At a time when volatility strikes every second day, investors are often seen to choose value investing over other options like growth or momentum. These investors wait for the moment when other investors start selling their stocks at a discount. They consider this distress selling as the perfect market entry point to get hold of good stocks at a cheaper price.
However, this apparently simple value investment technique has some drawbacks and not understanding the strategy properly may often lead to “value traps”. In such a situation, these value picks start to underperform over the long run as the temporary problems, which once drove the share price down, turn out to be persistent. There are many value investment yardsticks such as dividend yield, P/E or P/B, which are simple and can single out whether a stock is trading at a discount.
However, for investors looking to escape such value traps, it is also vital to determine where the stock is headed in the next 12 to 24 months. Warren Buffett advises these investors to focus on the earnings growth potential of a stock. This is where lies the importance of a not-so-popular value investing metric, the PEG ratio.
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 to 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 a very high 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 out of 11 stocks that qualified the screening:
Bausch Health Companies Inc. (BHC - Free Report) develops, manufactures, and markets a range of pharmaceutical, medical device, and over-the-counter products primarily in the therapeutic areas of eye health, gastroenterology, and dermatology. The company has an impressive expected five-year growth rate of 20%. The stock currently has a Value Score of A and carries a Zacks Rank #2. You can see the complete list of today’s Zacks #1 Rank stocks here.
Endava plc (DAVA - Free Report) is a U.K.-based company providing IT service to finance, insurance and healthcare, retail and consumer goods, telecommunications, media, and technology industries. Apart from a discounted PEG and P/E, the stock sports a Zacks Rank #1 and has a Value Score of A.
DaVita Inc. (DVA - Free Report) : This is a leading provider of dialysis services in the United States to patients suffering from chronic kidney failure, also known as end-stage renal disease (ESRD). The stock also can be an impressive value investment pick with its Zacks Rank #2 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 19.5%.
Perspecta Inc. (PRSP - Free Report) : The company provides enterprise information technology services to government customers in the United States federal, state, and local markets. The company has an impressive expected five-year growth rate of 13%. The stock has a Value Score of A and carries a Zacks Rank #2.
Athene Holding Ltd. (ATH - Free Report) : This is a retirement services company, issues, reinsures, and acquires retirement savings products in the United States, the District of Columbia, and Germany. The company has an impressive long-term expected growth rate of 16%. The stock has a Value Score of A and a Zacks Rank #1.
Get the rest of the stocks on the list and start putting this and other ideas to the test. It can all be done with the Research Wizard stock picking and backtesting software.
The Research Wizard is a great place to begin. It's easy to use. Everything is in plain language. And it's very intuitive. Start your Research Wizard trial today. And the next time you read an economic report, open up the Research Wizard, plug your finds in, and see what gems come out.
Click here to sign up for a free trial to the Research Wizard today.
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.