Many investors employ "simple" rules of thumb when investing. There's nothing wrong with using shortcuts such as these, especially when it allows you to quickly disregard certain stocks for failing to meet your selection criteria. These can be considered "negative" rules of thumb – parameters which hopefully help you avoid low quality stocks.
Positive rules of thumb are perhaps more dangerous as practiced incorrectly they may in fact lead you into buying a low quality, declining business – a scenario you almost certainly want to avoid. For example a "rule" of only buying low price-to-earnings (PE) stocks, on its own, can be dangerous.
While buying stocks trading on low PEs implies cheap, sometimes they are cheap for a reason. One way to protect yourself from potentially cheap and nasty stocks is by using the additional rule of thumb to only buy stocks with a PEG ratio of less than 1. To determine the PE-to-Growth (PEG) ratio, divide the PE ratio by a company's earnings per share (EPS) growth rate.
Here are four companies (with forecasts from Morningstar Research) that are trading on PEG ratios of less than 1, which could potentially mean that they are undervalued.
1) Chandler McLeod Group Limited (ASX: CMG) is forecast to grow earnings from 4.8 cents per share (cps) in FY 2014 to 5.5 cps in FY 2015. This implies a growth rate of 14.6% and a PE ratio of 6.2. Although this is appealing on face value, investors who demand certain balance sheet hurdles such as a low debt to equity ratio (another important rule of thumb measure) would probably strike Chandler McLeod out.
2) Despite RCR Tomlinson Limited's (ASX: RCR) exposure to the mining industry, the firm is still expected to grow EPS at a fast rate. Growth of 18.9% is forecast in FY 2015 placing the stock on a forward PE of 7.4.
3) GWA Group Ltd (ASX: GWA) is forecast to grow EPS by 25% in FY 2015, suggesting the stock has a PE of 14.3.
4) In FY 2015, Automotive Group Holdings Ltd (ASX: AHE) is forecast to grow EPS by 13.6%. Based on this forecast, the stock is trading on a PE of 11.1.
Rules of thumb can be both great starting points and also handy for making checks on your investment ideas. However, as Warren Buffett says – investing is simple but not easy – so rules of thumb only go so far with filling in the pieces of the investment puzzle.
