Value investing is gaining popularity by the day. The success of value investors like Warren Buffett further underscores this.
However, this apparently simple value investment technique has some drawbacks and not understanding the strategy properly may lead to “value traps”. These value picks start to underperform over the long run as the temporary problems, which once drove the share price down, turn out to be persistent. There are many value investment yardsticks such as dividend yield, P/E or P/B, which are simple and can show whether a stock is trading at a discount.
However, for investors looking to escape such value traps, it is also vital to determine where the stock is headed in the next 12 to 24 months. Warren Buffett advises these investors to focus on the earnings growth potential of a stock. This is where lies the importance of a not-so-popular value investing metric, the PEG ratio.
The PEG ratio is defined as: (Price/Earnings)/Earnings Growth Rate
A low PEG ratio is always better for value investors.
While P/E alone fails to identify a true value stock, PEG helps determine the intrinsic value of a stock.
There are some drawbacks of using the PEG ratio though. It doesn’t 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 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 four stocks that qualified the screening:
GMS Inc. GMS: It is a leading North American distributor of wallboard and suspended ceilings systems. The company operates a network of more than 210 distribution centers across the United States. GMS can be an impressive value investment pick with its Zacks Rank #1 and Value Score of A. The company’s expected earnings growth rate for the current fiscal is 62%.
Nucor Corporation NUE: The company manufactures and sells steel and steel products in the United States and internationally. It operates in three segments: Steel Mills, Steel Products, and Raw Materials. Apart from a Zacks Rank #2 and a Value Score of A, the stock has an impressive long-term historical growth rate of 13.4%.
Lennar Corporation LEN: The company operates as a homebuilder, primarily under the Lennar brand in the United States. The stock also can be an impressive value investment pick with its Zacks Rank #1 and Value Score of A. Apart from a discounted PEG and P/E, the stock has a stellar long-term expected growth rate of 19%.
Everest Re Group, Ltd. RE: This is a Bermuda holding company that operates through the following subsidiaries -- Everest Reinsurance Company (provides reinsurance to property and casualty insurers in both the United States and international markets) and Everest Reinsurance (Bermuda), Ltd., (provides reinsurance and insurance to worldwide property and casualty markets and reinsurance to life insurers). The stock has an impressive long-term expected growth rate of 10%. 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.
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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.
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GMS Inc. (GMS) : Free Stock Analysis Report
Lennar Corporation (LEN) : Free Stock Analysis Report
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Nucor Corporation (NUE) : Free Stock Analysis Report
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