A pure-play value investor often misses the chance of betting on stocks that have bright long-term prospects. The same way, growth investors often end up investing in expensive stocks. Going by Warren Buffett, these two approaches are joined at the hip.
Accordingly, some investors have come up to join the bridge between value and growth with a hybrid strategy of investment. Their theory suggests that to make a long-term investment more effective the principles of both value and growth strategies need to be combined.
Accordingly, GARP (growth at a reasonable price) investment, often known as a special case of value investment, is gaining popularity. What GARPers look for is whether the stocks are somewhat undervalued and have solid sustainable growth potential (Investopedia).
Here lies the importance of a not-so-popular fundamental metric, the price/earnings growth (PEG) ratio. Although it is categorized under value investing, this strategy follows the principles of both growth and value investing.
The PEG ratio is defined as: (Price/ Earnings)/Earnings Growth Rate
It relates the stocks P/E ratio with future earnings growth rate.
While P/E alone only gives an idea of stocks that are trading at a discount, PEG, while adding the growth element to it, helps to identify stocks that have solid future potential.
A lower PEG ratio, preferably less than 1, is always better for GARP investors.
Say for example, if a stock's P/E ratio is 10 and expected long-term growth rate is 15%, the company's PEG will come down to 0.66, a ratio that indicates both undervaluation and future growth potential.
However, the question that often arises is whether the market has an adequate number of companies that are growing earnings while trading at reasonable valuations? Going by a
CFA Institute Blog by Nicolas Rabener, “on average, 38% of all stocks exhibit a PEG ratio below 1, which is more than enough for security selection.”
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 a very high growth 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 the 19 stocks that qualified the screening:
Jazz Pharmaceuticals plc ( JAZZ Quick Quote JAZZ - Free Report) is a specialty biopharmaceutical company with focus in the areas of sleep and hematology/oncology. Key drugs include Xyrem, Erwinaze, Defitelio and Vyxeos. The stock can be an impressive value investment pick with its Zacks Rank #2 and a Value Score of A. Apart from a discounted PEG and P/E, the stock also has an impressive long-term historical growth rate of 15.9%. Tenet Healthcare Corporation ( THC Quick Quote THC - Free Report) is a diversified healthcare services company. 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 also has an impressive long-term expected growth rate of 15.6%. AXA Equitable Holdings, Inc. ( EQH Quick Quote EQH - Free Report) is a major financial services companies in the United States and has two complementary and well-established principal franchises, AXA Equitable Life Insurance Company and AllianceBernstein. The company has an impressive growth rate of 7.4% for the next five years. 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 . Seaspan Corporation is an independent charter owner and operator of containerships with industry leading ship management services. The company charters its vessels primarily pursuant to long-term, fixed-rate, time charters to the world's largest container shipping liners. Apart from a discounted PEG and P/E, the stock has a Value Score of B and holds a Zacks Rank #2. Alexion Pharmaceuticals, Inc. ( ALXN Quick Quote ALXN - Free Report) is a biopharmaceutical company focused on the development and commercialization of life-transforming drugs, for the treatment of patients with ultra-rare disorders. The stock carries a Zacks Rank #2 and has a Value Score of B.
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