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.
As Warren Buffett rightly said, these two approaches are joined at the hip. In other words, to make a long-term investment more effective, the principles of both value and growth strategies need to be combined.
The quest for a mixed investment strategy led to the introduction of the GARP (growth at a reasonable price) approach. What GARPers look for is whether the stocks are somewhat undervalued and have solid sustainable growth potential (Investopedia).
And 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 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, 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 does not consider the very common situation of changing growth rates such as the forecast of the first three years at very high growth rate 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 eight stocks that qualified the screening:
Magellan Health, Inc. (MGLN - Free Report) : Headquartered in Scottsdale, AZ, Magellan Health provides healthcare management services including behavioral healthcare services, diagnostic imaging and musculoskeletal management. The company also offers medical and pharmacy benefit programs through its Pharmacy Management segment. Apart from a Zacks Rank #2 and a Value Score of A, the company also has an impressive expected five-year growth rate of 15.5%.
Tetra Tech, Inc. (TTEK - Free Report) : The company is a global provider of consulting and engineering services. It supports global commercial and government clients focused on water, environment, infrastructure, resource management, energy, and international development. Apart from a discounted PEG and P/E, the stock has a Value Score of B and holds a Zacks Rank #2.
Avnet, Inc. (AVT - Free Report) : Avnet distributes electronic components worldwide. It has a comprehensive portfolio of design and supply chain services. The company has an impressive growth rate of 16.5% for the next year. The stock currently has a Value Score of A and a Zacks Rank #1. You can see the complete list of today's Zacks #1 Rank stocks here.
CoreCivic, Inc. (CXW - Free Report) : This is a diversified government solutions company with the scale and experience needed to solve tough government challenges in flexible cost-effective ways. Apart from a discounted PEG and P/E, the stock has a Value Score of A and holds a Zacks Rank #2.
Newmark Group, Inc. (NMRK - Free Report) : The company is a full-service commercial real estate services business that offers a complete suite of services and products for both owners and occupiers across the entire commercial real estate industry. The stock currently carries a Zacks Rank #2 and has a Value Score of A. It also has an impressive long-term expected earnings growth rate of 15%.
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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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