The common investing mantra is to chase stocks with a low price-to-earnings (P/E) ratio. That’s because this basic measure of how much investors are spending for $1 worth of earnings speaks of undervaluation. The logic is simple – a stock’s current market price does not justify its higher earnings and therefore leaves room for upside.
But have you ever given it a thought that stocks with a rising P/E can also be worth buying? We’ll tell you why.
Power of Increasing P/E
The concept is that as earnings rise, so should the price of the stock. As forecasts for expected earnings come in higher, strong demand for the stock should continue to push up its prices. After all, a stock's P/E gives an indication of how much investors are ready to shell out per dollar of earnings.
Suppose an investor wants to buy a stock with a P/E ratio of 30, it means that he is willing to shell out $30 for only $1 worth of earnings. Now if the P/E ratio becomes 35 within a short spell of time, it means that the person is now ready to pay $35 for only $1 worth of earnings. It shows that the investor expects earnings of the company to rise at a faster pace in the future owing to strong fundamentals.
So, if the P/E of a stock is rising steadily, it means that investors are assured of its inherent strength and expect some strong positives out of it. Also, studies have revealed that stocks have seen their P/E ratios jump over 100% from their breakout point in the cycle. So, if you can pick stocks early in their breakout cycle, you can end up seeing considerable gains.
The Winning Strategy
In order to shortlist stocks that are exhibiting an increasing P/E, we chose the following as our primary screening parameters.
EPS growth estimate for the current year is greater than or equal to last year’s actual growth
Percentage change in last year EPS should be greater than or equal to zero
(These two criteria point to flat earnings or a growth trend over the years.)
Percentage change in price over four weeks greater than the percentage change in price over 12 weeks
Percentage change in price over 12 weeks greater than percentage change in price over 24 weeks
(These two criteria show that price of the stock is increasing consistently over the said timeframes.)
Percentage price change for four weeks relative to the S&P 500 greater than the percentage price change for 12 weeks relative to the S&P 500
Percentage price change for 12 weeks relative to the S&P 500 greater than the percentage price change for 24 weeks relative to the S&P 500
(Here, the case for consistent price gains gets even stronger as it displays percentage price changes relative to the S&P 500.)
Percentage price change for 12 weeks is 20% higher than or equal to the percentage price change for 24 weeks, but it should not exceed 100%
(A 20% increase in the price of a stock from the breakout point gives cues of an impending uptrend. But a jump of over 100% indicates that there is limited scope for further upside and that the stock might be due for a reversal.)
In addition, we place a few other criteria that lead us to some likely outperformers.
Zacks Rank less than or equal to 2: Only companies with a Zacks Rank #1 (Strong Buy) or 2 (Buy) can get through.
Average 20-day Volume greater than or equal to 50,000: High trading volume implies that the stocks have adequate liquidity.
Just these few criteria narrowed down the universe from over 7,700 stocks to just 23.
Here are five out of the 23 stocks:
Summer Infant Inc. SUMR: The company is a designer and distributor of juvenile health, safety and wellness products. Its Zacks Industry Rank is in the top 25%, at the time of writing. The stock carries a Zacks Rank #1. You can see the complete list of today’s Zacks #1 Rank stocks here.
TerraVia Holdings Inc. TVIA: It provides food, nutrition and specialty ingredients. Its Zacks Industry Rank is in the top 25%. The stock has a Zacks Rank #2.
Addus HomeCare Corporation ADUS: This Zacks Rank #2 company is a provider of a broad range of social and medical services in the home. Its Zacks Industry Rank is in the top 34%.
Schnitzer Steel Industries Inc. SCHN: It is engaged in operating one of the largest metals recycling businesses in the United States. The stock carries a Zacks Rank #2. The Zacks Industry Rank is in the top 26%.
Research Frontiers Inc REFR: It is into the development and licensing of suspended particle technology and devices to control the transmission of light. It has a Zacks Rank #2. The Zacks Industry Rank is in the top 31%.
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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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