Investors seeking long-term growth often wonder whether they should resort to any of the fundamental strategies like growth or value, or follow an approach that combines the best of both. Going by Warren Buffett, 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.
It has been observed that strategic mingling of both growth and value investing principles gives us a mixed investing strategy. Termed as GARP (growth at a reasonable price), this approach is getting popular with each passing day. 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 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 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 nine stocks that qualified the screening:
Biogen Inc. (BIIB - Free Report) : Biogen is one of the world’s leading biotechnology companies, which focuses on developing innovative therapies for treating serious neurological and neurodegenerative diseases. Apart from a Zacks Rank #2 and a Value Score of A, the company also has an impressive historical five-year growth rate of 23.8%.
Thermo Fisher Scientific Inc. (TMO - Free Report) : Headquartered in Waltham, MA, Thermo Fisher Scientific is a scientific instrument maker and a world leader in serving science. The company has an impressive current-year growth rate of 15.8%. The stock currently has a Value Score of B and has a Zacks Rank #2. You can see the complete list of today’s Zacks #1 Rank stocks here.
HCA Healthcare, Inc. (HCA - Free Report) : This is the largest non-governmental operator of acute care hospitals in the United States. Headquartered in Nashville, TN, it operates hospitals and related health care entities. It operates in two geographically organized groups – the National and American Groups. Apart from a discounted PEG and P/E, the stock has a Value Score of A and holds a Zacks Rank #1.
Gilead Sciences Inc. (GILD - Free Report) : Headquartered in Foster City, CA, Gilead Sciences is a biopharmaceutical company, focused on developing drugs for the treatment of human immunodeficiency virus (HIV), liver diseases such as chronic hepatitis C virus (HCV) infection and chronic hepatitis B virus (HBV) infection, cardiovascular, hematology/oncology and inflammation/respiratory diseases. The stock currently carries a Zacks Rank #1 and has a Value Score of B. The company also has an impressive long-term historical growth rate of 35.4%.
QUALCOMM Incorporated (QCOM - Free Report) : The company designs, manufactures and markets digital wireless telecom products and services based on the Code Division Multiple Access (CDMA) technology. The stock currently carries a Zacks Rank #2 and has a Value Score of B. It also has an impressive long-term historical earnings growth rate of 10.9% for the next year.
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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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