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To create the list below we began with a universe of stocks that appear undervalued relative to earnings growth, with PEG below 1. The PEG ratio is used to determine a stock's value while taking into account earnings growth. Similar to the PE ratio, a lower PEG means that the stock appears undervalued. We found around 60 stocks that met the criteria.

We then screened stocks that appear undervalued relative to the Graham Number. The Graham Number is a measure of maximum fair value created by the "godfather of value investing" Benjamin Graham.

It is based off of a stock's EPS and book value per share (BVPS).

Graham Number = SQRT(22.5 x TTM EPS x MRQ BVPS)

The equation assumes that P/E should not be higher than 15 and P/BV should not be higher than 1.5. Stocks trading well below their Graham Number may be undervalued.

Finally, we researched their 13F's looking for those with bullish sentiment from institutional investors, with significant net institutional purchases over the last quarter representing at least 5% of share float. This indicates that institutional investors such as hedge fund managers and mutual fund managers expect these names to outperform into the future.

The List

Our final list consisted of 5 stocks. Do you think these valuations played a role in hedge funds' decision to invest? Use the list below as a starting point of your analysis.

For an interactive version of this chart, click on the image below. Analyst ratings sourced from Zacks Investment Research.

1. AFLAC Inc. (AFL): Provides supplemental health and life insurance.

  • Market cap at $24.1B, most recent closing price at $51.56.
  • Net institutional purchases in the current quarter at 30.5M shares, which represents about 6.66% of the company's float of 458.04M shares. The top 2 holders of the stock are The Vanguard Group, and State Street Capital.
  • Diluted TTM earnings per share at 6.11, and a MRQ book value per share value at 34.16, implies a Graham Number fair value = sqrt(22.5*6.11*34.16) = $68.53. Based on the stock's price at $49.39, this implies a potential upside of 38.75% from current levels.
  • PEG at 0.88.

2. CAI International Inc. (CAP): Engages in the intermodal marine cargo container leasing business worldwide.

  • Market cap at $649.45M, most recent closing price at $29.44.
  • Net institutional purchases in the current quarter at 4.2M shares, which represents about 26.96% of the company's float of 15.58M shares. The top 2 holders of the stock are Columbia Wanger Asset Management, and William Blair & Co.
  • Diluted TTM earnings per share at 3.18, and a MRQ book value per share value at 15.73, implies a Graham Number fair value = sqrt(22.5*3.18*15.73) = $33.55. Based on the stock's price at $28.02, this implies a potential upside of 19.73% from current levels.
  • PEG at 0.68.

3. Cardinal Financial Corp. (CFNL): Operates as the holding company for Cardinal Bank that provides banking products and services to commercial and retail customers in Virginia and greater Washington.

  • Market cap at $464.34M, most recent closing price at $15.35.
  • Net institutional purchases in the current quarter at 2.3M shares, which represents about 7.88% of the company's float of 29.18M shares. The top 2 holders of the stock are Eagle Asset Management, and Chartwell Investment Partners.
  • Diluted TTM earnings per share at 1.51, and a MRQ book value per share value at 10.19, implies a Graham Number fair value = sqrt(22.5*1.51*10.19) = $18.61. Based on the stock's price at $15.02, this implies a potential upside of 23.88% from current levels.
  • PEG at 0.57.

4. Encore Capital Group, Inc. (ECPG): Engages in consumer debt buying and recovery business.

  • Market cap at $647.46M, most recent closing price at $27.92.
  • Net institutional purchases in the current quarter at 1.9M shares, which represents about 9.29% of the company's float of 20.45M shares. The top 2 holders of the stock are Alydar Partners LLC., and The Vanguard Group.
  • Diluted TTM earnings per share at 2.69, and a MRQ book value per share value at 17.5, implies a Graham Number fair value = sqrt(22.5*2.69*17.5) = $32.55. Based on the stock's price at $27.13, this implies a potential upside of 19.96% from current levels.
  • PEG at 0.61.

5. Kronos Worldwide Inc. (KRO): Engages in the production and marketing of titanium dioxide pigments in North America and Europe.

  • Market cap at $1.84B, most recent closing price at $15.88.
  • Net institutional purchases in the current quarter at 2.0M shares, which represents about 9.98% of the company's float of 20.04M shares. The top 2 holders of the stock are American International Group, and Bank of New York Mellon.
  • Diluted TTM earnings per share at 1.89, and a MRQ book value per share value at 9.16, implies a Graham Number fair value = sqrt(22.5*1.89*9.16) = $19.74. Based on the stock's price at $15.07, this implies a potential upside of 30.97% from current levels.
  • PEG at 0.93.

*EPS and BVPS data sourced from Yahoo! Finance, all other data sourced from Finviz.

Source: Hedge Funds Are Buying These 5 Stocks Undervalued By Earnings Growth And The Graham Number