At a time when volatility strikes every second day, investors often rely on value investing rather than other options like growth or momentum. As soon as other investors start selling their stocks at a cheaper rate in times of market uncertainty, these value investors take this as an opportunity to pick good stocks at a discounted price.
However, this apparently simple value investment technique has some drawbacks and not understanding the strategy properly may often lead to “value traps”. In such a situation, 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 single out 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 would be 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 lower PEG ratio is always better for value investors.
While P/E alone fails to identify a true value stock, PEG helps to find the intrinsic value of a stock.
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 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 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 four out of nine stocks that qualified the screening:
Unilever plc (ADR) (NYSE:UL) is one of the world’s leading suppliers of Food, Home Care, Personal Care and Refreshment products with sales in over 190 countries. Its leading brands in the U.S. and Canada include Axe, Becel, Ben & Jerry’s, Dove, Lipton, Magnum, Nexxus, Noxzema, Pond’s, and Vaseline among many more. The company currently holds a Zacks Rank #1 and has a Value Style Score of ‘B’. The company also has an impressive expected five-year growth rate of 12%.
Nextera Energy Partners LP (NYSE:NEP): This Florida-based growth-oriented limited partnership formed by NextEra Energy acquires, manages and owns contracted clean energy projects with stable, long-term cash flows. The company also owns interests in wind and solar projects in North America as well as natural gas infrastructure assets in Texas. Apart from a discounted PEG and P/E, the stock has a Value Style Score of ‘A’ and holds a Zacks Rank #2. You can see the complete list of today’s Zacks #1 Rank stocks here.
Renewable Energy Group Inc (NASDAQ:REGI): This is a provider of cleaner, lower carbon intensity products and services. It internationally produces biomass-based diesel and develops renewable chemicals. The company also claims to be North America’s largest producer of advanced biofuel. The stock currently sports a Zacks Rank #1 and has a Value Style Score of ‘A’. The company also has an impressive long-term growth rate of 82%.
CAI International Inc (NYSE:CAI): This is a leading transportation finance and logistics company. The company holds a Zacks Rank #1 and has a Value Style Score of ‘A’. The stock also has an impressive earnings growth rate of 19.2% for the next year.
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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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