With the equity benchmarks crossing newer milestones on various occasions this year, both the Dow Jones Industrial Average (DJIA) and the S&P 500 stock index have earned the distinction of being serial record-breakers. Markets appear to be almost relentless in their ascent, shrugging aside geopolitical tensions stemming in Ukraine and Iraq as well as a sluggish domestic recovery.
The Bull Run is marking its 65th month, which has shown an impressive rise that began following the darkness of the last recession, and seems to be going from strength to strength. Perhaps the time has come for investors to get off the sidelines and hone their stock-picking skills once again to gain from this unusual market environment.
Are Growth Stocks Too Rich Now?
Growth stocks performed impressively last year as the Federal Reserve’s policies encouraged investors to pump money into the fastest-growing sectors. But now with the economy seemingly improving, albeit at a sluggish pace, and corporate profits looking fairly resilient, the Fed is gradually retracting its support.
Investors wishing to jump on the bandwagon of growth and strong return prospects should thus exercise caution. The skeptics, perhaps rightly so, are worried that the rally has stretched stock valuations beyond fair.
Growth and momentum stocks pushing the market to its current highs, in spite of still having potential, seem too expensive to buy now. Auto major Tesla Motors, Inc. (TSLA - Analyst Report) registered over 100% earnings per share (EPS) growth last year, while the stock recorded a one-year return of over 80%. The EPS of Chinese online social networking platform YY Inc. grew over 360% last year, with the share price jumping over 160% over the past year.
Oil exploration & production stocks like Matador Resources Co. (MTDR - Snapshot Report) and Sanchez Energy Corp. (SN - Snapshot Report) relate the same story, as do numerous other growth companies inhabiting the pricier corners of the market.
In fact, some high-growth companies like Vestas Wind Systems A/S (VWDRY - Snapshot Report) seem to have lost momentum recently, falling around 10% in the past month after recording a one-year return of roughly 220%. RadNet, Inc. (RDNT - Snapshot Report), Enservco Corp. and ULURU Inc. have displayed a similar trend.
Seeking Value in a Bull Market
Perhaps the time is ripe for sluggish value stocks to hog the limelight. Going by what history suggests, value stocks are inclined to perform well in the later stages of the economic cycle. While growth stocks have historically led the front in strong Bull Markets, value stocks have typically outperformed in periods of consolidation.
However, finding value stocks is currently a challenge for investors as valuations look stretched in almost all corners of the market after five years of bullishness. Traditional value metrics such as a low price-to-earnings (P/E) ratio compared to the overall P/E of the market are not quite adequate to unearth true value.
Instead, we use a measure called the PEG ratio, popularized by Peter Lynch, that takes P/E ratio one step further by factoring in expected earnings growth. The PEG ratio is calculated by dividing the price-to-earnings (P/E) ratio by the growth rate. It compares how cheap or expensive a business is relative to its growth rate.
According to Lynch, a stock with a PEG ratio under 1.0 is considered undervalued relative to its future growth prospects, implying that the market is underestimating the earnings, and/or the company is growing faster than expected. Zacks calculates PEG ratio as a company’s forward P/E divided by its expected long-term growth rate.
3 Great Value Picks
We have shortlisted three stocks with a PEG ratio below 1 and Price/Cash Flow ratio (P/CF) less than 10. The latter indicates that the company is generating robust cash flows to justify its price and judges the market expectations of the company’s future financial health. A P/CF ratio below 10 is considered to be a worthwhile metric to bank upon.
Stocks with these features have lagged the market in terms of year-to-date price returns, and thus, possess attractive valuations. In addition, these stocks have been recently witnessing healthy upward estimate revisions and thus sport a favorable Zacks Rank.
Prudential Financial, Inc. (PRU - Analyst Report)
This leading financial services institution is a niche player in the U.S. life insurance market, boasting an extensive product portfolio. The company, witnessing robust growth in assets under management, is set to capitalize on an aging American population. It also has a significant presence in the lucrative overseas market.
The stock lost 0.3% year-to-date. Although its shares are trading close to its 52-week high, it has a forward P/E of just 9.65x.
PEG Ratio = 0.98
P/CF Ratio = 8.45
Zacks Rank #2 (Buy)
Endurance Specialty Holdings Ltd. (ENH - Snapshot Report)
The Bermuda-based company is a global provider of property and casualty insurance and reinsurance. Endurance has been attempting to take over rival firm Aspen Insurance Holdings Ltd. (AHL - Snapshot Report) in a $3.2 billion bid, in order to expand its market share and create value.
The stock lost 8.5% year-to-date. It has a forward P/E of just 8.55x.
PEG Ratio = 0.95
P/CF Ratio = 6.54
Zacks Rank #1 (Strong Buy)
Huntington Ingalls Industries, Inc. (HII - Snapshot Report)
The company is engaged in designing, building and maintaining ships primarily for the U.S. Navy and the U.S. Coast Guard. Last month, it acquired Houston-based UniversalPegasus International Holdings, an established player in the energy infrastructure market, in an effort to consolidate its presence in the oil and gas market.
The company also acquired Broomfield, CO-based S.M. Stoller Corp., which provides environmental, nuclear and technical consulting and engineering services. These acquisitions highlight the company’s strategy of diversifying into the energy sector from its well-established presence in military shipbuilding.
The stock gained 6.4% year-to-date. It has a forward P/E of 12.56x, which is considerably lower than the forward industry P/E of 16.80x.
PEG Ratio = 0.5
P/CF Ratio = 9.07
Zacks Rank #2
The PEG ratio, though apparently fascinating and intuitive, is only a rule of thumb for picking undervalued stocks. Fundamentals and other qualitative aspects of the company also have an important place in the analysis as well.
Thus, the PEG ratio, when used in conjunction with a solid Zacks Rank, rising earnings estimate revisions and robust cash flow, is a great method to find value in this overvalued market.