfolios.
The difference survives CAPM beta adjustment — a genuine anomaly relative to the model.
Why it matters
A historical anchor for value investing and one of the earliest "anomalies" that motivated the move
from the CAPM to multi-factor models; the P/E effect foreshadows the book-to-market (HML) value factor.
Limitations and risks
Subject to the joint-hypothesis problem (anomaly vs. wrong risk model) and to look-ahead in earnings
data if not handled carefully.
Later subsumed by the broader value factor; magnitude varies across eras.
Key references
Basu, S. (1977) — Investment Performance of Common Stocks in Relation to Their Price-Earnings Ratios — Journal of Finance
Fama, E. & French, K. (1992) — The Cross-Section of Expected Stock Returns — Journal of Finance
Lakonishok, J., Shleifer, A. & Vishny, R. (1994) — Contrarian Investment, Extrapolation, and Risk — Journal of Finance
