How To Find Undervalued Stocks With Strong Fundamentals (2024)

Value investing is simple in concept, but not easy to do in real life. In a nutshell, value investing is about buying stocks for prices below the intrinsic value of the business. The idea is quite powerful and easy to understand, but finding undervalued stocks is much easier said than done.

This article is presenting a quantitative strategy designed to find stocks with low valuation ratios in comparison to the company's growth expectations and other return drivers. The main point is that variables such as growth and fundamental quality are a component of value, and including these different dimensions into the equation can lead to superior performance over the long term.

Strategy Design

There is no perfect formula to find undervalued stocks. Discounted cash flow models are very strong from a theoretical perspective, but long-term cash flow forecasting carries a high degree of error. Valuation ratios such as PE are intuitive and easy to calculate, but most valuation ratios are based on current earnings and cash flows, while the true value of the business will ultimately depend on the company's ability to produce earnings and cash flows in the future.

This is where the price to earnings growth (PEG) ratio can be a good alternative. The PEG ratio is obtained by dividing the classic price to earnings ratio (P/E) by the expected growth rate in earnings. In this case we are using long-term earnings growth estimates.

All else the same, the higher the expected growth rate in earnings, the more valuable each dollar in earnings from such company. In other words, the P/E ratio is 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 forward-looking, which makes it far more valuable and comprehensive than traditional valuation ratios based solely on current earnings.

The quantitative strategy has two requirements for companies in the portfolio related to the PEG ratio. Companies need to have a PEG ratio below the industry average PEG ratio, and companies also need to be in the best 50% of companies in the industry based on the PEG ratio. This double requirement is to guarantee that the company has a relatively low PEG ratio by industry standards.

Among the companies that fit the requirements for low PEG ratios, the strategy selects the 30 names with the highest PowerFactors ranking. This is a quantitative algorithm that ranks companies in a particular universe according to a combination of four factors: financial quality, valuation, fundamental momentum, and relative strength.

In simple terms, the PowerFactors system is looking to buy good businesses (quality) for a reasonable price (valuation) when the company is doing well (fundamental momentum) and the stock is outperforming (relative strength).

The main idea behind the PowerFactors ranking is that companies with strong metrics in areas such as financial quality, fundamental momentum, and relative strength deserve higher valuation ratios, and the algorithm puts all those variables together to reach a final ranking for every stock based on a combination of multi-dimensional factors.

According to the backtested data, the higher the PowerFactors ranking, the higher the expected returns over the long term, and companies in the top segment substantially outperform the market.

Data from S&P Global via Portfolio123

Wrapping up, companies in the portfolio need to have a PEG ratio below the industry average, and they also need to in the best 50% of stocks in the industry based on the PEG ratio. Among the names that meet those requirements for low PEG ratios, the strategy buys the 30 stocks with the highest PowerFactors rankings.

Backtested Performance

The backtest excludes over-the-counter stocks, and it considers only companies with a market capitalization value above $250 million. This is to guarantee a minimum size and liquidity level for companies in the portfolio. The portfolio is rebalanced monthly, and trading expenses are assumed to be 0.2% per transaction. The benchmark is the SPDR S&P 500 ETF (SPY).

Backtested performance is quite strong since January of 1999 the strategy gained 2,198% versus a much smaller gain of 244% for the market tracking ETF. The strategy Alpha amounts to 11.59% per year.

Data from S&P Global via Portfolio123

The table below provides more details into the backtested performance numbers, and it's important to note that the strategy has underperformed the benchmark in the past year.

This is to be expected, even the best strategies - meaning those with the strongest performance metrics over the long term - go through periods of short-term underperformance from time to time, and it's practically impossible to tell in advance when the strategy is entering a period of underperformance or outperformance.

Investors looking to outperform the market through a disciplined and rules-based approach to investing need to be patient and tolerate periods of short-term underperformance in order to benefit from long-term outperformance. In the words of Aristotle: "Patience is bitter, but its fruit is sweet".

Practical Considerations And Portfolio

It's important to keep in mind that this strategy is not including any criteria for sector diversification, and this has obvious risks in terms of portfolio concentration. The main idea is not that investors should blindly replicate the strategy, but rather use it as a tool to identify promising ideas for further research.

Another important consideration is that the strategy compares the PEG ratio for the stock versus industry standards. If you believe that a particular industry is overvalued, then the fact that the stock is less overvalued than the average stock in the industry is not particularly promising.

The PEG ratio is also based on forward-looking growth expectations. In cases in which the market is overestimating the company's growth potential, the valuation ratio is also overestimating the company's true value. Investors need to make sure that the company can meet and preferably exceed growth expectations when making investment decisions based on the PEG ratio.

Without further prologue, the table below has the 30 stocks currently picked by the quantitative strategy. Data in the table includes market capitalization in millions, the PEG ratio for the stock, and the average PEG ratio in the industry.

No strategy can be perfect or infallible, and it's important to always analyze the business behind the numbers when selecting stocks based on these kinds of quantitative strategies. Nevertheless, investment decisions supported by hard data and time-proven indicators can lead to superior returns in comparison to buying and selling stocks based solely on opinions, emotions, and subjectivities.

Statistical research has proven that stocks and ETFs showing certain quantitative attributes tend to outperform the market over the long term. A subscription to The Data Driven Investor provides you access to profitable screeners and live portfolios based on these effective and time-proven return drivers. Forget about opinions and speculation, investing decisions based on cold hard quantitative data can provide you superior returns with lower risk. Click here to get your free trial now.