Value investing is gaining popularity by the day. The success of value investors like Warren Buffett further underscores this. 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. Book value per share rose at a CAGR of 19.1%, from $19 to $211,750 in these 53 years.
However, this apparently simple to understand investing discipline has its own share of pitfalls. Value investors often miss the chance of betting on stocks that have bright long-term prospects. 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 the stocks’ 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 12 stocks that qualified the screening:
General Mills, Inc. (GIS - Free Report) : It is one of the leading global food companies. Its brands include Cheerios, Annie's, Yoplait, Nature Valley, Häagen-Dazs, Betty Crocker, Pillsbury, Old El Paso, Wanchai Ferry, Yoki, Blue and more. The stock can be an impressive value investment pick with its Zacks Rank #2 and Value Score of A. The company’s long-term historical earnings growth rate is 7.3%.
Career Education Corporation (CECO - Free Report) : The company owns academic institutions that offer quality education to a diverse student population in a variety of disciplines through online, campus-based and blended learning programs. Apart from a Zacks Rank #2 and a Value Score of B, the stock has an impressive long-term expected growth rate of 12.5%.
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 can also 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 12%.
Tenet Healthcare Corporation (THC - Free Report) : It is a diversified healthcare services company. Through its subsidiaries, partnerships and joint ventures, including United Surgical Partners International, the company operates general acute care and specialty hospitals, ambulatory surgery centers, urgent care centers and other outpatient facilities. 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.
ProPetro Holding Corp. (PUMP - Free Report) : This is an oilfield services company providing pressure pumping and other complementary services to leading upstream oil and gas companies engaged in the exploration and production of North American unconventional oil and natural gas resources. It has a Value Score of B and carries a Zacks Rank #2.
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Disclosure: Performance information for Zacks' portfolios and strategies are available at: https://www.zacks.com/performance.