The popularity of value investing is on the rise. The success of billionaire value investors like Warren Buffett is testament to 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).
According to an article by Rajiv Bhuva, Buffett and his business partner Charlie Munger have managed to drive 20.9% compound annual growth in the market value of Berkshire Hathaway from 1965 to 2017. The book value per share has risen at 19.1% CAGR, from $19 to $211,750 in these 53 years.
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 for 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 does not 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 M 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 24 stocks that qualified the screening:
General Motors Company (GM - Free Report) : Detroit, MI-based General Motors is a leading global automotive company. The company is engaged in designing, building and selling cars, trucks, crossovers and automobile parts worldwide. General Motors can be an impressive value investment pick with its Zacks Rank #2 and Value Score of B. The company’s long-term historical earnings growth rate is 13.9%.
Gray Television, Inc. (GTN - Free Report) : The company owns and/or operates television stations in 57 markets, broadcasting over 200 separate programming streams, including over 100 affiliates of the CBS/NBC/ABC/FOX networks. Apart from a Zacks Rank #2 and a Value Score of A, the stock has an impressive long-term historical growth rate of 22.6%.
Hill-Rom Holdings, Inc. (HRC - Free Report) : This global medical device company partners with health care providers in more than 100 countries by focusing on patient care solutions that improve clinical and economic outcomes in areas like Advancing Mobility, Wound Care and Prevention, Clinical Workflow, Surgical Safety and Efficiency, and Respiratory Health. The stock also can be an impressive value investment pick with its Zacks Rank #2 and Value Score of B. Apart from a discounted PEG and P/E, the stock has a stellar long-term expected growth rate of 14%.
Anthem, Inc. (ANTM - Free Report) : This is one of the largest publicly traded managed care organizations in terms of membership. The stock has an impressive expected growth rate of 30.7% for the current fiscal. It 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.
AutoZone, Inc. (AZO - Free Report) : This is one of the nation’s leading specialty retailers of automotive replacement parts and accessories, operating in the Do-It-Yourself (“DIY”) retail, Do-It-for-Me (“DIFM”) auto parts and products markets. The stock also can be an impressive value investment pick with its Zacks Rank #2 and a Value Score of B. Apart from a discounted PEG and P/E, the stock has a stellar long-term historical growth rate of 12.8%.
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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.