In the equity market, investments always need to be prudently hedged, in order to overcome uncertainties and limit losses related to external shocks. A question that arises often is whether one should resort to a value strategy that seeks discounted stocks or opt for growth investing, in times of extreme market instability.
The investing track of the Oracle of Omaha over the past few decades and his gradual shift from being a pure-play value investor to a GARP (growth at a reasonable price) investor might give us all the answers.
Under the GARP theory, the strategic mingling of growth and value-investing principles gives us a hybrid strategy offering an ideal investment by utilizing the best features of both. What GARPers look for is whether or not the stocks are somewhat undervalued and have solid sustainable growth potential (Investopedia).
GARP investing gives priority to one of the popular value metrics — 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 the future earnings growth rates.
While P/E alone gives an idea of stocks that are trading at a discount, PEG, while adding the growth element to it, helps identify stocks with 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 the expected long-term growth rate is 15%, the company's PEG will come down to 0.66, a ratio indicating both undervaluation and future growth potential.
Unfortunately, this ratio is often neglected due to investors' limitations 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 rate, followed by a sustainable but lower growth rate over the long term.
Hence, PEG-based investing can 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 18 stocks that qualified the screening:
Headquartered in Denver, CO, DaVita Inc. (DVA - Free Report) 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 can be an impressive value investment pick with its Zacks Rank #1 and a Value Score of A. Apart from a discounted PEG and P/E, the stock also has an impressive long-term expected growth rate of 20.4%.
Legg Mason Inc. is a global asset management firm focused on growth and preservation of its clients' capital through the company’s proprietary mutual funds and separately-managed accounts (SMAs). 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 a solid long-term expected growth rate of 13.2%.
PG&E Corporation (PCG - Free Report) is the parent holding company of California’s largest regulated electric and gas utility, Pacific Gas and Electric Company. Apart from a discounted PEG and P/E, the stock has a Value Score of A and holds a Zacks Rank #2. You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.
Cardinal Health, Inc. (CAH - Free Report) is a nation-wide drug distributor and provider of services to pharmacies, healthcare providers and manufacturers. The company has an impressive growth rate of 6.2% for the next five years. The stock currently has a Value Score of A and carries a Zacks Rank #2.
McKesson Corporation (MCK - Free Report) is a health care services and information technology company that distributes branded and generic pharmaceutical drugs, along with other healthcare-related products on a global basis worldwide. The stock carries a Zacks Rank of 2 and has a Value Score of A.
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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.