Not a single investor this era can casually overlook any of the investment picks and market tips of the Oracle of Omaha. If we delve deeper into how Warren Buffet became the most successful value investor of the 21st century — it is not difficult to realize the huge significance of the “intrinsic value” of the stock that does most of the tricks.
One wonders how this single term has managed to successfully continue as the fundamental value investing mantra for so long despite all kinds of vagaries of the market. The answer is apparently simple – pick the stocks which the market is currently undervaluing. Yardsticks such as dividend yield, the ratio of price to earnings or to book value are the most common forms of intrinsic value calculation, which can easily single out whether a stock is trading at a discount.
But will this alone ensure success? What if there is a dearth of catalysts to propel growth even though the stock is cheap? In such a case, if you buy a stock at less than its fair value, you might still end up paying more. To avoid such value traps, Buffet has advised investors to keep a focus on the earnings growth potential of a stock. And here comes 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 finding 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 (Strong Buy) or #2 (Buy) 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 or 2 offer the best upside potential.
Here are five of the 10 stocks that qualified the screening:
Dean Foods Company (DF)
BASF SE (BASFY)
Trinseo SA (TSE)
Manulife Financial Corporation (MFC)
Tutor Perini Corporation (TPC)
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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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