Successful investing doesn't need to be too complicated. It all comes down to trying to find out which stocks to buy and when to buy them. The following article offers a quantitative system based on a combination of valuation ratios, earnings expectations, and momentum to try to buy the right stocks at the right time.
No quantitative system is perfect or infallible, but the main idea behind the quantitative system makes sense from a theoretical perspective, and backtested performance numbers look quite encouraging.
My Favorite Valuation Ratio
The PEG - price to earnings growth - ratio, can offer plenty of advantages versus other valuation indicators. In this case, we are calculating the PEG ratio by dividing the forward PE ratio by the expected long-term growth rate in earnings.
Most valuation indicators have a key weakness, which is that they don’t have growth in consideration. Ratios such as price to earnings (P/E) and price to cash flow (P/FCF) can be very intuitive. However, if two companies have different expected growth rates, then you can't compare them based on current earnings and cash flows alone.
All else the same, the higher the expected growth in earnings, the more valuable each dollar in earnings from such company. In other words, the PE ratio should obviously higher for high growth companies. By dividing the P/E ratio by the expected earnings growth rate, the resulting ratio is far more valuable and comprehensive.
In a nutshell, the PEG ratio is a particularly strong valuation ratio because it incorporates the impact of different growth rates into valuation, and this makes it superior to most other valuation metrics.
The system starts with a screener, meaning that only companies that meet certain requirements are considered for inclusion in the portfolio.
To begin with, the system excludes over the counter stocks and companies with a market capitalization level below $250 million from the investable universe. This is to guarantee a minimum size and liquidity.
After that, the system selects only companies with a PEG ratio below the industry average. The company also needs to be in the best 50% of stocks in the industry based on the PEG ratio.
To make the valuation criteria more robust, the company must also be in the best 50% of all companies in the industry based on the forward PE ratio.
This can raise an important question: If PEG is a much stronger indicator than traditional PE, why should we also include the forward PE as a consideration in the screen?
It’s important to analyze the PE ratio in comparison to growth expectations, since higher growth should obviously mean a higher PE. However, that relationship should not be linear. Rapid growth is more difficult to sustain over time than moderate growth. This means that you want to be cautious when paying up for high growth stocks.
In other words, you want to make sure that the stock is also reasonable based on current earnings as opposed to looking only at long term growth expectations. This screen is using the forward PE ratio based on earnings expectations for next fiscal year, so it’s forward looking as opposed to backward looking like the traditional PE.
After that, the screen requires companies to have rising earnings expectations over the past 13 weeks. This is another way of saying that the average earnings estimate for the current year needs to be higher than it was 13 weeks ago.
The main rationale is quite simple, stock prices are not only driven by value and fundamentals, but also by expectations. When expectations for a company are rising, this generally means that the stock price is rising too.
Wrapping up, the screen has the following requirements
- Non-over the counter, and market capitalization above $250 million.
- PEG ratio below the industry average and PEG ratio in the cheapest 50% of stocks in the industry.
- Forward PE ratio in the best 50% of stocks in the industry based on earnings expectations for next fiscal year.
- Rising earnings estimates for the current year over the past 13 weeks.
This set of criteria is quite demanding, from an initial database of almost 6,000 stocks we have only 604 names that meet the screening requirements. Among those names, the system picks the 50 stocks with the highest price momentum over the past year.
Momentum can a powerful return driver for stocks, since stocks that are outperforming the market tend to continue doing so more often than not. Besides, money has an opportunity cost. If we are going to pick stocks among a group of companies with reasonable valuations and rising earnings expectations, it makes sense to start with the stocks that are generating superior returns for investors right now.
Leaving the mathematical details aside, the main concept behind the system is actually quite simple and straightforward. We are looking to buy stocks that are reasonably priced when considering their growth potential, and we also want to buy them when expectations for the business are improving and the stock is outperforming the market.
The following backtest picks the 50 stocks recommended by the quantitative system and it builds an equally weighted portfolio with those names. The portfolio is monthly rebalanced, and it has an assumed annual expense ratio of 1%. The benchmark is the SPDR S&P 500 ETF (NYSEARCA:SPY).
Since January of 1999 the system more than tripled the benchmark, with annual returns of 19.13% per year versus an annual return of 6.23% for the market-tracking ETF in the same period. In cumulative terms, the system gained 2,957.66% versus 213.68% for the benchmark.
Data from S&P Global via Portfolio123
In other words, a $100,000 investment in the SPDR S&P 500 ETF in January of 1999 would currently be worth around $325,400, and the same amount of capital allocated to the portfolio recommended by the quantitative system would have a much larger value of $3.05 million.
Without further prologue, the table below lists the 50 stocks currently recommended by the system. Data in the table also includes the PEG ratio for each stock and the average PEG ratio in the industry to provide a quick reference on valuation.
|Name||Mkt.Cap (millions)||PEG||Ind PEG|
|Acadia Healthcare (ACHC)||$3,730||1.46||1.47|
|Boot Barn Holdings (BOOT)||$661||0.86||1.29|
|Career Education (CECO)||$1,272||0.92||1.72|
|Chefs' Warehouse (CHEF)||$828||1.26||1.49|
|Colliers International (CIGI)||$3,196||0.97||1.04|
|CyberArk Software (CYBR)||$2,338||2.39||2.57|
|Deckers Outdoor (DECK)||$3,490||1.45||1.8|
|DMC Global (BOOM)||$732||1.15||1.37|
|Edwards Lifesciences (EW)||$32,092||2.04||2.45|
|Ensign Group (ENSG)||$1,939||1.35||1.47|
|EPAM Systems (EPAM)||$7,034||1.6||1.76|
|First BanCorp (Puerto Rico) (FBP)||$1,798||0.38||1.62|
|First Data Corp. (FDC)||$21,117||1.17||1.76|
|Fortinet Inc (FTNT)||$11,214||1.8||2.57|
|Funko Inc (FNKO)||$416||0.93||1.66|
|GoDaddy Inc (GDDY)||$11,637||1.22||2.26|
|HMS Holdings (HMSY)||$1,996||2.21||2.43|
|ICF International Inc (ICFI)||$1,365||1.51||1.62|
|Intuit Inc. (INTU)||$55,369||2.42||2.57|
|Korn/Ferry International (KFY)||$3,710||1.22||1.62|
|Ligand Pharmaceuticals (LGND)||$4,885||1.23||1.55|
|LivaNova PLC (LIVN)||$5,256||2.42||2.45|
|Mastercard Inc (MA)||$219,640||1.61||1.76|
|Mitel Networks Corp (MITL)||$1,331||0.4||1.51|
|ONEOK Inc. (OKE)||$28,931||1.05||1.59|
|PTC Inc (PTC)||$11,144||1.82||2.57|
|Quidel Corp (QDEL)||$2,610||0.81||2.45|
|QuinStreet Inc (QNST)||$660||1.21||2.26|
|Ryerson Holding Corp (RYI)||$465||0.1||3.66|
|Simply Good Foods (SMPL)||$1,193||1.42||2.02|
|TechTarget Inc (TTGT)||$878||2.2||2.26|
|Tenet Healthcare (THC)||$3,764||1.24||1.47|
|The Meet Group (MEET)||$303||0.87||2.26|
|Trade Desk (TTD)||$3,797||1.78||2.26|
|TriState Capital Holdings (TSC)||$863||1.48||1.62|
|Ultimate Software Group (ULTI)||$8,856||2.06||2.57|
|United Continental Holdings (UAL)||$21,852||0.46||0.79|
|Veeva Systems (VEEV)||$11,481||2.14||2.43|
|WEX Inc (WEX)||$8,433||1.24||1.76|
|World Wrestling Entertainment (WWE)||$6,251||1.27||1.39|
|Xcerra Corp (XCRA)||$775||0.85||1.25|
There is no infallible formula to pick winning stocks, and backtested performance does not guarantee future returns. However, buying stocks based on quantified factors such as growth-adjusted valuation levels, rising earnings expectations, and market-beating price performance sounds like a smart idea from a fundamental investing point of view, and statistical evidence indicates that these kinds of companies tend to deliver superior returns over the long term.
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Disclosure: I am/we are long CRM, MA. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.