Picking undervalued stocks with a low price-to-earnings (P/E) ratio is a common investing strategy. The logic is simple — the stock’s current price does not reflect its higher earnings and therefore leaves room for upside.
But very few believe that stocks with a rising P/E are worth buying. Let’s discuss this less-favored strategy in details.
Strength of Increasing P/E
The concept is that as earnings rise, so should the price of the stock. As forecasts for expected earnings come in higher, strong demand for the stock should continue to drive its price. After all, a stock's P/E gives an indication of how much investors are ready to shell out per dollar of earnings.
Suppose an investor wants to buy a stock with a P/E ratio of 30, it means that he is willing to pay $30 for only $1 worth of earnings. Now if the P/E ratio becomes 35 within a short spell of time, it means that the person is now ready to pay $35 for only $1 worth of earnings. It shows that the investor expects earnings of the company to rise at a faster pace in the future owing to strong fundamentals.
So, if the P/E of a stock is rising steadily, it means that investors are assured of its inherent strength and expect some strong positives out of it. Also, studies have revealed that stocks have seen their P/E ratios jump over 100% from their breakout point in the cycle. So, if you can pick stocks early in their breakout cycle, you can end up seeing considerable gains.
The Winning Strategy
In order to shortlist stocks that are exhibiting an increasing P/E, we chose the following as our primary screening parameters.
EPS growth estimate for the current year is greater than or equal to last year’s actual growth
Percentage change in last year EPS should be greater than or equal to zero
(These two criteria point to flat earnings or a growth trend over the years.)
Percentage change in price over four weeks greater than the percentage change in price over 12 weeks
Percentage change in price over 12 weeks greater than percentage change in price over 24 weeks
(These two criteria show that price of the stock is increasing consistently over the said timeframes.)
Percentage price change for four weeks relative to the S&P 500 greater than the percentage price change for 12 weeks relative to the S&P 500
Percentage price change for 12 weeks relative to the S&P 500 greater than the percentage price change for 24 weeks relative to the S&P 500
(Here, the case for consistent price gains gets even stronger as it displays percentage price changes relative to the S&P 500.)
Percentage price change for 12 weeks is 20% higher than or equal to the percentage price change for 24 weeks, but it should not exceed 100%
(A 20% increase in the price of a stock from the breakout point gives cues of an impending uptrend. But a jump of over 100% indicates that there is limited scope for further upside and that the stock might be due for a reversal.)
In addition, we place a few other criteria that lead us to some likely outperformers.
Zacks Rank less than or equal to 2: Only companies with a Zacks Rank #1 (Strong Buy) or 2 (Buy) can get through.
Average 20-day Volume greater than or equal to 50,000: High trading volume implies that the stocks have adequate liquidity.
Just these few criteria narrowed down the universe from over 7,700 stocks to just 11.
Here are five of 11 stocks that passed the screen:
Fortuna Silver Mines Inc. (FSM - Free Report) : It is in the exploration, mining and development of silver and base metal properties in Latin America. The stock belongs to a Zacks Sector Rank in the top 19%. It carries a Zacks Rank #2. You can see the complete list of today’s Zacks #1 Rank stocks here.
Ritter Pharmaceuticals Inc. (RTTR - Free Report) : This is involved in developing therapeutic products to treat inflammatory, gastrointestinal and metabolic diseases. The stock carries a Zacks Rank #2 and belongs to a Zacks Industry Rank in the top 34%.
Organovo Holdings, Inc. (ONVO - Free Report) : This is a three-dimensional biology company. The stock belongs to a Zacks Industry Rank in the top 43% and carries a Zacks Rank #2.
Western Digital Corporation (WDC - Free Report) : This provider of a portfolio of compelling and high-quality storage solutions belongs to a Zacks Industry Rank in the top 37%. The stock has a Zacks Rank #1.
Willdan Group Inc. (WLDN - Free Report) : This is a provider of professional technical and consulting services. The Zacks Industry Rank is in the top 15%. It carries a Zacks Rank #2.
You can get the rest of the stocks on this list by signing up now for your 2-week free trial to the Research Wizard and start using this screen in your own trading. Further, you can also create your own strategies and test them first before taking the investment plunge.
The Research Wizard is a great place to begin. It's easy to use. Everything is in plain language. And it's very intuitive. Start your Research Wizard trial today. And the next time you read an economic report, open up the Research Wizard, plug your finds in, and see what gems come out.
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.
Zacks Restaurant Recommendations: In addition to dining at these special places, you can feast on their stock shares. A Zacks Special Report spotlights 5 recent IPOs to watch plus 2 stocks that offer immediate promise in a booming sector. Download it free »