Undervalued Stocks With Rising Earnings Expectations

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Includes: ANSS, ARCB, ATTU, BHC, BMY, CCMP, CHDN, CNK, CYBR, CYOU, DGII, DIOD, DXPE, ENDP, ESNT, FIX, FLNT, FN, FNKO, GHDX, GPOR, GTN, HSII, HUBS, KREF, MBUU, MCFT, MED, MEET, NVEE, OUT, PAGP, PANW, PCRX, PMT, QTS, REGN, SAVE, SBGI, SCS, SSNC, TECD, TGLS, TGNA, TREE, TTD, UPLD, VPG, WIX, XEC
by: Andres Cardenal, CFA
Summary

Investing in undervalued stocks is a great strategy, and buying undervalued stocks that are moving in the right direction can be even more effective.

Introducing a quantitative system focused on companies with low PEG ratio and rising earnings expectations.

Backtested performance for the system is quite attractive.

Past performance does not guarantee future returns, but the system makes sense from a fundamental perspective.

Simplicity is the ultimate sophistication. The more simple and straightforward the rationale for buying a stock, the better the chances of success. At the end of the day, investing is all about answering two main questions: what to buy and when to buy it.

This article is introducing a quantitative system aimed at investing in relatively undervalued stocks that are also benefiting from rising earnings expectations. In other words, the system looks for cheap companies, and it's also looking to buy them when they are moving in the right direction.

System Design

Most valuation indicators have a key weakness, which is that they don't include growth into the equation. Ratios such as price to earnings (P/E), enterprise value to EBITDA (EV/EBITDA), and price to cash flow (P/FCF) can be very intuitive and useful. However, if two companies have different expected growth rates, then the analysis is far more nuanced than simply looking at the stock price versus current earnings or cash flows.

The price to earnings growth (PEG) ratio, on the other hand, incorporates the impact of different growth rates into the valuation. The PEG ratio is simply obtained by dividing the P/E ratio by the expected long-term growth rate in earnings.

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 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 when comparing stocks. By dividing the P/E ratio by the expected earnings growth rate, the resulting ratio is far more valuable and comprehensive.

Valuation ratios are obviously very dissimilar across different sectors and industries, and this fact needs to be kept in consideration when comparing valuation ratios. For this reason, the quantitative system is looking for stocks with a PEG ratio below the industry average.

Even the cheapest stock in the world can turn out to be a disappointing investment when the business fundamentals are deteriorating. In order to make sure that the company remains strong, the quantitative system also requires that earnings expectations for the company in both the current year and next year have been increased over the past 13 weeks.

Among the companies that meet the criteria required for inclusion, the system buys the 50 stocks with the strongest upward revisions in earnings and sales estimates over the past 3 months. This is done with a ranking algorithm that calculates the percentage change in earnings and sales forecasts for different companies, and it picks the stocks with the strongest upward revision trends.

Wall Street analysts can make mistakes just like everyone else, and in fact they often make serious miscalculations. However, if earnings expectations for the company are being revised higher and analysts are increasingly bullish on the stock, this generally means that there is some consensus on the idea that the company is moving in the right direction.

Wrapping up, a stock needs to meet the following criteria to be included in the quantitative system:

  • The PEG ratio is below the industry average.
  • Earnings expectations for the current year have increased in the past 13 weeks.
  • Among the stocks that pass the screen, the system buys the 50 names with the strongest upward revisions in earnings and sales estimates over 3 months.

Leaving the numerical considerations aside, the logic behind the quantitative system is actually quite simple. We are looking to buy stocks that are undervalued when considering their growth potential, and we also want to buy them when the consensus is indicating that the fundamentals are increasingly strong.

Backtested Performance And Recommended Portfolio

The following backtest eliminates over-the-counter stocks, and it considers only companies with a market capitalization level above $250 million to guarantee a minimum size and liquidity level. 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 14.13% per year versus an annual return of 6.31% for the market-tracking ETF in the same period. In cumulative terms, the system gained over 1,200% versus 234% for the benchmark.

In other words, a $100,000 investment in the SPDR S&P 500 ETF (NYSEARCA:SPY) in January of 1999 would currently be worth around $333,600, and the same amount of capital allocated to the portfolio recommended by the quantitative system would have a much larger value of $1.3 million.

Practical Considerations And Stock Picks

Backtested performance results should always be taken with a grain of salt. To begin with, past performance does not guarantee future returns. Even more complicated, when a particular investment style is delivering outstanding returns, there is a good chance that returns will revert to the mean over the middle term.

An investing strategy that picks stocks with rising earnings expectations is based on fundamental momentum, and these strategies tend to do particularly well when risk appetite is elevated. Conversely, when investors are looking for safety and stability, stocks of this kind tend to substantially underperform the market.

In most rebalancing dates, the portfolio rotation level is in the range of 30% to 60%. Trading expenses are already incorporated in the backtesting numbers, with an assumed trading expense of 0.2% for every buy and sell. Since many brokers are currently offering aggressively low trading costs, the assumption for trading costs in the backtest is arguably too high. However, it makes sense to err on the side of caution when making these kinds of assumptions.

Capital gain taxes vary substantially among investors, but the point remains that the tax cost of implementing the strategy can be substantial in some cases.

In any case, this quantitative system is particularly narrow and focused on a specific theme. The main idea is not that investors should automatically replicate the buy and sell recommendations from the system, but rather use it as a tool to identify interesting investing ideas for further research.

When picking stocks based on this quantitative system, we need to keep in mind that the numbers alone don't tell you the whole story. It's important to understand the fundamentals behind those numbers in order to tell if financial performance can be sustained or not.

Those risks being acknowledged, making investment decisions based on hard quantified data is a sounder approach than relying on opinions and speculations to pick stocks. Besides, it makes sense to expect solid returns when investing in relatively cheap stocks with rising earnings expectations.

Without further prologue, the table below lists the 50 stocks currently recommended by the system. Data in the table also includes market cap value in millions, the PEG ratio for each stock, and the average PEG ratio in the industry to provide a quick reference on valuation. In addition, the table shows the average earnings per share estimate for the company in the current year and what that number was 13 weeks ago to show how expectations have evolved.

Name

MktCap

PEG

PEG Ind

EPS estimate

EPS estimate 13 weeks ago

ANSYS (ANSS)

$13,613

2.03

2.54

5.31

5.04

ArcBest (ARCB)

$1,034

0.33

1.09

3.79

3.24

Attunity (ATTU)

$477

2.43

2.54

0.46

0.27

Bausch Health Cos (BHC)

$8,517

0.59

1.64

3.78

3.44

Bristol-Myers Squibb (BMY)

$87,257

1.29

1.64

3.86

3.61

Cabot Microelectronics (CCMP)

$2,741

1.03

1.15

6.71

5.56

Changyou.com (CYOU)

$1,009

1.13

1.41

1.75

1.02

Churchill Downs (CHDN)

$3,778

1.13

1.72

12.32

10.98

Cimarex Energy (XEC)

$7,838

0.16

1.39

7.52

6.82

Cinemark Holdings (CNK)

$4,483

1.19

1.41

2.15

2.11

Comfort Systems USA (FIX)

$1,960

0.86

1.45

3.05

2.73

CyberArk Software (CYBR)

$2,615

2.02

2.54

1.76

1.47

Digi International (DGII)

$325

1.27

1.48

0.48

0.46

Diodes Inc (DIOD)

$1,748

1

1.15

2.31

2.19

DXP Enterprises (DXPE)

$637

0.7

1.03

1.72

1.59

Endo International (ENDP)

$2,698

1.27

1.64

2.74

2.6

Essent Group (ESNT)

$3,784

0.71

1.43

4.61

4.53

Fabrinet (FN)

$1,942

1.12

1.24

3.63

3.34

Fluent Inc. (FLNT)

$267

0.66

1.16

0.14

0.1

Funko Inc. (FNKO)

$371

0.83

1.56

0.71

0.69

Genomic Health (GHDX)

$2,856

0.17

1.52

1.05

0.55

Gray Television (GTN)

$1,641

0.8

1.16

2.3

2.06

Gulfport Energy (GPOR)

$1,476

0.66

1.39

1.84

1.64

Heidrick & Struggles International (HSII)

$695

1.17

1.66

2.32

1.94

HubSpot Inc. (HUBS)

$5,409

2.33

2.54

0.81

0.65

KKR Real Estate Finance Trust (KREF)

$1,131

2.09

2.86

1.86

1.81

LendingTree (TREE)

$3,370

1.3

1.43

5.96

5.79

Malibu Boats (MBUU)

$1,006

0.96

1.13

3.38

2.88

MasterCraft Boat Holdings (MCFT)

$485

0.63

1.13

2.74

2.29

Medifast Inc. (MED)

$1,775

1.47

2.38

4.5

4.47

NV5 Global (NVEE)

$915

1.04

1.45

3.28

3.13

Outfront Media (OUT)

$2,898

3.9

7.37

0.73

0.67

Pacira Pharmaceuticals (PCRX)

$1,984

1.49

1.64

0.83

0.55

Palo Alto Networks (PANW)

$16,188

1.37

1.48

5.17

4.87

PennyMac Mortgage Investment Trust (PMT)

$1,283

2.27

2.86

1.86

1.61

Plains GP Holdings LP (PAGP)

$3,522

0.74

1.39

1.61

1.15

QTS Realty Trust Inc. (QTS)

$2,075

3.8

7.37

0.64

0.51

Regeneron Pharmaceuticals Inc. (REGN)

$39,567

1.24

1.52

21.57

20.37

Sinclair Broadcast Group Inc. (SBGI)

$3,165

0.36

1.16

3.07

2.25

Spirit Airlines Inc. (SAVE)

$4,377

0.54

1.03

4.21

3.38

SS&C Technologies Holdings (SSNC)

$11,575

0.87

2.54

2.81

2.51

Steelcase Inc. (SCS)

$1,891

1.08

1.56

1.1

0.92

Tech Data Corp (TECD)

$3,395

0.64

1.24

10.9

9.77

Tecnoglass Inc. (TGLS)

$372

0.55

1.35

0.77

0.64

TEGNA Inc. (TGNA)

$2,861

1.13

1.16

1.81

1.7

The Meet Group Inc. (MEET)

$296

0.6

1.44

0.34

0.3

Trade Desk (TTD)

$6,152

2.11

2.54

2.41

2.17

Upland Software (UPLD)

$606

0.88

2.54

1.6

1.52

Vishay Precision Group (VPG)

$457

0.83

1.24

2.05

1.93

Wix.com (WIX)

$4,375

0.57

1.49

0.88

0.79

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.