Naked PE

The naked PE is a long term sector relative PE that has been further adjusted for the effect on the PE of company size. The term was coined by the originator of the idea, Keith Anderson, an academic whose research provides evidence of the effectiveness of using the naked PE for stock picking.

Apart from the empirical evidence, this approach does make sense. It combines long term PE and sector relative PE, so the arguments and evidence for each of these also favour the naked PE. Given that company size does have an effect on valuation as well (for good reasons), there is a clear rationale for adjusting for this as well.

The idea behind the naked PE is essentially it isolates the part of the PE that cannot be explained by the effects of sector and size, and uses this to pick out value shares. This is not greatly different from what many investors have done using sector relative PEs. What makes the naked PE interesting is that it makes this approach systematic enough to be used as a mechanical strategy.

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