Value Or Growth? Both!

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Includes: AAPL, ABBV, ADBE, AEIS, ALSN, ANSS, AVGO, BKNG, BRK.A, BRK.B, CACC, CDNS, CELG, CERN, CHKP, CPRT, CSX, DLX, EBS, ESIO, ESNT, EW, EXEL, FB, INTU, JAZZ, LGND, LMAT, LTC, LVS, MA, MDXG, MED, MNST, MSGN, MTG, MU, PAYC, PEG, PSA, RHT, ROI, SBRA, SNA, SPG, SPGI, SPY, STMP, SWKS, TSM, UBNT, V, VMW, VRTX, WAL
by: Andres Cardenal, CFA

Summary

You don't really have to choose between value and growth since growth is a component of a company's value.

Valuation metrics such as the PEG ratio can be smart tools to incorporate growth expectations into the valuation equation and find truly undervalued growth stocks.

The following article is introducing a quantitative stock picking system based on companies with low PEG ratios and attractive profitability.

Backtested performance for the system is quite promising.

There is no infallible formula to pick winning stocks, but it makes sense to expect attractive returns when investing in stocks that are attractively priced in comparison to their growth potential and have solid profitability metrics.

Value investing is not just about buying stocks with low valuation metrics, that's a too simplistic and myopic approach. The true essence of value investing is buying a company for a market price below the intrinsic value of the business.

All else the same, a business with superior growth rates creates more value for investors. This means that a stock with a comparatively high price to earnings ratio can be undervalued if earnings are growing rapidly enough.

Warren Buffett knows a thing or two about value investing, and he believes that investors should not consider growth and value like two opposite approaches. Far from that, according to Buffett, growth and value are two sides of the same coin.

In his Berkshire Hathaway (BRK.A) (BRK.B) shareholders letter in 1992, Buffett wrote:

Most analysts feel they must choose between two approaches customarily thought to be in opposition: "value" and "growth." Indeed, many investment professionals see any mixing of the two terms as a form of intellectual cross-dressing.

We view that as fuzzy thinking (in which, it must be confessed, I myself engaged some years ago). In our opinion, the two approaches are joined at the hip: Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive."

In the same letter, Buffett explains that growth alone does not necessarily create value for investors. Growth only creates value when the business is profitable enough so that each dollar reinvested in the business has a higher profitability than the cost of capital.

Similarly, business growth, per se, tells us little about value. It's true that growth often has a positive impact on value, sometimes one of spectacular proportions. But such an effect is far from certain...Growth benefits investors only when the business in point can invest at incremental returns that are enticing - in other words, only when each dollar used to finance the growth creates over a dollar of long-term market value. In the case of a low-return business requiring incremental funds, growth hurts the investor.

Growth, Value, And Profitability

The price to earnings growth (PEG) ratio can be an effective tool when it comes to incorporating growth into the valuation equation. The PEG ratio is obtained by dividing the classic price to earnings ratio (P/E) by the expected growth rate in earnings.

The P/E ratio is obviously higher for high growth companies. This means that focusing solely on the P/E ratio would make high-growth companies erroneously look overvalued. By dividing the P/E ratio by the earnings growth rate, the resulting ratio is far more useful when it comes to comparing companies with different growth rates.

The quantitative system excludes over the counter stocks from the investable universe to guarantee a minimum size and liquidity level. Then it considers only companies with a PEG ratio below the industry average based on the average long-term earnings growth expectations for the business.

Among the companies with a PEG ratio below industry levels, the quantitative system will pick the 50 stocks with the highest profitability. This is calculated through a ranking system that includes six different metrics: return on investment (ROI), return on assets (ROA), return on equity (ROE), gross profit margin, operating margin, and free cash flow margin.

Leaving the mathematical details aside, the main rationale behind the system is quite straightforward and easy to understand. It begins by looking for companies with low PEG ratios. Once you have a list of companies that are attractively valued in terms of the PEG ratio, it makes sense to pick the most profitable companies from such a universe to build a portfolio.

Backtested Performance And Recommended Portfolio

The quantitative system has produced solid backtested performance over the long term. The chart below shows how the 50 stocks selected by the system performed in comparison to the SPDR S&P 500 (SPY) ETF since 1999. The backtesting assumes an equal-weighted portfolio, monthly rebalanced, and with a trading expense ratio of 0.2% per transaction.

Data from S&P Global via Portfolio123

The system more than doubled the benchmark, with annual returns of 14.14% per year versus an annual return of 6.21% for the market-tracking ETF in the same period. In other words, a $100,000 investment in the SPDR S&P 500 ETF in January of 1999 would currently be worth around $324,600, and the same amount of capital allocated to the portfolio recommended by the system would have a much larger value of $1.3 million.

System Alpha during the backtest period was an impressive 7.83%, and the system materially outperformed the benchmark on a risk-adjusted basis, as shown by indicators such as Sharpe Ratio and Sortino Ratio.

The table below shows the 50 stocks currently picked by the system including market capitalization levels in millions and the PEG ratios for the companies included as well as the industry averages. Please keep in mind that we are using long-term growth expectations when calculating the PEG ratio as opposed to using solely growth expectations for a particular year.

Name

Mkt. Cap

PEG

Industry PEG

AbbVie Inc (ABBV)

$139,709

0.88

1.41

Adobe Inc (ADBE)

$126,609

2.15

2.77

Advanced Energy Industries (AEIS)

$1,900

1.04

1.17

Allison Transmission Holdings (ALSN)

$6,418

1.23

1.34

ANSYS Inc (ANSS)

$13,383

2.25

2.77

Apple (AAPL)

$1,071,205

1.73

1.82

Booking Holdings (BKNG)

$88,388

1.18

1.48

Broadcom (AVGO)

$97,951

0.83

1.17

Cadence Design Systems (CDNS)

$11,425

2.4

2.77

Celgene Corp. (CELG)

$59,215

0.47

1.41

Cerner Corp. (CERN)

$21,129

1.76

2.68

Check Point Software Technologies (CHKP)

$17,825

2.12

2.77

Copart, Inc. (CPRT)

$11,927

1.43

1.49

Credit Acceptance (CACC)

$8,115

0.77

0.79

CSX Corp. (CSX)

$60,727

1.08

1.1

Deluxe Corp. (DLX)

$2,514

0.84

1.49

Edwards Lifesciences (EW)

$31,093

1.91

2.55

Electro Scientific Industries (ESIO)

$568

0.58

1.18

Emergent BioSolutions (EBS)

$3,150

1.28

1.41

Essent Group (ESNT)

$3,999

0.77

1.27

Exelixis (EXEL)

$5,067

0.53

1.41

Facebook (FB)

$460,883

1.07

1.6

Intuit (INTU)

$56,593

1.83

2.77

Jazz Pharmaceuticals (JAZZ)

$9,597

0.79

1.59

Las Vegas Sands (LVS)

$45,200

1.76

1.84

LeMaitre Vascular (LMAT)

$557

2.25

2.55

Ligand Pharmaceuticals (LGND)

$4,283

1.06

1.41

LTC Properties (LTC)

$1,732

3.35

7.2

Mastercard (MA)

$215,613

1.64

1.67

Medifast (MED)

$2,597

2.16

2.3

MGIC Investment (MTG)

$4,704

1.27

1.27

Micron Technology (MU)

$49,168

0.43

1.17

MiMedx Group (OTC:MDXG)

$588

1.1

1.41

Monster Beverage (MNST)

$29,076

1.87

2.08

MSG Networks (MSGN)

$1,979

1.15

1.29

Paycom Software (PAYC)

$7,877

2.17

2.77

Public Storage (PSA)

$34,462

5.34

7.2

Red Hat, Inc. (RHT)

$21,954

2.32

2.77

S&P Global (SPGI)

$47,924

1.56

1.58

Sabra Health Care REIT (SBRA)

$3,928

7.11

7.2

Simon Property Group (SPG)

$53,417

4.23

7.2

Skyworks Solutions (SWKS)

$15,882

0.82

1.17

Snap-on (SNA)

$9,451

1.09

1.34

Stamps.com (STMP)

$3,694

1.06

1.48

Taiwan Semiconductor Manufacturing (TSM)

$205,213

1.16

1.17

Ubiquiti Networks (UBNT)

$6,753

1.38

1.48

Vertex Pharmaceuticals (VRTX)

$47,276

0.76

1.41

Visa (V)

$317,094

1.66

1.67

VMware (VMW)

$60,437

1.63

2.77

Western Alliance Bancorporation (WAL)

$5,770

1.15

1.47

There is no infallible formula to pick winning stocks, and backtested performance does not guarantee future returns. There are some important risks and limitations to consider when implementing these kinds of quantitative strategies.

To begin with, the portfolio of 50 stocks is more concentrated than the broad market indexes, and it also has a larger presence of relatively volatile names. During a deep bear market such as the ones in 2001 and 2008, with all probability, the quantitative portfolio will fall harder than the market in general.

Even during bull market environments, it's impossible to tell what kind of performance a quantitative system is going to produce in a particular year. The academic research shows that quantitative return drivers have a high chance of producing market-beating returns over long periods of time, meaning five to ten years. On a single year, however, relative performance for a quantitative system versus the market can be notoriously volatile and unpredictable.

It's important to be careful when relying on these kinds of systems to pick stocks. The system can tell you that a specific group of companies with certain quantitative attributes has a good chance of delivering market-beating returns over long periods of time, but it does not tell you much about a particular stock.

You need to take a look at the business behind the numbers in order to truly understand the main risks and return drivers in a particular investment. The quantitative system should be used as a source of potential ideas for further research. In other words, the research process starts with the quantitative system, it does not end there.

Those risks being acknowledged, buying high-profitability stocks with low PEG ratios 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.

Disclosure: I am/we are long AAPL, BKNG, FB, BRK.B, MA, MU, SPGI.

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.