Why a P/E of 7.2 Isn’t as Great as It Sounds
What Value Investors Are Missing When They Evaluate Investments
Last month, I received an email from a prominent value investor (who shall remain unnamed) promoting his mutual fund, which I shall call Fund W.
"The cumulative 2-year gain of 58% in the S&P 500 in 2023 and 2024 is the highest the index has recorded in 36 years! The S&P 500’s trailing P/E ratio at the end of 2024 was 29 versus its long-term average of 16.
By contrast, Fund W trades at a P/E of 7.2. Fund W is trailing the S&P 500 significantly since inception 15 months ago. This is a marathon, not a sprint. Our mission is to beat the S&P 500 over the long term and I love how well we are positioned to do so from here. We are very bullish on the Fund’s prospects."
You see this kind of thing a lot from value investors: The market has gone crazy, stocks are overvalued, but my fund—my wonderful, underappreciated, deeply discounted fund—is sitting here with a single-digit P/E ratio, just waiting for the market to come to its senses.
And yet, the market does not seem to be coming to its senses. Despite the recent drawdown, the market still gives the S&P 500 a P/E of 28 while ignoring the "cheap" stocks that Fund W specializes in. As of the end of February 2025, Fund W is underperforming the S&P 500 by almost 40 percentage points over 17 months1.
At some point, you have to ask: Is the market wrong, or is Fund W?
Profits Are Just One Piece of the Puzzle
One of the favorite arguments of value investors is that stock prices should be based on profits. The lower the price relative to profits, the better the deal.
But let’s look at some actual data.
Consider the rankings of the top 50 most valuable companies (by market capitalization2) and the top 50 most profitable companies (by FY2023 net income). How much overlap is there?
40? Nope.
30? Still too high.
Just 22 companies (44%) appear on both lists.
Of those 22 companies:
12 have a higher market cap rank than profit rank. That is, their stock market value is higher than their profits alone would suggest.
(Google’s market cap rank and profit rank are identical: #4.)
Only 9 of the top 50 most profitable companies (18%) have a higher profit rank than market cap rank—meaning they are among the rare companies where profits alone seem to drive their valuation.
So if you are a value investor who only looks at P/E ratios, what you are really doing is focusing on the way that just 18% of the top 50 most valuable companies got there.
That does not seem like a very good strategy.
The Ben Graham Problem
Part of the problem is that value investing, as practiced by many of its adherents today, is stuck in the past.
NYU Professor of Finance Aswath Damodaran put it best when he discussed how value investing has changed since Ben Graham published The Intelligent Investor (1949):
"To run Ben Graham's 12 screens in the 1950s, you'd have to sit down with the ledger sheet, take every company, enter the numbers by hand, sit there with an abacus—there were no calculators—and compute each ratio.
Just doing this on 50 companies—the thought of it gives me a headache. But if you were able to do it, you had a significant advantage over other people who didn't have access to those annual reports, who didn't have the time and the patience or the resources to do it.
Today I can go online and there are all these automated ‘Ben Graham 12 screens.’ I hit them, they're on the 12 screens for me two seconds later, the companies pop up, and the question is: If I can pull that up, what makes you think that running these screens is going to give you a differential advantage?"
Fund W’s manager brags about his 7.2 P/E ratio, but what he is really bragging about is running screens—which gives you minimal alpha in today’s digital world.
The Market Is Usually Right
In the book Hedge Fund Market Wizards, when asked what he looks for in a trader, the billionaire hedge fund manager Michael Platt commented:
"The type of trader I don't want is an analyst who has never traded—the type of person who does a calculation on a computer, figures out where a market should be, puts on a big trade, gets caught up in it, and doesn’t stop out. And the market is always wrong; he’s not. Market makers know that the market is always right. You are wrong if you are losing money for any reason at all. Market makers have that drilled into their head.”
That’s a lesson that value investors struggle with.
They love to cite Ben Graham’s allegory of Mr. Market—the irrational stock market that sometimes offers you great deals and sometimes offers you terrible ones.
And sure, sometimes the market is wrong. Some amount of underperformance due to medium-term volatility is expected in the process of generating long-term capital appreciation.
But if you are consistently underperforming the S&P 500, by as much as 40 percentage points over 17 months, at some point, you have to admit that maybe—just maybe—it’s not the market that’s wrong.
It’s you.
Buffett Is Not a Value Investor (At Least Not in the Way You Think)
When people think of "value investing," they think of Warren Buffett.
But Buffett’s portfolio does not look like what Fund W’s manager imagines a value portfolio should look like.
Consider Berkshire Hathaway’s top 9 holdings (individual companies that account for at least 2.5% of the Berkshire’s portfolio). They have a P/E ratio of 243.
The S&P 500’s P/E at the end of 2024? 29
Fund W’s P/E? 7
Buffett’s portfolio P/E ratio is much closer to the supposedly overvalued S&P 500 than to Fund W.
Why?
Because Buffett is not just buying low P/E stocks. He’s buying great companies.
Look at his top three holdings: Apple, American Express, and Coca-Cola.
All have strong brands, loyal customer bases, and wide economic moats.
And none of them are "cheap" in the way Fund W’s manager means. Their P/E ratios range from 19 to 34.
None of them have single-digit P/E ratios.
Buffett is not just a value investor. He is a quality investor. And quality does not come cheap.
Conclusion: Value Investing Needs to Evolve
The problem with value investors is not that they believe in "buying low and selling high."
The problem is that many of them are just running screens rather than actually valuing companies.
The problem is that they assume the market is wrong, instead of considering that they might be.
The problem is that they think Buffett is a low-P/E investor, when really he’s a quality investor.
If you want to be a great investor, you don’t need to abandon value investing.
You just need to stop doing it wrong.
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17 months is how long Fund W has traded since inception.
I don't want to name the specific value investor, but let me just say that he is a hedge fund manager who’s been around for a while who has started selling to retail investors.
In his 13Fs for the past several years, he hasn't invested in the best companies.
Generally speaking, if you have raise money from retail, making a 1.25% expense ratio instead of 25%+ performance fees, that's a sign that the hedge fund isn’t working out as hoped.
Market cap calculated as of Aug 26, 2024
P/E ratio calculated as of Mar 13, 2025
An important article that more amateur investors (and many professionals) need to read.
If a stock is cheap (trading at a low multiple), it means the market is not giving it much credit for the companies future.
Sometimes you can spot something everybody else is missing, but unless you are doing serious research or have insight into an industry or company most wouldn't have, you're probably just buying junk.