A pure-play value investor often misses the chance of betting on stocks that have bright long-term prospects. Similarly, growth investors often end up investing in expensive stocks. These kind of investments particularly gain significance during periods of economic turbulence, minimizing recessionary hurdles. This strategy helps find out all good stocks with solid long-term prospects, which become absurdly cheap amid economic woes.
For that reason, some investors have look to bridge the gap between value and growth with a hybrid strategy of investment. Their theory suggests that the principles of both value and growth strategies need to be combined in order to make a long-term investment more effective.
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 or not the stocks are somewhat undervalued and have solid sustainable growth potential (Investopedia).
And 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 the future earnings growth rate.
While P/E alone only gives an idea of the stocks that are trading at a discount, PEG, while adding the growth element to it, helps 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 or not 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 over 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 of 29 stocks that qualified the screening:
Regal Beloit RBC is a leading manufacturer of electrical and mechanical motion control products. The company offers an array of electric motors, blowers, electric generators, transfer switches, gearboxes, power generation components and controls. The stock can be an impressive value investment pick with its Zacks Rank #2 and a Value Score of B. Apart from a discounted PEG and P/E, the stock also has an impressive long-term expected growth rate of 10%. You can see the complete list of today’s Zacks #1 Rank stocks here.
The Allstate Corp. ALL is one of the major property-casualty (P&C) insurers and personal lines carriers in the United States. The company also provides a range of life insurance and investment products to its diverse customer base. The stock can also 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 historical growth rate of 14%.
United Rentals, Inc. URI is a leading equipment rental company in the world, with an integrated network of 1,181 rental locations in North America and Europe. The company offers 4,000 classes of equipment for rent at a total original equipment cost of $14.1 billion. The company has an impressive long-term historical growth rate of 24%. The stock currently has a Value Score of A and carries a Zacks Rank of 1.
PulteGroup Inc. PHM engages in homebuilding and financial services businesses, primarily in the United States. The company conducts operations through two primary business segments — Homebuilding and Financial Services. Apart from a discounted PEG and P/E, the stock has a Value Score of B and holds a Zacks Rank #1, at present. The company has an impressive long-term historical growth rate of 21%.
Fresenius Medical Care FMS is one of the largest integrated providers of products and services for individuals undergoing dialysis following chronic kidney failure. Currently, the stock carries a Zacks Rank #2 and has a Value Score of A.
You can get the rest of the stocks on this list by signing up now for your 2-week free trial to the Research Wizard and start using this screen in your own trading. Further, you can also create your own strategies and test them first before taking the investment plunge.
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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.
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The Allstate Corporation (ALL) : Free Stock Analysis Report
PulteGroup, Inc. (PHM) : Free Stock Analysis Report
Fresenius Medical Care AG Co. KGaA (FMS) : Free Stock Analysis Report
Regal Beloit Corporation (RBC) : Free Stock Analysis Report
United Rentals, Inc. (URI) : Free Stock Analysis Report
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