Ask Colin

Should PE ratio filter rules for blue chip stocks be set higher to allow for greater institutional demand?

You raise an important issue. Because institutional investors focus on the blue chip stocks, they may never get as cheap as smaller stocks. There will be exceptions, though when a blue chip stock really gets to be out of favour for some reason.

Whether you adjust the PE ratio depends on what you are trying to do. There are many reasons why you might use PE ratios to do a scan.

You might just be looking for value model stock charts, to save you looking through the market. In this case, I don't think it matters what PE ratio you use, within a broad band. There are also other scans you can do to achieve the same thing. Dividend yield would be good. I find monthly MACD crossovers are also good.

However, if you are looking to follow the value approach from a fundamental point of view and this is why you are doing the scan, I think that raising the PE ratio for blue chip stocks that may be valued more highly because of demand is defeating the whole purpose.

I set my PE ratio now in relation to the bond rate. Thus, I want an earnings yield (inverse of the PE ratio) that is 50% above the bond rate to allow for the greater risk in stocks. You may care to set the earnings yield higher than that (lower PE ratio), but I would not be inclined to go far the other way.

The whole point is to find stocks that are out of favour with the market and because they are out of favour, the market is under pricing them. If blue chip prices are high because they are favoured by the market, this is the very group we should be trying to filter out, not catch in our scan.

Having said all this, there is a place for blue chip stocks in a portfolio. Even though they are not justified on PE ratio, you may want to put some in your portfolio to balance it. To do this, I would be more inclined to rank the group by PE ratio and select the lowest third of them, much as the "Dogs of the Dow" method does with dividend yield.