In a market hurt by external shocks, value investing is fast gaining popularity. The success of value investors like Warren Buffett further underscores this. Buffett and his business partner, Charlie Munger, managed to register 20% compound annual growth in the market value of Berkshire Hathaway from 1965 through 2020 compared with 10.2% rise of the S&P 500 during the same period.
However, while searching for a suitable investment option, value investors with varied risk appetite are unlikely to consider price/earnings to growth (PEG) ratio among a number of other popular metrics like price/earnings (P/E), price/sales (P/S) or price/book value (P/B).
This is because they often find this ratio complicated, considering the limitations in calculating the future earnings growth potential of a stock. Yardsticks, such as dividend yield, P/E or P/B, are most commonly used to single out stocks trading at a discount.
However, these ratios, while not taking into account the future growth potential of a stock, might end up convincing us to invest in stocks that are at a discount just because of their poor show. This might often lead to “value traps” — a situation when these value picks start to underperform over the long run as the temporary problems, which once pulled down the share price, turn out to be persistent.
In such a case, even if you buy a stock at less than its fair value, you might still end up paying more. And here comes the importance of this not-so-popular but crucial value investing metric, the PEG ratio.
The PEG ratio is defined as: (Price/ Earnings)/Earnings Growth Rate
A low PEG ratio is always better for value investors.
While P/E alone fails to identify a true value stock, PEG helps find the intrinsic value of a stock.
There are some drawbacks to using the PEG ratio though. It doesn’t consider the very common situation of changing growth rates, such as the forecast of the first three years at a very high growth rate, followed by a sustainable but lower growth rate over the long term.
Hence, PEG-based investing can turn out to be even more rewarding if some other relevant parameters are also taken into consideration.
Here are some of the screening criteria for a winning strategy:
PEG Ratio less than X Industry Median P/E Ratio (using F1) less than X Industry Median (for more accurate valuation purpose) Zacks Rank of 1 (Strong Buy) or 2 (Buy) (Whether good market conditions or bad, stocks with a Zacks Rank #1 or 2 have a proven history of success.) Market Capitalization greater than $1 Billion (This helps us to focus on companies that have strong liquidity.) Average 20 Day Volume greater than 50,000 (A substantial trading volume ensures that the stock is easily tradable.) Percentage Change F1 Earnings Estimate Revisions (4 Weeks) greater than 5% (Upward estimate revisions add to the optimism, suggesting further bullishness.) Value Score of less than or equal to B: Our research shows that stocks with a Style Score of A or B when combined with a Zacks Rank #1, 2 or 3 (Hold) offer the best upside potential.
Here are seven out of the 56 stocks that qualified the screening:
The Mosaic Company ( MOS Quick Quote MOS - Free Report) : This Minnesota-based company is a leading producer and marketer of concentrated phosphate and potash for the global agriculture industry. In 2021, the company is expected to gain from strong global demand for fertilizers based on solid worldwide demand for grains and oilseeds. Mosaic has a long-term historical growth rate of 7%. The stock currently carries a Zacks Rank of 1 and has a Value Score of B. You can see the complete list of today’s Zacks #1 Rank stocks here . Omnicom Group Inc. ( OMC Quick Quote OMC - Free Report) : This is one of the largest advertising, marketing and corporate communications companies in the world. The company is currently benefiting from ongoing operating efficiency initiatives in real estate, back office services, procurement and IT areas. The company currently holds a Zacks Rank #2 and has a Value Score of A. It also has an impressive five-year expected growth rate of 9.3%. GIII Apparel Group, LTD. ( GIII Quick Quote GIII - Free Report) : Based in New York, this is a manufacturer, designer and distributor of apparel and accessories under licensed brands, owned brands and private label brands. Currently, the company is focused on growing the digital business with expansion in the distribution channel. It is on track to drive growth across the digital landscape via investments in internal talent, re-platformed e-commerce sites, improved logistics capabilities along with a new CRM and loyalty program. Apart from a discounted PEG and P/E, the stock currently sports a Zacks Rank #1 and has a Value Score of A. Korea Electric Power Corporation ( KEP Quick Quote KEP - Free Report) , an integrated electric utility company, generates, transmits, and distributes electricity in South Korea and internationally. The company operates through Transmission and Distribution, Electric Power Generation (Nuclear). The company has an impressive growth rate of 5% for the next five years. The stock currently has a Value Score of A and carries a Zacks Rank of 2. Franchise Group, Inc. ( FRG Quick Quote FRG - Free Report) : This is an owner and operator of franchised and franchisable businesses. Franchise Group’s business lines include Pet Supplies Plus, American Freight, The Vitamin Shoppe, Buddy’s Home Furnishings, and Liberty Tax Service. The company currently holds a Zacks Rank #2 and has a Value Score of A. It also has an impressive five-year expected growth rate of 15%. Owens & Minor, Inc. ( OMI Quick Quote OMI - Free Report) : This is a global healthcare solutions company that incorporates product manufacturing, distribution support and innovative technology services to deliver significant and sustained value across the breadth of the industry – from acute care to patients in their home. Apart from a discounted PEG and P/E, the stock currently sports a Zacks Rank #1 and has a Value Score of A. Dow Inc. ( DOW Quick Quote DOW - Free Report) : This is a material science company, providing a world-class portfolio of advanced, sustainable and leading-edge products. The company is currently investing in a number of high-return growth projects including the expansion of downstream silicones capacity. The company currently holds a Zacks Rank #1 and has a Value Score of A. It also has an impressive five-year expected growth rate of 19.3%.
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Click here to sign up for a free trial to the Research Wizard today. Disclosure: Officers, directors and/or employees of Zacks Investment Research may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material. An affiliated investment advisory firm may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material. Disclosure: Performance information for Zacks’ portfolios and strategies are available at: https://www.zacks.com/performance .