By Andrew Bary
or the past decade, investors had a pretty sure-fire way of making money in the stock market, but lately that system has gone haywire. Despite this setback, true believers abound, and right now they are betting on stocks such as BankAmerica /zigman2/quotes/200894270/composite BAC +0.64% , RJR Nabisco and Deere /zigman2/quotes/207941296/composite DE +1.26% . In essence, the system we're talking about helps investors find stocks that are undervalued. It does this by comparing a company's estimated rate of earnings growth to its price-to-earnings ratio. To new investors, this may sound like mumbo-jumbo, but the theory is actually based on a solid foundation. For example, if you buy shares in a company for $20, and that company is earning $1 a share per year, you've bought a stock with a price-to-earnings ratio of 20, and, in theory at least, the company's earnings would give you a 5% annual return.
Is that a good deal? Well, it depends. If the company's earnings are growing at, say, 50% a year, then those earnings will hit $2 a share in a few years' time and your earnings return will climb to 10% a year. With growth like that, the price of the stock is almost sure to rise, which is how you make money.
By contrast, if the company's earnings are not growing, then you've bought yourself a stock with a 5% earnings return, and that's not much better than you could have gotten in a risk-free certificate of deposit down at your local bank. More to the point, if the company's earnings aren't growing, its stock price isn't likely to rise, either.
That's why people like to compare a stock's estimated rate of earnings growth with its price-to-earnings ratio. The theory holds that if a company's estimated annual rate of earnings growth is greater than its P/E, it's a good buy. If the estimated rate of earnings growth is a lot less than its P/E ratio, steer clear.
This approach, which has come to be known as P/E-to-growth investing, or PEG, has plenty of intuitive appeal because it enables investors to buy stocks with rapidly growing earnings at relatively low prices. Various studies, including one by Morgan Stanley a year ago, showed that a disciplined strategy of buying stocks with the lowest P/Es relative to their estimated annual earnings growth handily beat the Standard & Poor's 500 Index over the past decade (" New Value in Old Saw ," August 25, 1997).
Yet the strategy has been a loser this year, according to Ted Murphy, president of Paradigm Investment Services, which operates MarketPlayer.com , a financial Website. He calculates that of the stock market's 1,000 largest companies, the companies with the lowest P/E-to-growth ratios generated a negative 16.2% return through the end of September, compared with a 4.2% gain for the market's 1,000 largest stocks, which are contained in the Russell 1000 Index.
"This calls the strategy into question," Murphy argues. "The problem with PEG is that it relies on a forecast of long-term earnings growth that's often inaccurate." The profit-growth forecast generally used in the PEG formula is based on forecasts of a company's five-year earnings growth, which are compiled by averaging the estimates of the Wall Street analysts who follow that company. But the problem with the long-term forecasts is that they are often the last ones changed by analysts, who tend to react to trouble by first lowering their near-term earnings expectations and leaving revisions in their long-term forecasts until later.
On top of that, analysts are known to have unrealistically high long-term profit forecasts for inherently cyclical businesses, like the oil-service industry. Indeed, the stocks that had low P/E-to-growth ratios at the start of this year included a heavy dose of oil-service issues. Back in January, such companies looked inexpensive based on expected earnings growth rates. But the earnings didn't come through as expected. In essence, the stock market was assessing the future more accurately than the analysts.
In a Barron's article a year ago, the most attractive firms based on P/E-to-growth discipline included: Seagate Technology , Western Digital /zigman2/quotes/204213617/composite WDC +2.50% , Corporate Express , Iomega , MedPartners and Diamond Offshore Drilling . All of them have since fallen substantially.
Followers of the PEG discipline calculate a stock's P/E-to-growth rate by dividing the P/E by the growth rate. The lower the resulting ratio, the more attractive the stock.
Using this approach, Morgan Stanley came up with a list of the most attractive stocks among the market's top 1,000 as of October 30th. On the list below are the 15 best, including: Washington Mutual , Gulfstream Aerospace , Global Marine and Household International . Also attractive, though falling short of the top 15, were BankAmerica, Deere and RJR Nabisco.
If long-term earnings forecasts hold up for these companies, their stocks should perform nicely. Remember, the fundamentals still apply.