PEG Ties Value To Growth
The idea behind the PEG ratio is highly compelling: a single number that wraps together a company's valuation and its long-term growth prospects. The PEG ratio divides a stock's forward P/E ratio by its five-year estimated per-share-profit growth.
Unfortunately, the PEG ratio's predictive power has been atrocious recently. In the year ended March, the one-fifth of stocks with the lowest PEG ratios experienced their worst 12-month relative performance since we began tracking the metric in February 2004. Stocks with low PEGs have outperformed in just two of the past 16 rolling 12-month periods.
PEG has worked over the long haul, though not as well as core valuation metrics like price/sales and enterprise ratio. Nor has it done quite as well as the P/E ratio based on estimated current-year earnings.
If that's the case, why are we running a story featuring stocks with low PEGs?
• The ratio has intuitive appeal, especially in a time of slowing profit growth. It also fits our strategy of buying stocks that offer growth at an attractive price. Our Quadrix Overall score steers us toward such stocks, which we then examine more closely to gauge whether the companies are likely to realize their growth estimates. Based on our track record over the years, we think we're pretty good at making that assessment.
• Long-term growth projections frequently prove inaccurate, but PEG ratios can be helpful without being precise. Sometimes low-PEG stocks suffer from fading long-term prospects that have not yet been fully reflected in analysts' growth estimates. But other times the PEG ratio identifies solid growers temporarily down on their luck. We view the PEG as a source of stock ideas. We also consider stocks with the highest combined Quadrix scores for forward P/E and long-term expected growth factors. For example, Centene ($60; CNC) trades at 15 times estimated 2016 earnings, translating to a factor score of 60. It has an estimated five-year growth rate of 19% for earnings per share, good for a score of 79. The sum of those two factor scores is 139, which ranks in the highest quintile of stocks in our research universe.
• Valuation ratios often deliver streaky, mean-reverting performances. Our historical data for PEG is relatively meager compared to most other valuation metrics. But in the 12 years we've tracked PEG, its performance has usually rebounded impressively after major losing streaks. Encouragingly, Quadrix Value has rebounded in the past two months.
In the following paragraphs, we review five recommended stocks that look attractive based on their forward P/E ratio, long-term growth forecast, and PEG ratio.
Apple's ($107; AAPL) sales surged 17% in the 12 months ended December, driven by the iPhone (up 29% to represent 66% of revenue) and China (up 60%, 26%). But growth decelerated in the second half of the year, and sales are expected to decline in the next couple quarters. Apple reportedly slashed iPhone production 30% in the March quarter and plans to keep production lower in the June quarter. A key Apple supplier, Taiwan Semiconductor Manufacturing ($25; TSM), has noted slower demand for smartphones priced above $500.
Apple trades at just 12 times estimated earnings for fiscal 2016 ending September, resulting in a Quadrix factor score of 77. Per-share profits are projected to rise at an annualized rate of 14% over the next five years, translating to a factor score of 62. The sum of these two factor scores is 139, ranking in the top quintile of our research universe. Using the most bearish analyst estimate, Apple's forward P/E is just 13 — about 29% below the median for S&P 1500 technology stocks. Apple is a Focus List Buy and a Long-Term Buy.
Investors sometimes discount growth purchased through acquisitions, and that appears to be the case with Centene ($60; CNC), which acquired Health Net for $6.0 billion in March. Centene is projected to grow per-share profits 38% this year, followed by 17% growth in 2017. Yet the stock trades at just 15 times estimated 2016 earnings and 13 times estimated 2017 earnings — both ratios are 11% below the median managed-care stock in the S&P 1500 Index. Encouragingly, analyst profit estimates for 2016 and 2017 have trended higher in the past 90 days.
The Health Net deal will reduce Centene's reliance on Medicaid (estimated to become 64% of revenue, versus 83% previously), while increasing exposure to Medicare (8%, versus 1%) and commercial plans and health-care exchanges (16%, versus 2%). Centene's per-share profits are projected to rise at an annualized clip of 19% over the next five years. Centene, earning a Value rank of 82, is a Focus List Buy and a Long-Term Buy.
Shares of Owens Corning ($51; OC), a supplier of construction materials to residential and commercial builders, have returned 9% including dividends in 2016. Although the stock's valuation looks somewhat elevated compared to the other recommended stocks in the nearby table, it remains reasonably priced versus its peers. At 17 times estimated 2016 earnings, Owens trades at a 21% discount to the median for S&P 1500 building-products stocks, while its PEG ratio of 1.15 is also 21% below the industry median.
The consensus calls for 16% higher per-share profits this year, and a pair of recent acquisitions should augment growth. Owens also announced plans to raise prices on asphalt shingles in May. Industrywide volumes for shingles have been soft recently, creating some skepticism about the price hike's success. Roofing accounted for 32% of Owens' revenue last year. Owens is a Focus List Buy and a Long-Term Buy.
Compared to other S&P 1500 semiconductor makers, Skyworks Solutions ($73; SWKS) enjoys a lower forward P/E ratio (13 versus an industry median of 19) and a superior long-term expected profit-growth rate (21% versus 12%). As a result, its PEG ratio of 0.6 is lower than every other S&P 1500 semiconductor stock with a market value above $300 million. Skyworks also looks attractive compared to other stocks in our research universe, scoring above 70 in Quadrix for both forward P/E ratio and expected long-term profit growth — the same can be said of just 2% of the nearly 5,000 stocks in our research universe.
Skyworks makes radio-frequency semiconductors used in smartphones, so Apple's recent cuts to iPhone production could weigh on near-term results. Although growth for global smartphone shipments is projected to slow to 7%, management expects demand for its type of radio-frequency components to at least double that pace. Skyworks remains well-positioned as more consumers migrate toward faster smartphones powered by higher-end components. Skyworks is a Buy and a Long-Term Buy.
Southwest Airlines ($47; LUV) shares delivered an 11% total return over the past 12 months but failed to keep pace with the airline's per-share profits, up 95% last year. Consequently, Southwest shares trade at just 13 times trailing earnings, near their lowest level since 2012 and 28% below their five-year average.
Southwest's per-share profits are expected to grow at an annualized rate of 16% over the next five years, ranking in the top 30% of our research universe. The airline's PEG ratio of 0.66 is just slightly below its industry median but ranks among the cheapest 10% of stocks in Quadrix — a steep discount that likely reflects the airline industry's volatile history. With that in mind, it's worth considering the industry's structural changes in recent years, as the wave of consolidation appears to have made airlines more disciplined on pricing and capacity growth. Scheduled to post results on April 21, after our publishing deadline, Southwest Airlines is a Buy and a Long-Term Buy.