Looking for value in the market can be dangerous at times because stocks that are considered to be "values" based on fundamentals could be far from bargains. A stock typically will become a value opportunity after the share price falls, and as earnings and revenues remain stagnant or increase.
Another way a stock can be more attractive from a valuation viewpoint is for growth to increase faster than the price of the stock, creating a situation where valuations fall.
There is one sector in particular that has a large number of stocks that are value plays based on one important statistic—the PEG ratio. The PEG ratio is a reading that takes the price-to-earnings (P/E) ratio of a stock and divides it by the growth. For example, a stock with a P/E ratio of 20 and a growth rate of 5 would have a PEG ratio of 4.0. If a stock has the same P/E ratio of 20, but a growth rate of 40 it would have a PEG ratio of 0.5.
The lower the number, the higher the value in the stock. This measurement eliminates the misconception of a low P/E ratio. The growth must be put into the equation to get the true valuation of a stock. I will typically view a PEG ratio under 1.0 as an attractive stock based solely on valuation.
The industrials have several large-cap stocks with PEG ratios under 1.0 and they have charts that are quickly becoming bullish. Nearly all the stocks I am about to highlight have pulled back from 2012 highs and are nearing long-term support, which makes buying them at current levels a high reward-to-risk setup.
Eaton Corporation (ETN) provides electrical equipment and systems for a wide range of industries worldwide. Its products are by utilities, construction, mining, and the auto industry to name a few. The current PEG ratio is 0.91 and the company pays a 3.9% dividend. The chart shows the stock rally from a recent low of $36/share and it held the 52-week closing low of $34.16 set in October 2011. The stock is also trading above the 50-day moving average for the first time since March.
Caterpillar Inc. (CAT) is a giant in the manufacturing and distribution of construction and mining equipment around the globe. The stock is closely tied to the growth in China, as demand for its products depends on the projects underway. The PEG ratio is a mere 0.49 and the stock pays a dividend of 2.9%. Technically, the chart shows a stock with a similar pattern to Eaton. The stock hit a low of $78.25 and held above the one-year closing low of $70.55. The pullback that began in February cost Caterpillar about one-third of its value, and at current levels, it's is once again a value play.
Cummins Inc. (CMI) is a maker of diesel and natural gas engines, as well as engine-related components around the world. The company trades with a PEG ratio of 0.74 and pays a 2.3% dividend. The stock took a big hit recently after an earnings warning in mid-July. The stock traded as low as $82.20, but was able to hold above long-term support at the $80 area. This is a risky play, but as long as it can hold above $80, the setup has a high reward-to-risk ratio.
The success of all three companies mentioned above relies heavily on the global economic situation. If the eurozone, China, and North America can hold steady and avoid a global recession, they will be benefit greatly. And with such attractive valuations and above-average dividend yields, it makes them worth the risk.
Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in CAT over the next 72 hours.
