The popularity of value investing is on the rise. The success of billionaire value investors like Warren Buffett further underscores the fact. Over the past five years, his conglomerate Berkshire Hathaway's book value has grown at a compound annual rate of 11% (
The Economist). Per a July Motley Fool article last year, over the past 50 years, the stock has yielded a compound annual return of 20.8%. This indicates that an investment of $10,000 in 1965 would be 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 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 metrics that can 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:
PACCAR Inc PCAR: Headquartered in Bellevue, WA, PACCAR is a leading manufacturer of heavy-duty trucks in the world and has substantial manufacturing exposure to light/medium trucks. The company also provides customer support for its products by supplying aftermarket parts as well as finance and leasing services. The company has an impressive expected five-year growth rate of 10.8%. The stock currently 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 . Colfax Corporation ( CFX Quick Quote CFX - Free Report) : Headquartered in Fulton, MD, the company is one of the leading manufacturing and engineering companies, specializing in products and services related to air and gas handling and fabrication technology. The stock currently sports a Zacks Rank #1 and has a Value Score of B. The company also has an impressive growth rate of 29.3% for the current year. Park Hotels & Resorts Inc. PK is a leading lodging REIT with a diverse portfolio of hotels and resorts with significant underlying real estate value. Park Hotels’ portfolio consists of 54 premium-branded hotels and resorts with more than 32,000 rooms, the majority of which are located in prime United States markets with high barriers to entry. Apart from a discounted PEG and P/E, the stock holds a Zacks Rank #2 and has a Value Score of B. ArcBest Corporation ARCB is a renowned logistics company with creative problem solvers who deliver integrated solutions. The company currently holds a Zacks Rank #1 and has a Value Score of A. The company also has an impressive expected five-year growth rate of 40.2%. Caterpillar Inc. CAT is the world’s leading manufacturer of construction and mining equipment, diesel and natural gas engines and industrial gas turbines. It is also a leading exporter in the United States with more than half of its sales generated outside the nation. Caterpillar operates through two divisions – Machinery, Energy & Transportation systems, and Financial Products. The company holds a Zacks Rank #1 and has a Value Score A. The stock also has an impressive earnings growth rate of 69.3% for the current fiscal.
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