Today we start a new series in our Investment Lessons section called “Popular Myths” where we try to dispel notions we feel to be incorrect, whether it be due to faulty logic or just because it’s the way of our Malaysian stock market.

#1 - High PE Companies have high PE’s because they are being rewarded for having either strong performance or strong balance sheet. You should buy into them because there is momentum behind the stock to push the price up to where it is.

Okay, we read a lot about this not only on blogs and through the emails but also from books and journals. But let’s get our understanding straight - a high PE is telling you that a company’s price is high compared to its earnings. That is it. It does not tell you whether the company is growing or whether it has some amazing asset that is undervalued. Normally, in more liquid and efficient markets like the US where shorting is allowed, this is a good sign because if a stock does not deserve to have a high price, it would get sold or shorted back down. So the fact that it isn’t means that there is strong reason for it to be there. However, that assumption does not apply in a low liquid, non-shorting market like Malaysia. Firstly, participants are not allowed to punish these counters because shorting is not allowed, and secondly volumes are so low for some stocks that it is actually possible for someone with not more than $50K to move a counter up and not encounter any resistance. Because of this, shares are susceptible to ramping, and if you have any technical analysis software you can run a test for it to trade on breakouts and see how far that gets you. The majority of moves in the Malaysia market which generate a breakout tend to be false. It is usually just a ramp up to draw some suckers in for the smart money to offload and then the price breaks down again.

Real growth/breakout trading strategy takes more than just a high PE into account. It looks for some event, such as an earnings surprise or news announcement which changes the fortunes of a company. Then it looks for price action, such as a breakout, to support the news. Then, it looks for an explosion in volume to show that trading activity is really increasing, and above all, it looks for a growth in earnings. And I mean, quarter on quarter non-stop growth. And even then, traders who use this strategy are very stringent with their stop-losses and get out at the first available opportunity to avoid being caught when the tide turns, because you never when “High” becomes “Too High” and people start to sell. Sometimes they even sell prematurely.

Conclusion: Traders who use this strategy are susceptible to the “greater fool theory” - there is no guarantee that the greater fool will be there to buy your share when you want to sell.