Following the investment track of Oracle of Omaha, we can see how, in quest of excellence, this pure play value investor gradually shifted to become a GARP (growth at a reasonable price) investor. According to him, while picking undervalued stocks, investors also need to focus on its earnings growth potential.
GARP combines both growth and value investing principles and offers a mixed investing strategy that has a proven track record of success.
What GARPers look for is whether 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 future earnings growth rate.
While P/E alone only gives the idea of stocks, which are trading at a discount, PEG while adding the GROWTH element to it, helps to find those 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 which indicates both undervaluation and future growth potential.
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 very high growth rates 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 five of the 28 stocks that qualified the screening:
Coca-Cola FEMSA, S.A.B. de C.V. (KOF – Free Report) : This franchise bottler produces, markets, distributes, and sells Coca-Cola trademark beverages. The company offers a portfolio of products, including sparkling beverages, still beverages, juices, sports, and energy drinks, as well as teas, waters, isotonics, and dairy products. Apart from a Zacks Rank #1 and a Value Style Score of B, the stock also has an impressive long-term expected growth rate of 17.5%.
Banco Bilbao Vizcaya Argentaria, S.A. (BBVA – Free Report) : BBVA Compass ranks among the top 25 largest U.S. commercial banks based on deposit market share and ranks among the largest banks in Alabama (2nd), Texas (4th) and Arizona (5th). The stock also can be an impressive value investment pick with its Zacks Rank #2 and Value Style Score of A. Apart from a discounted PEG and P/E, the stock also has an impressive long-term expected growth rate of 10.3%.
Lantheus Holdings, Inc. (LNTH – Free Report) : The company develops, manufactures, and commercializes diagnostic medical imaging agents and products for the diagnosis and treatment of cardiovascular and other diseases worldwide. Apart from a Zacks Rank #2 and Value Style Score of A, the company also has an impressive expected growth rate of 52% for the current fiscal.
Gilead Sciences, Inc. (GILD – Free Report) : This biopharmaceutical company is focused on developing drugs for the treatment of human immunodeficiency virus (HIV), liver diseases such as chronic hepatitis C virus (HCV) infection and chronic hepatitis B virus (HBV) infection, cardiovascular, hematology/oncology and inflammation/respiratory diseases. The company holds a Zacks Rank #2 and has a Value Style Score A. It also has an impressive five-year historical growth rate of 44%.
Lam Research Corporation (LRCX – Free Report) : This is a global supplier of innovative wafer fabrication equipment and services to the semiconductor industry. Apart from a Zacks Rank #1 and Value Style Score of B, the company also has an impressive long-term expected growth rate of 17.2%.
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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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