How to PEG down growth shares at a reasonable price

The Alternative Investment Market has surged by 20% since the EU referendum. That’s the sort of 3-month performance we haven’t seen since mid-2013, when the ISA exemption was lifted on AIM shares. In this kind of environment it may well get harder to track down growth stocks at reasonable prices. But an investment metric used by some of the legends of growth investing could make it easier to pin down possible opportunities.

Well known investors like Peter Lynch in the US, and Jim Slater in the UK, forged their reputations by pursuing fast growing companies. But while blistering earnings growth was a crucial part of their strategies, both resisted the temptation to over pay for it. To strike a balance between growth and value, each employed a useful measure called the PEG - or price-earnings to growth ratio - and this is how it works...

How PEG investing works

For Lynch, who had a hugely successful run as a fund manager at Fidelity Investments, it’s crucial to compare a stock’s valuation with its growth rate. In his book, One Up on Wall Street, he wrote that on any chart showing a company’s earnings line running alongside its stock price, the two lines will move in tandem. Or if the stock price strays away from the earnings line, sooner or later it will come back to the earnings.

Lynch showed showed that if you can pick up a stock with price-to-earnings 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 invested. For instance, a glamorous growth company on a PE of 20 growing at 30% per year would be on a PEG of 0.66. But a company on a PE of 10 growing at 5% per year would be on a PEG of 2.

Protection from overstretched shares

Slater’s take on the PEG was slightly different to Lynch’s because he calculated it by using forecast ratios for PE and EPS growth, rather than the trailing ratios. As a result, Slater’s PEG has been criticised for effectively ‘double counting’ earnings growth (because it’s a component of both the forecast PE and the forecast EPS). However, Slater combined his PEG with a several other growth indicators in his search for stellar stocks.

Slater saw the PEG as a useful guide to robust growth shares. 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.”

Screening for growth at a reasonable price

To get an idea of the sorts of small-cap companies that are delivering earnings growth but remain on low PEGs, here’s a snapshot of a Jim Slater-inspired screen - with the PEG set to a maximum of 1.0. Stockopedia members can access the original strategy screen here - which has seen a 26.2% return over the past two years.

With the exception of Liontrust Asset Management and MD Medical, these are all AIM quoted shares. All of them have been on a strong run in recent months.

In terms of market cap, the companies passing these rules range from Swallowfield, which makes personal care and beauty products, to Burford Capital, which provides investment funding in the legal sector. In between are several well known names among growth investors, including Empresaria, the recruitment firm, Iomart, an IT managed hosting company, and Ab Dynamics, a company that supplies testing products to the automotive industry.

Watch the risks with smaller growth stocks

While the likes of Peter Lynch and Jim Slater made names for themselves by netting spectacular returns from growth stocks, it’s worth remembering that there are risks in targeting fast growing smaller companies. Strong sales and earnings growth can be eye-catching but small-caps are susceptible to unpredictable setbacks. But as Slater insisted, 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.