In the course of strict screening to determine the intrinsic value of a company, investors often miss the chance of betting on stocks that have bright long-term prospects. The same way, growth investors often end up investing in expensive stocks.
If we keenly observe the investment track of the Oracle of Omaha, Warren Buffett, we can see how, in quest of eliminating these hazards, this pure play value investor has gradually shifted to a mixed investment strategy or more precisely GARP (growth at a reasonable price) strategy.
This strategy combines both growth and value investing principles and has a proven track record of success. What GARPers look for is whether the stocks are somewhat undervalued and have solid sustainable growth potential (Investopedia).
Here lies the importance of a not-so-popular fundamental metric, the price/earnings growth (PEG) ratio. Although it is categorized under value investing, this strategy follows the principles of both growth and value investing.
The PEG ratio is defined as: (Price/ Earnings)/Earnings Growth Rate
It relates the stocks P/E ratio with future earnings growth rate.
While P/E alone only gives the idea of stocks, which are trading at a discount, PEG while adding the GROWTH element to it, helps to find those stocks that have solid future potential.
A lower PEG ratio, preferably less than 1, is always better for GARP investors.
Say for example, if a stock’s P/E ratio is 10 and expected long-term growth rate is 15%, the company’s PEG will come down to 0.66, a ratio which indicates both undervaluation and future growth potential.
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 rates 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 also 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 of the 23 stocks that qualified the screening:
The Chemours Company (CC - Free Report) is a leading player in the field of titanium technologies, fluoroproducts and chemical solutions, catering to a wide range of industries with market-defining products, application expertise and chemistry-based innovations. The company has an impressive expected five-year growth rate of 15.5%. The stock currently has a Value Score of A and sports a Zacks Rank #1. You can see the complete list of today’s Zacks #1 Rank stocks here.
Nine Energy Service, Inc. (NINE - Free Report) is an oilfield services company that offers completion and production solutions throughout North America. The stock also can be an impressive value investment pick with its Zacks Rank #1 and Value Score of A. Apart from a discounted PEG and P/E, the stock also has an impressive long-term expected growth rate of 72%.
Boise Cascade Company (BCC - Free Report) is one of the largest producers of engineered wood products and plywood in North America and a U.S. wholesale distributor of building products. Apart from a discounted PEG and P/E, the stock holds a Zacks Rank #1 and a Value Score of B.
Seagate Technology plc (STX - Free Report) : The company provides data storage technology and solutions in Singapore, the United States, the Netherlands and internationally. Seagate manufactures and distributes hard disk drives, solid state drives and their related controllers, solid state hybrid drives and storage subsystems. The company has an impressive expected five-year growth rate of 18.9%. The stock has a Value Score of A and carries a Zacks Rank #1.
The Meet Group, Inc. (MEET - Free Report) : The company operates a social network for meeting new people primarily on mobile platforms in the United States. The company has an impressive long-term expected growth rate of 20%. The stock has a Value Score of B and a Zacks Rank #2.
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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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