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How the PEG5 Was Developed      

By Moe Chernick ([email protected])

El Segundo, CA (July 6, 1999) -- During my first year in the Workshop, I learned about the power of mechanical investing. My first mechanical investments included Keystone, Unemotional Growth (UG), and Formula 90.

While I was intrigued with UG and Formula 90, I wondered how a screen-based strategy would do if it looked at projected future earnings instead of the past earnings used by both UG and Formula 90. It was this thought, in addition to the availability of old Value Line data (for a hefty cost), that started me on the process of developing a new screen.

I initiated the process by importing lessons that I learned from my previous experience with mechanical strategies. What those screens looked for that I wanted to retain was high quality stocks with strong relative strength. To achieve the quality goal, I decided, like Keystone, to use Value Line stocks with timeliness ratings of 1 or 2. The reason for utilizing stocks with a 2 rating was to broaden the selection process to 400 stocks from 100 stocks. With a selection of 400 stocks, I was able to choose the top echelon of relative strength stocks and still have enough stocks left to pick growth gems from that list.

In order to obtain the top relative strength stocks, I next cut the list to 25 stocks with the best 26-week total return. With this list, it was now time to pick the growth gems, which I chose by sorting the list by Value Line's Projected EPS Growth Rate. In choosing the top 5, this screen produced a list of top quality companies with high growth and great relative strength. For January starts, the return was approximately 40% for an annual hold. Workshop board contributor Elan Caspi named this screen EG for Earnings Per Share Growth.

While the EG results were impressive, an analysis of this list showed that the top 5 stocks did not do better then the top 10 stocks. I wondered if adding another factor to the top 10 stocks could improve my results. I thought that if a factor could be added to help determine which stock's big run-up was near its peak and which still had a way to go, the screen's performance could be improved. Thus I decided to add my favorite value indicator, PEG, to this screen. Because I really wanted to emphasize growth, I decided to define PEG for this screen as follows:

Current P/E (based on previous 12 months' earnings)

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Projected EPS Growth Rate

The top 10 EG stocks were then sorted by their PEG ratio, and the top 5 stocks were selected. When I did this, I discovered one flaw, which is that sometimes the top 10 list contains stocks with no P/E ratio listed by Value Line and thus no PEG for that stock. To eliminate this flaw I added a new filter -- the stocks that comprised the top 25 also list had to have a P/E greater than 0.

With that addition, the PEG screen was born. With January starts and an annual hold the PEG screen has an average return of 46.3% from 1987-1998. Its only losing year to the Standard & Poor's 500 Index was last year, when the screen had a return of -23%. For semiannual returns with a January start date (i.e. switching every January and July), the returns are even better, with an average return of 50.8%. Between 1987-1998 the semiannual method has had no losing years, and while the annual version of this screen lost 23% last year, the semiannual version returned 59.9% last year. (To see the complete returns for both of these period check the following website: http://members.aol.com/cesaraa/MMM/).

This is how a new, powerful growth screen with a value touch added in came into being. In future articles, I will look closer at the PEG screen to determine whether it belongs in your portfolio.


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