A MODIFIED PRICE-EARNINGS INVESTMENT STRATEGY ? AN ALTERNATIVE RISK-CONTROL APPROACH

Price-Earnings (PE) ratio is widely used as the key indicator for many value investment strategies. Existing studies use market beta as the risk-adjustment measure to modify PE strategies. In this study, we use financial and operating leverage ratios to control risks when forming low PE strategies. Our results show that, when compared to the market and traditional low PE firms, the less leveraged low PE firms yield higher returns and greatly reduce the portfolio risk. Further investigation indicates that the outperformance is mainly contributed by the bearish market returns, a finding that helps explain the contradiction to the expected risk-reward relationship.