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 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 26 stocks that qualified the screening:
Guess', Inc. (GES - Free Report) : This famous global lifestyle brand designs, markets, distributes and licenses a lifestyle collection of contemporary apparel, denim, handbags, watches, eyewear, footwear and other related consumer products. The stock can be an impressive value investment pick with its Zacks Rank #1 and Value Score of B. The company’s long-term expected earnings growth rate is 17.5%.
The Goldman Sachs Group, Inc. (GS - Free Report) : This is a leading global financial holding company providing investment banking, securities and investment management services to a diversified client base. The company is headquartered in New York, with offices in London, Frankfurt, Tokyo, Hong Kong and other major financial centers around the world. Apart from a Zacks Rank #2 and a Value Score of A, the stock has an impressive long-term expected growth rate of 12%.
General Motors Company (GM - Free Report) : This leading global automotive company is engaged in designing, building and selling cars, trucks, crossovers and automobile parts worldwide. The company is also expanding autonomous vehicle business. The stock can also 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 has a stellar long-term historical growth rate of 15.5%.
MetLife, Inc. (MET - Free Report) : It is an insurance-based global financial services company providing protection and investment products to a range of individual and institutional customers. In addition to offering individual insurance, annuity, and investment products, the company provides group insurance, retirement and savings products, and services. The stock has an impressive long-term expected growth rate of 8%. 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.
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. The company has a Value Score of A and carries a Zacks Rank #2.
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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.