I tried to create an investing strategy of value stocks that can outperform the market by a big margin. The following screen shows such promise. I have searched for highly profitable companies that are included in the Russell 1000 index with a very low PEG ratio and a low debt. Those companies would have to show also good earnings growth prospects, and their current ratio is greater than the current ratio one year before.
The PEG ratio is defined as:
A stock's price-to-earnings ratio divided by the growth rate of its earnings for a specified time period. The price/earnings to growth (PEG) ratio is used to determine a stock's value while taking the company's earnings growth into account, and is considered to provide a more complete picture than the P/E ratio. While a high P/E ratio may make a stock look like a good buy, factoring in the company's growth rate to get the stock's PEG ratio can tell a different story. The lower the PEG ratio, the more the stock may be undervalued given its earnings performance. The calculation is as follows: P/E ratio/Annual EPS Growth.
Russell 1000 Index
The Russell 1000 Index measures the performance of the large-cap segment of the U.S. equity universe. It is a subset of the Russell 3000® Index and includes approximately 1000 of the largest securities based on a combination of their market cap and current index membership. The Russell 1000 represents approximately 92% of the U.S. market.
The screen's method requires all stocks to comply with all following demands:
- The PEG ratio is less than 1.00.
- The trailing P/E is less than 10.
- Total debt-to-equity ratio is less than 0.50.
- Average annual earnings growth estimates for the next 5 years is greater than 5%.
- The current ratio is greater than the current ratio one year before.
- The 8 stocks with the highest earnings growth estimates for the next 5 years among all the stocks that complied with the first five demands.
I used the Portfolio123's powerful screener to perform the search and to run back-tests. Nonetheless, the screening method should only serve as a basis for further research. All the data for this article were taken from Portfolio123.
After running this screen on May 21, 2013, before the market open, I discovered the following eight stocks: Cadence Design Systems Inc (NASDAQ:CDNS), Golar LNG Ltd (NASDAQ:GLNG), Lear Corp (NYSE:LEA), HollyFrontier Corp (NYSE:HFC), Marathon Petroleum Corp (NYSE:MPC), Joy Global Inc (NYSE:JOY), Humana Inc. (NYSE:HUM) and Apollo Group Inc (NASDAQ:APOL).
The table below presents the eight companies, their last price, their market cap and their industry.
The table below presents the PEG ratio, the trailing P/E, the debt-to-equity ratio, the average annual EPS growth estimates for the next five years, the current ratio and the current ratio one year before for the eight companies.
In order to find out how such a screening formula would have performed during the last year, last 5 years and last 14 years, I ran the back-tests, which are available by the Portfolio123's screener.
The back test takes into account running the screen every four weeks and replacing the stocks that no longer comply with the screening requirement with other stocks that comply with the requirement. The theoretical return is calculated in comparison to the benchmark (S&P 500), considering 0.25% slippage for each trade and 1.5% annual carry cost (broker cost). The back-tests results are shown in the charts and the tables below.
One year back-test
Just a matter of curiosity, the table below presents the eight companies originated by the screen formula one year before, on May 19, 2012.
Five years back-test
The table below presents the eight companies originated by the screen formula five years before, on August 09, 2008.
Fourteen years back-test
The table below presents the eight companies originated by the screen formula fourteen years before, on January 29, 2000.
The Russell 1000 value stocks screen has given much better returns during the last year, the last five years and the last 14 years than the S&P 500 benchmark. The Sharpe ratio, which measures the ratio of reward to risk, was also much better in all the three tests. The one year return of the screen was exceptionally high at 69.53% while the return of the S&P 500 index during the same period was at 27.60%. The difference between the Russell 1000 value stocks screen to the S&P 500 benchmark was much more noticeable in the 14 years back-test. The 14-year average annual return of the screen was at 15.97% while the average annual return of the S&P 500 index during the same period was only 2.14%. Although this screening system has given superior results, I recommend readers use this list of stocks as a basis for further research.