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Companies with the potential to grow quickly are like a magnet to investors in the stock market. And while they can suffer in volatile conditions, they’re still the source of some of the most inspiring investment success stories you’ll ever hear. At their best, they can have a transforming impact not just on their shareholders but also their staff, customers and even entire industries.
But while growth companies can be appealing, they can also come with hefty price tags. In buoyant economic conditions and periods when investors feel confident, growth shares can become, relatively, very expensive. But that’s not always a bad thing…
Paying what looks like a high price for a share - which is typically measured by the price-to-earnings ratio (P/E) - may be justified if a company is growing quickly. When a firm consistently beats earnings forecasts, the market can find itself in perpetual catch-up mode. And that makes valuing it quite tricky.
As the share price leaps along behind the rapid clip of earnings growth - and as more investors buy into the story - the momentum can be very powerful. For growth investors who are relaxed about high valuations, this momentum is exactly what they are after. But there can be problems…
The catch is that if and when momentum begins to weaken, the performance can plummet. Given that many growth companies tend to be smaller in size, they can be particularly vulnerable and unpredictable. So when things go wrong, valuations can tumble heavily.
Another risk with growth stocks is a change in the economic outlook. A deteriorating backdrop can quickly scare investors out of more speculative shares. Inflation can also be a drag. That’s because the valuations of growth stocks are often based on their future cashflows. If the value of those cashflows comes under pressure from rising inflation, then the multiples that investors are prepared to pay for them today will also come down.
With these kinds of risks in mind, one way of finding the next potential stars of the stock market is a strategy that focuses on growth - but without overpaying for it. It’s called ‘growth at a reasonable price’ and one of the keys to the approach is a metric called the PEG...
One of the early industry advocates for buying growth stocks at reasonable prices was an investor called Peter Lynch. He forged his reputation with a highly successful run as the manager of a major fund at Fidelity Investments. In the armoury of techniques he used for finding ideas was what he called the price to earnings growth rate - the PEG.
The PEG is intended to help avoid overpaying for expected future growth. In his book, One Up on Wall Street, Lynch explained that on any chart showing a company’s earnings line running alongside its stock price, the two lines generally move in tandem. If the stock price ever strays from the earnings line, it will always revert back to the earnings trend eventually.
Lynch showed that if you can pick up a stock with a P/E ratio that’s less than its growth rate, then you may have found a bargain. He worked out the PEG by taking a company’s trailing P/E ratio and dividing it by its earnings per share (EPS) growth rate.
The idea is to look for companies on low PEGs of less than 1. By doing that you squeeze more growth for each pound or dollar invested. A glamorous growth company on a P/E of 20 growing at 30% per year would have a PEG of 0.66. But a company on a P/E of 10 growing at 5% per year would have a PEG of 2.
Lynch’s PEG went on to become a popular measure for growth investors wary of how much they are paying from the promise of growth. Another famous user of the metric was the British investor Jim Slater.
Slater’s take on the PEG was slightly different to Lynch’s because he calculated it using forecast ratios for both P/E and earnings per share (EPS) growth.
In some ways, Slater’s PEG ‘double counts’ earnings growth (because it’s a component of both the forecast P/E and the forecast EPS). Nonetheless, he combined his PEG with several other growth indicators to great effect.
In his book, The Zulu Principle, he said: “...You are looking for the best shares within the market at absolutely bargain prices, Finding shares like these will ensure that you have the maximum chance of capital appreciation, and will at the same time provide you with an important safety factor.”
Today, the PEG features in a variety of “growth at a reasonable price” strategies that aim to find tomorrow’s growth stars. In many cases they look for a range of factors that tend to be the fingerprints of successful growth investments.
In the Stockopedia Screener, the PEG can be found in the “Value” section. It offers the option to choose between the trailing or rolling PEG, Jim Slater’s version or 5y Growth.
Applied to the screen, you can select the level of PEG to screen for. In this case I’ve used a rolling PEG of 1 or less. I have also included other typical GARP screen rules, including strong EPS growth, a strong Return on Capital Employed (as a measure of financial quality) and positive price momentum over one year.
The results of this screen - which you can find here - look like this:
Depending on the prevailing conditions, high growth stocks can be found in several places, and they don’t have to be glamorous names in hot sectors. It could be that they are small, potentially pre-profit companies early in the growth life-cycle. They might be hidden in unlikely industry groups or simply be unloved businesses that are fixing themselves and poised to recover quickly.
Targeting growth stocks has the potential to deliver portfolio-transforming returns, but they come with risks. They can attract stretched valuations despite many of them being small and susceptible to shocks. While earnings growth can be very appealing, keeping an eye on valuation might save you from overpaying.
As Jim Slater said, the PEG provides an important safety measure by overlooking companies on very high multiples, whilst still managing to target some of the most exciting companies in the market.
Find Stockopedia’s Jim Slater screen here and Peter Lynch screen here.
About Ben Hobson
Stockopedia writer, editor, researcher and interviewer!
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This is interesting. Worth bearing in mnd that when Peter Lynch was a fund manager c1977 to c1990, inflation was higher, quite a lot of so called growth was just price inflation, hence finding a stock with an annual earnings growth rate of 10% and a PE ratio of 10, means something very different in the higher inflation environment. The equivalent in a very low inflation environment might be, say, a PE ratio of 10 and a growth rate of perhaps around 6% pa.
Lynch would look for high growth businesses in non-growth or low growth industries. The reason for this is that growing and highly successful businesses in low growth sectors tended to be overlooked and the sector would draw in less competition. High growth sectors tending to attract a larger number of new competitors.
The time period during which Lynch invested, c77 to c90, was the perfect time for the value growth investor, with hindsight at least, the markets were still very jittery in 77 following the oil price shocks and the market collapse from c3 years earlier. During other periods, value growth investors have had to sit through extended periods when their high quality under valued holdings were ignored by the market for years on end. John Neff in his investing biography covers this extensively, the hot stock era of the 1960s was intsensely frustrating at times for Neff when the whole US market seemed obsessed with what Jerry Tsai might be buying.
Just one other point. Declared earnings can be a useful indicator, but I only treat them as indicative, often so called retained earnings never make it to the balance sheet equity line in full and can often be diluted down by share issuing. Hence my valuations are always equity growth based rather than earnings based.
But, take ScS for example. Typical Lynch stock, i.e. high growth in a low growth sector. ScS does appear to have transformed itself during Covid. Major investment in their on line offering, along with other changes, appears to have greatly improved the business in terms of turnover and profitability.
Here is the 'But'. Although in year ending to July 21, ScS generated tangible equity growth of over 30% of its current MCap - this is the kind of ratio normally only seen in 1932, 1974 and 2008, makes you want to check that you have not put the decimal in the wrong place, a 'real' PE of c3. There was a one off sector post lockdown bounce back in 21 and year ending July 22 will also be impacted by supply chain hold ups. So for the year end to July 22, ScS will likely only see its net tangible equity grow by an amount equivalent to c15% to 20% of its current MCap - I say only!
But, according to a PEG ratio this is not growth is it because 2022 earnings will almost certainly be lower than 2021 earnings. And yet, the net tangible equity for ScS at the end of 2022 will likely be 15% to 20% higher at the end of July 2022 and the tangible equity will have grown by over 50% as a % of MCap over the 2 year period - i.e. tangible shareholder wealth within the business having been increased by c50% of their investment, based upon the current share price.
So what is real growth, should one be tied to year on year earnings growth, or is the continuing build up in tangible equity, i.e. the real wealth created by the business, the growth that really matters?
*Past performance is no indicator of future performance. Performance returns are based on hypothetical scenarios and do not represent an actual investment.
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Excellent article and most informative. Thank you.