Close

    Avoiding the Traps of Being Early: Value on the Move Screens

    by Wayne A. Thorp

    “The early bird gets the worm, but the second mouse gets the cheese.” Although this saying is identified with a New York City entertainer, it is apropos for value investors, who typically seek to get in early on worthy stocks but who need to avoid the traps set by unworthy stocks.

    Numerous studies have shown that value-oriented investing is more profitable than most other strategies over the long term. Value screens, such as a price-earnings screen, tend to look for low prices relative to actual measures of company performance, in this case earnings per share. A screen that looks only for low price-earnings stocks, however, can also be a trap with unintended results.

    Typically, firms with high growth potential trade at high(er) price-earnings ratios, while those with low growth potential trade at low(er) price-earnings ratios. As a result, a screen that simply seeks stocks with low price-earnings ratios may leave you with a list of companies that have little or no growth prospects, or stocks concentrated in industries with low price-earnings ratios.

    Another value trap is buying a low-priced stock only to have it remain low-priced, either because the stock deserves the low price or the market never catches on to the mispricing.

    One way of avoiding these traps is to look for some indication of growth, or growing demand for the stock (increasing price momentum) before investing in it.

    The PEG Ratio

    A popular technique for capturing elements of both value and growth centers on stocks with low price-earnings growth relative to their earnings growth-rate. The price-earnings-to-growth rate ratio—commonly known as the PEG ratio—is computed by dividing the price-earnings ratio by the earnings per share growth rate. As a rule of thumb, ratios below 1.0 indicate that a stock may be undervalued, while stocks with ratios above 1.0 may be overvalued. The idea is to purchase a stock with some demonstrated earnings growth before the market recognizes the company’s potential and bids up the price-earnings ratio.

    Stock Investor Pro, AAII’s fundamental stock screening and research database program, includes two built-in screens that seek potential value companies that are exhibiting a level of price momentum.

    Both PEG screens isolate exchange-listed companies that are undervalued based on their PEG ratios. However, one screen uses the historical growth rate in earnings per share to calculate the PEG ratio while the other screen uses an estimated earnings growth rate provided by analysts following the company. Furthermore, both screens require:

    • Positive, long-term annual earnings,
    • Same-quarter growth in earnings, and
    • Strong relative price performance.

    Screen Performance

    Figure 1.
    Performance of Value
    on the Move Screens
    CLICK ON IMAGE TO
    SEE FULL SIZE.

    The two PEG screens are built into AAII’s Stock Investor Pro. The companies passing both the Historical and Estimated Growth PEG ratio screens are posted on AAII.com under the name Value on the Move and the performance of these stocks in hypothetical portfolios is tracked on-line. The exact set of screening criteria for the two PEG screens is provided at the end of this article.

    Both PEG screens have outperformed the large-cap S&P 500 index and other broad market indexes since the beginning of 1998. As shown in Figure 1, the Historical Growth PEG screen has generated a cumulative return of 366.5% over the period from January 1998 through July 2006, while the Estimated Growth PEG screen has returned 712.7% over the same period. In addition, both screens have posted positive returns in each of the last eight years.

    Profile of Passing Companies

    The characteristics of the stocks passing both the Historical and Estimated PEG screens are presented in Table 1.

    The screens’ value orientation is evident in the median price-earnings ratios for those companies currently passing both the Historical Growth PEG and Estimated Growth PEG screens. The median price-earnings ratio for the Historical Growth PEG universe is 16.0 versus 14.8 for the Estimated Growth PEG universe. Compare this to the median price-earnings ratio of 18.4 for all exchange-listed stocks.

    Value screens are good at identifying neglected firms, but secondary screens for earnings growth are helpful in identifying stocks that are either poised for or are already participating in an upturn. With its emphasis on past earnings growth, the median historical earnings per share growth rate for those companies passing the Historical Growth PEG screen is 23.9%, compared to 21.0% for those stocks passing the Estimated Growth PEG screen. The median historical earnings growth rate for all exchange-listed stocks is 11.5%.

    As we have shown, the companies passing the two PEG screens have been able to outperform the market over the last several years. Additionally, Table 1 shows that the current roster of passing companies has outperformed the market over the last year. The Historical Growth PEG companies has outperformed the S&P 500 by 16% and the Estimated Growth PEG companies have outpaced the S&P by 23%. In contrast, exchange-listed stocks have underperformed the index by 1%.

    Table 1. Characteristics of Value on the Move Portfolios
    Portfolio Characteristics (Median) PEG Ratio Exchange-
    Listed
    Stocks
    Hist
    Grth
    Est
    Grth
    Price-earnings ratio (X) 16 14.8 18.4
    Price-to-book-value ratio (X) 2.82 2.91 2.03
    EPS 5-yr. historical growth rate (%) 23.9 21 11.5
    EPS 3-5 yr. estimated growth rate (%) 14 17.4 14.4
    PEG ratio (hist EPS growth) 0.7 0.7 1.1
    PEG ratio (est EPS growth) 1.2 0.8 1.3
    Market cap. ($ million) 2,135.20 2,127.50 418.2
    Relative strength vs. S&P (%) 16 23 –1
    Monthly Observations
    Average no. of passing stocks 100 49  
    Highest no. of passing stocks 216 138  
    Lowest no. of passing stocks 11 10  
    Monthly turnover (%) 36.5 44.3  

    Passing Companies

    Table 2 lists the top 10 companies for both the Historical Growth PEG and Estimated Growth PEG screens that have the highest 26-week relative strength rank as of August 11, 2006. For both groups, the companies are ranked in descending order by their 26-week relative strength rank.

    Currently, both PEG screens are generating more passing companies than their historical monthly average. For the Historical Growth PEG screen, 121 companies now pass the screen, compared to its historical monthly average of 100. Currently, there are 60 companies passing the Estimated Growth screen while historically 49 companies, on average, have passed the screen.

    The cornerstone of both strategies is the PEG ratio, which for both screens must be less than or equal to 1.0 and greater than 0.2. From the list in Table 2, four companies have the lowest historical growth PEG ratio (0.5) in their group, Intervest Bancshares, a bank holding company; Oceaneering International, which provides technical services and hardware primarily for underwater oil and gas exploration; Credit Acceptance Corp., a provider of auto loans; and pharmaceutical company AstraZeneca PLC. Spartan Motors, Inc., which engineers and manufacturers custom motor vehicle chassis and bodies including motor homes and emergency vehicles, has the lowest estimated growth PEG ratio in its group at 0.3.

    The two PEG screens also require that firms have positive earnings for each of the last five fiscal years. As stated, the Historical Growth PEG companies as a whole have a higher median historical earnings growth rate (23.9%) than that of the Estimated Growth PEG companies (21.0%). Leading the way for the historical growth screen is Oceaneering International at 41.7%.

    However, it is important to consider the base number when examining growth rates. It is much easier for a firm to have a very large growth rate when the starting point is low. Oceaneering International has increased its earnings per share from continuing operations from $0.21 to $1.21 between 2000 and 2005.

    On the flipside, the median estimated growth rate in earnings for the companies passing the Estimated Growth PEG screen surpasses that of the Historical Growth PEG screen, 17.4% to 14.0%. Among the top companies passing the Estimated Growth PEG screen, Spartan Motors has the highest consensus estimated earnings growth rate of 46.8%.

    Six of the 10 companies passing the Historical Growth PEG screen and listed in Table 2 have a consensus estimated growth rate for earnings. For the Estimated Growth PEG screen, an implicit criterion is that a company must have analyst coverage in order to have an estimated earnings growth rate. Less than 40% of companies in the Stock Investor database are covered by at least one analyst.

    While the two PEG screens require that companies have a 26-week relative price strength rank in the top 70% of the entire database, current market price as a percentage of the 52-week high price is another popular price momentum indicator. If a firm’s stock price continues to be strong, it should be trading near its 52-week high. As a group, the companies passing the Historical Growth PEG ratio screen are exhibiting slightly stronger price momentum, with a median price-as-a-percentage-of-52-week-high figure of 92, compared to 88 for those companies passing the Estimated Growth PEG screen. Smithtown Bancorp, a commercial and consumer banking holding company, has the highest price-as-a-percentage-of-52-week-high value among the top Historical Growth PEG movers from Table 2, as its current price is also at its 52-week high. Meanwhile, Marathon Oil Corporation, an oil and natural gas exploration and production company, has the highest value for the top Estimated Growth PEG movers of 96.

     

    Conclusion

    No matter how well a stock screening methodology has performed (or how badly it has underperformed) over the long term, stock screening is only the first step in the stock selection process.

    The stocks passing the Historical Growth PEG and Estimated Growth PEG screens do not represent “recommended” or “buy” lists of stocks. It is important to perform due diligence to verify the financial strength of the passing companies and to identify those stocks that match your investing tolerances and constraints before committing your investment dollars.

       What It Takes: Value on the Move Criteria
    • The ratio of the price-earnings ratio to the growth rate in earnings per share (five-year historical growth for the Historical Growth PEG screen, or three- to five-year estimated growth rate for the Estimated Growth PEG screen) is less than or equal to one and greater than 0.2;
    • Earnings per share from continuing operations for the last 12 months and for each of the last five fiscal years are positive;
    • Earnings per share from continuing operations for each of the last four fiscal quarters is greater than the same quarter one year earlier;
    • The 26-week relative price strength ranks in the top 70% of the entire database.


    Wayne A. Thorp, CFA, is financial analyst at AAII and editor of Computerized Investing.


→ Wayne A. Thorp