This week, we cover the Value on the Move strategy using estimated growth and give you a list of stocks currently passing our screen based on the approach. Investors are engaged in the battle of trying to buy low and sell high. Strategy and tactics are critical elements in this struggle. Growth strategies do well over certain market periods, but long-term studies still point to successful investing results by following a disciplined contrarian, value-driven strategy. Value investors argue that while the market may be efficient in the long term, emotions often dominate in the short term. These emotions can overtake rational analysis, pushing a stock’s price above its intrinsic value during periods of euphoria and below its true worth when reacting to bad news.
The Value on the Move strategy focuses on finding stocks that are growing while currently trading at a reasonable price. As of May 31, 2023, AAII’s Value on the Move — PEG With Estimated Growth screen has an annual gain since inception (1998) of 12.9%, versus 5.7% for the S&P 500 index over the same period. The screen is up 6.2% year to date, compared to an increase of 9.8% for the S&P 500 over the same period.
Value on the Move Strategy Overview
Value screens seek out companies trading with low prices relative to actual measures of company performance or assets. The price-earnings (P/E) ratio, or multiple, is computed by dividing a stock’s price by trailing 12-month earnings per share. The price-earnings ratio is followed closely because it embodies the market’s expectations of future company performance and risk through the price component of the ratio and relates it to historical company performance as measured by earnings per share.
However, a simple search for low price-earnings ratios can be misleading as a screen for undervalued stocks. Price-earnings ratios adjust to expectations of future earnings performance. Stocks with high expectations normally trade with high price-earnings ratios, while stocks with low perceived growth potential or low probability of achieving their growth potential trade with low price-earnings ratios. Simple screens for low price-earnings stocks without additional qualifiers typically turn up lists of troubled stocks or stocks with earnings expected to drop in the future. It is not uncommon to see firms in dying industries, companies on the brink of insolvency or even stocks facing potentially devastating litigation pass low price-earnings screens. Screening for high price-earnings stocks is not the answer either. While firms with high price-earnings ratios normally have everything going positively for them now, investors have typically overpaid for their expectation.
As investors change their perceptions of the risk-reward possibility of a stock, the price-earnings multiple changes to reflect the new consensus. A stock that exceeds expectations could get a large price boost from an expansion of the price-earnings ratio coupled with the actual earnings increase. However, stocks with very high expectations often get hammered after issuing an earnings warning, as analysts decrease the price-earnings ratio they are willing to pay for the firm in addition to lowering future earnings estimates. Stock movement is not only controlled by the level of earnings, but it is also affected by results compared to expectations. Your analysis should focus on whether the market consensus of future earnings growth is realistic.
Price-Earnings to Earnings Growth: The PEG Ratio
One of the most popular techniques used to balance the relationship of company value to growth involves simply relating the price-earnings ratio to its earnings growth. The price-earnings-to-earnings-growth (PEG) ratio is computed by dividing the price-earnings ratio by the earnings growth rate. Ratios below one indicate that a stock may be undervalued, while stocks with ratios above one may be overvalued. The idea is to purchase a stock with demonstrated or expected earnings growth before the market recognizes the company’s potential and bids up the price-earnings ratio.
The PEG ratio can be created using either the historical or the expected growth rate. Investment analysis is forward-looking. While historical earnings are easy to view, expectations are more difficult to judge. Services such as I/B/E/S collect and report analyst expectations of earnings, but many small-cap companies will have only a small number of analysts tracking earnings, if any at all.
A PEG ratio using expected growth should help to highlight firms with reasonable price-earnings ratios given their expected growth rates. Keep in mind that studies indicate that even analysts are normally too optimistic in their long-term growth forecasts for firms with high expectations. A PEG ratio constructed with historical earnings growth should highlight firms priced reasonably given their record of accomplishment. It should also highlight a broader range of companies. The weakness with relying solely on historical growth is that it may no longer be reflective of future potential.
Very high growth rates are not sustainable. Normally, growth rates above 20% per year cannot be sustained in the long term. Extremely high growth rates are usually due to special situations in which earnings for the base year of the growth rate calculation are near zero or negative. We are not setting a floor or limit for the growth rate used in the PEG ratios, but you should carefully examine both the year-by-year historical figures and the basis of the expected company growth.
It is important to remember that the growth rate is a raw growth figure that does not divulge any change in trend or indicate the variability of earnings. The easiest and most direct way to judge earnings is to examine the earnings directly year by year, looking for stability and accelerating growth. As a basic screen, we are requiring positive earnings per share from continuing operations for the trailing 12 months and each of the last five years.
The sales growth rate is often used to confirm the strength of earnings growth. Sales are less susceptible than earnings to variability due to accounting choices by management, and sales often point to changes in company trends before it becomes apparent in earnings. Beyond examining the overall sales growth rate, it is important to look at the year-by-year sales figures to determine the consistency and trend of the growth.
Quarterly Earnings per Share Strength
Value screens such as low price-earnings filters are good at identifying neglected firms, but secondary screens for quarterly earnings growth are useful complements. Quarterly earnings may indicate a change in the trend of earnings more quickly than just examining annual earnings figures. Quarterly earnings are closely examined by the market and deviations from the expected norm are quickly rewarded or punished.
When studying quarterly earnings, you typically cannot compare one quarter to the previous quarter in a meaningful manner. It is more useful to look at “quarter-on-quarter” or “comparable-quarter” earnings changes, where one quarter is compared to the same quarter from the previous year. Many firms have annual seasonal cycles in either sales or production; the stronger the pattern, the more important it is to make quarter-on-quarter comparisons.
Our screen requires that each of the last four quarters’ earnings per share be higher than the same quarter one year earlier.
As always, it is important to look at factors leading to the growth and determine if the growth is sustainable. When examining a firm’s earnings patterns, it is necessary to carefully read both quarterly and annual reports, which can clue you in to possible explanations in the earnings growth pattern. Is the economy expected to slow down? Was a significant portion of the earnings growth achieved through acquisition or internal growth? Did earnings growth in a franchise come from increases in same-store sales or the opening of new stores? Did currency translations impact earnings? Are competitive conditions changing within the industry? Are margins increasing or decreasing? For example, without increasing sales and earnings from existing stores or steady or improving margins, earnings momentum may slow.
Price momentum is often used as a signal that the market has recognized the relative attractiveness of a company. Price momentum is normally measured by comparing the stock price change to that of a market index or against a segment of stocks. Investors look for stock price performance better than that of other stocks with the belief that the rising price will attract other investors, who will drive up the price even more.
There are many tools used to measure price momentum; our screen relies on the relative strength rank. The relative strength rank indicates how a company’s stock price has performed relative to all other stocks. A rank of 50% indicates that the stock’s performance is better than 50% of all firms, while a rank of 90% indicates that a stock has outperformed 90% of all stocks. We specify a minimum relative strength rank of 70% over the last 26 weeks for our screen. Looking at performance over the last half year helps to identify stocks that have had relevant strong price performance. The table below presents the companies with low estimated PEG ratios, along with the historical PEG ratios. The PEG ratios for both use the current price-earnings ratio but use different growth rates. The estimated PEG ratio is calculated with the I/B/E/S consensus long-term earnings per share growth rate estimate, while the historical PEG ratio is calculated with the historical five-year growth rate. The companies in the table are ranked by their relative price strength.
Value screens attempt to identify undervalued stocks. However, patience is required while waiting for the market to recognize the value of a stock. Combining value with price and earnings momentum screens should help to identify reasonably priced stocks on the move. But always keep in mind that the purpose of these screens is to illustrate a potential useful combination of value and momentum analysis with real firms. The screens are a mere first step in the stock selection process.
Stocks Passing the Value on the Move — PEG With Estimated Growth Screen (Ranked by 26-Week Relative Strength Rank)
The stocks meeting the criteria of the approach do not represent a “recommended” or “buy” list. It is important to perform due diligence.
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