The success of billionaire value investor Warren Buffett underscores the efficiency of his investing mantra. Going by a Motley Fool article published last year, over the past 50 years, his conglomerate Berkshire Hathaway’s stock has yielded a compound annual return of 20.8%. This indicates that an investment of $10,000 in 1965 is worth $88 million today.
However, apparently simple to understand, this investing discipline has its own share of pitfalls. A value investor mostly misses the chance of betting on stocks that have bright long-term prospects and in their quest of cheaper stocks, they often end up picking stocks that have weak future prospects.
Buffett believes that proper understanding of the “intrinsic value” of a stock may ease out many problems with regard to value investment. According to him, going by the fundamentals of value investing while picking undervalued stocks, investors need to focus on their earnings growth potential.
While yardsticks such as dividend yield, the ratio of price to earnings, sales or book value are the most common value investing matrices that can easily single out stocks trading at a discount, these ratios fail to consider the potential of a stock. PEG is the ratio with the earnings growth component in it.
The PEG ratio is defined as: (Price/Earnings)/Earnings Growth Rate
A lower 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.
Unfortunately, this ratio is often neglected due to investors’ limitation to calculate the future earnings growth rate 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 very high growth, followed by a sustainable but lower growth rate in the long term.
Hence, PEG-based investing can turn out to be even more rewarding if some other relevant parameters are taken into consideration.
Here are 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 five out of the 28 stocks that qualified the screening:
US Foods Holding Corp. (USFD - Free Report) : The company is one of America’s great food companies and a leading foodservice distributor. It has partnered with approximately 250,000 restaurants and foodservice operators to help their businesses run successfully. The stock can be an impressive value investment pick with its Zacks Rank #1 and Value Score of B. Apart from a discounted PEG and P/E, the stock also has an impressive long-term expected growth rate of 18.9%.
The Marcus Corporation (MCS - Free Report) : The company is a prominent name in the field of lodging and entertainment industries, with significant company-owned real estate assets. Apart from a Zacks Rank #2 and a Value Score of A, the company also has an impressive growth rate of 15% for the next five years.
The Gap, Inc. (GPS - Free Report) : This global retailer offers clothing, accessories, and personal care products for men, women, and children under the Old Navy, Gap, Banana Republic and Athleta brands. The company has an impressive current-year growth rate of 23.5%. The stock has a Value Score of A and a Zacks Rank #2. You can see the complete list of today's Zacks #1 Rank stocks here.
Horizon Pharma Public Limited Company (HZNP - Free Report) : The company develops and commercializes innovative medicines that address unmet treatment needs for rare and rheumatic diseases. Apart from a discounted PEG and P/E, the stock has a Value Score of A and holds a Zacks Rank #2.
The Chemours Company (CC - Free Report) : The company provides performance chemicals in North America, the Asia Pacific, Europe, the Middle East, Africa, and Latin America. It operates through three segments: Titanium Technologies, Fluoroproducts, and Chemical Solutions. The stock carries a Zacks Rank #1 and has a Value Score of A. It also has an impressive long-term expected earnings growth rate of 15.5%.
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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.
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