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In part one of this series we introduced the notion that in all
markets whether bear or bull, there will always exist individual
stocks that are fairly valued, overvalued or undervalued. In this
same vein we argued that it's a market of stocks, not a stock
market. For those who missed it, here's
a link to part one
. To put this into context, we are simply suggesting that the
discerning investor can always find bargains if they are willing to
look and do their homework. However, we should also add that
bargains can come from many different types of equities.
Therefore, this and the following articles in this series will
look at bargains that can be found within various equity
classes. In this part two, we will look for bargains in
high-growth stocks. Although this may be the riskiest equity asset
class of all, it is also the most profitable, as long as sound and
prudent investing principles are adhered to.
High Growth Stocks Defined
One of my favorite quips is about Tennessee Ernie Ford leading
his church's choir when he allegedly said: "
everyone turn to page 26 and sing along with me, but if you
don't have page 26 then sing page 13
twice, because we all need to be on the same page."
Therefore, as it relates to this article, in order for us all to be
on the same page, we need to share a common definition of growth
stocks, before a fair and impartial analysis can be conducted.
Consequently, for purposes of this article, we define growth
stocks as follows: In order to be considered a growth stock, the
company must have a history of growing their earnings in excess of
15% per annum, while simultaneously possessing a forecast expected
future growth rate of at least 15% or better. For companies that
possess these levels of past and future growth, we will utilize a
PEG (PE equals growth rate) formula to calculate fair value. The
valuation theory being applied states that companies possessing
these significantly above-average growth rates deserve a premium
valuation over slower growing peers.
The premium valuation concept presented above represents one
aspect of why growth stocks, under our definition, possess higher
risk than blue chips. First of all, achieving these high levels of
growth are not only rare, but also extremely difficult to
accomplish. Consequently, it is a challenge for companies to
maintain high rates of growth, and this challenge is amplified the
bigger the company gets. Therefore, we offer this very
important caveat. Regarding growth stocks, it is even more
imperative to focus on future growth over historical growth, than
it is for any other equity class.
There is a second factor related to the above caution and that
is the importance of valuation. Typically, Mr. Market will
ask the prospective investor to pay a higher valuation (PE ratio)
to buy a growth stock than most other equity categories. Having to
pay a higher valuation for above-average growth is usually not only
necessary, but also rational to a point. In fact, due to the
high rates of potential growth, coupled with the power of
compounding, means that above-average rates of return can be
achieved with growth stocks, even if you pay a little more to buy
one than you should. In other words, the compounding power of rapid
earnings growth can bail you out from an aggressive purchase over
time.
On the other hand, one of the most common mistakes investors
make with high-growth stocks is overpaying for them. This
usually occurs because of the hype that often leads to hysteria
which tweaks the greed response. Companies with extremely
high rates of growth can for a time attract significant investor
interest leading to incredible short-term momentum.
Consequently, a rapidly rising stock price can excite investor
greed to the point of irrational behavior. One place where this
psychological response is often seen is with hot IPOs. Later
in this article we will present a vivid example of how dangerous
this can be.
High Growth Stocks in the S&P 500
This series of articles is oriented to dealing with the wide
diversity of equity classes that make up the S&P 500.
Therefore, we are only going to concern ourselves with high-growth
stocks that are constituents of the S&P 500. Of course,
this also means that there are many very high-growth stocks that
will be excluded from this discussion. Consequently, what
follows is by no means presented as a comprehensive list of
high-growth stocks.
Moreover, and most importantly, the following tables comprised
of high-growth stocks in the S&P 500 also had to meet the
hurdle of reasonable valuation. As a result, there were several
S&P 500 growth stocks that did not make the cut. In other
words, the following tables look at S&P 500 high-growth stocks
that appear to be at or near fair value based on expected future
rates of growth. S&P 500 growth stocks that we believe
are overvalued were not included.
We have listed 17 S&P 500 high-growth stocks that met our
criteria and we have organized them based on capitalization and
earnings growth rate. Interestingly, all of the S&P 500
high-growth stocks that made our list are large-cap
companies. Our first table reports on seven companies with
earnings growth rates exceeding 20% per annum (The reader should
note that both the 15-year historical EPS growth rate and the
estimated 5-year EPS growth rate are both in excess of 20% in table
1). Our second table covers 10 additional S&P 500 growth
stocks with historical and estimated growth rates in excess of 15%
per annum.
Both of the following tables provide a summary of important
fundamental measurements. The first two columns list
historical earnings growth, followed by forecast EPS growth
rates. The next two columns are focused on valuation by
showing the historical normal PE followed by the current market
PE. Then we provide debt levels and sector, followed by
annualized historical performance, and finally, an estimate of
future potential compounded annual rates of return. (It is
important to note that the reader should understand that any
companies on the list with poor historical returns (highlighted in
red) can be assumed attributed to beginning overvaluation).
Analyzing S&P 500 High-growth Stocks Through the Lens
of F.A.S.T. Graphs
™
Next we're going to evaluate several examples from our list of
S&P 500 high-growth stocks in value, utilizing the
F.A.S.T. Graphs
™
fundamentals analyzer software tool. This exercise will serve
the dual purpose of allowing us to analyze the fundamental value of
each company and to illustrate and elaborate on several of the
points previously presented in this article. Furthermore,
although we believe that the following analysis provides a
comprehensive evaluation of the fundamentals underpinning each of
these examples, additional due diligence is recommended.
Cognizant Technology Solutions (
CTSH
)
Cognizant Technology Solutions is a leading provider of custom
information technology, consulting and business process outsourcing
services. The following earnings and price correlated graph on this
quality company depicts a quintessential example of a true growth
stock. Not only has earnings growth averaged 38% per annum,
the consistency of the growth has also been extraordinary. This
rate of growth is very rare, as few companies are capable of
growing this consistently fast.
Furthermore, notice how stock price (the black line on the
graph) has closely tracked earnings (the orange line on the graph)
up through calendar year 2007, but has since deviated (see red
circle). This long-term picture of the earnings and price
relationship clearly alerts us that something has changed since
2008. The first reaction of course would be that the great
recession of 2008 made an impact. However, upon further
review we discover that the recession did impact stock price for
sure, but we also see that earnings growth continued to advance
nicely, thereby suggesting that this company was clearly recession
resistant.
On the other hand, a glance at the bottom of the graph (see
yellow highlights) shows that the earnings growth rate, although
continuing to be strongly above average, had slowed down. However,
thanks to the dynamic nature of the F.A.S.T. Graphs ™ research
tool, we can run a graph since 2008 (the recession), and analyze
this inflection in earnings growth and the impact it had on price
and valuation. However, before we do, let's take a look at
performance since calendar year 1999 in order to illustrate just
how powerful a return generator that a high-growth stock can
be.
When we calculate the performance that Cognizant Technologies
has produced for its shareholders since calendar year 1999, we see
a stunning example of the incredible power of compounding, and the
incredible economic benefit it can provide. A simple $1000
investment in Cognizant's stock on December 31, 1998, and held till
now would have turned a $1000 initial investment into over $54,000
today. Comparing this more than 33% per annum compounded rate of
return from this S&P 500 constituent to the S&P 500 itself,
clearly illustrates just how powerful the return that this growth
stock has produced.
A quick glance back at the historical earnings and price
correlated graphic above shows that the company was reasonably
priced with a PE ratio of just under 40, or only slightly above its
38% per annum earnings growth rate on December 31, 1998. Remember,
the formula used to value high growth stocks is the PEG (PE equals
growth rate) formula. Consequently, even though the company appears
undervalued during the later years based on its historical growth
which averaged 38% per annum, the compounded rate of return it
provided shareholders is highly correlated to its long-term
earnings growth.
Next, and as promised, let's use the dynamic feature of F.A.S.T.
Graphs ™ and look at Cognizant Technologies since the beginning of
calendar year 2008 (the great recession). Here we discover that our
research tool has recalculated the company's earnings growth rate
and simultaneously provides a more recent iteration of fair
valuation. Since calendar year 2008, Cognizant's earnings
growth rate has fallen from averaging 38% per annum to averaging
22% per annum.
Nevertheless, although this is still significantly above-average
earnings growth, it does imply a valuation adjustment.
Consequently, by applying the PEG ratio valuation because earnings
growth is over 15%, we see that the market has been rationally
valuing the company at its adjusted growth rate since 2008.
Therefore, although it is useful to see how powerful this growth
stock has been since 1999, it is also both imperative and useful to
evaluate it based on its more recent history. This explains
why the price was not tracking its long-term earnings growth rate
during the latter years on the long-term earnings and price
correlated graphic above.
When we review the performance of Cognizant since calendar year
2008, and consider that it was moderately overvalued with a PE
ratio above 25 relative to an earnings growth rate of 22%, we
continue to see evidence of the strong returns that a high growth
stock can provide. Furthermore, this also illustrates that
you can moderately overpay for a high-growth stock, and still
generate a significant long-term rate of return.
Astute investors who purchased Cognizant on December 31, 2007,
would have more than doubled their money, averaging approximately a
15.7% per annum return. When you compare this to investing in the
S&P 500 Index, the value of owning a high-growth stock bought
at a reasonable valuation is vividly revealed. Remember, that
even though Cognizant was moderately overvalued, the power of
compounding earnings growth during and through the great recession,
allowed the company to provide its shareholders very attractive and
highly above-average returns.
When we turn our attention to the future, we discover that
expectations are high that Cognizant Technologies can continue to
grow earnings at a very high rate of growth. The consensus of
21 analysts expect the company to continue growing at approximately
20% per annum, and therefore, the current PE ratio of 21 would
imply that the company is reasonably priced based on its expected
high future growth. However, the reader should remember the
caveats mentioned above regarding the difficulty of achieving such
a high rate of growth. Here the concept of risk versus reward
comes into play.
Priceline.Com Inc. (
PCLN
)
The long-term graphic on Priceline.com provides a lot of lessons
on investing in general, but most importantly, on investing in
growth stocks specifically. Additionally, the importance of
investing at sensible valuations is clearly articulated.
Furthermore, we can use this example to reflect on lessons to be
learned when investing in IPOs, as promised earlier in this
article.
Priceline.com went public on April Fools' Day 1999; however,
investing in its initial public offering was no joking
matter. From the graph below we can see that for the first
month after its IPO, Priceline.com's stock price almost doubled in
value. However, for the next 20 months or so following its
price peaking, the stock fell from a high of over $974 per share to
a low of $6.38 per share. Furthermore, it should be pointed out
that there were no earnings being generated by the company at this
time to support its high price.
When you calculate Priceline.com's performance since its IPO to
current time, we discover how devastating overvaluation can be to
long-term performance. Even though the company eventually
began earning money (its first earnings occurred in 2002), and even
though its long-term rate of earnings growth has been
extraordinary, long-term shareholder performance has been rather
anemic. This week performance is attributed solely to its
stock price being irrationally priced by the market at its
IPO. With no earnings to buoy the stock price, a fundamental
collapse was inevitable.
One of the valuable attributes of the F.A.S.T. Graphs ™ research
tool is the ability to go back in time and focus on historical
periods in order to learn from the past. The following
graphic looks at Priceline over the historical timeframe 1999 to
2003. This time period covers the company from its IPO to its
first years of generating a profit. From this perspective,
the collapse in stock price following the first three years or so
after its IPO are easily understood and justified. In other words,
hype and hysteria eventually gave out to sound fundamental
value.
When you measure the company's price performance from its IPO in
1999 to year-end 2003, we see just how devastating overvaluation
can be. A $1000 investment in Priceline at its IPO would have
generated a compounded 50% per annum loss on its shareholders
behalf, thereby turning the original $1000 investment into a mere
$35.98.
The moral of this story is to not invest in IPOs no matter how
enticing (think Facebook) unless the company's initial earnings
support the stock price. Since the company is going to trade
for a long time, the patient investor would more often than not
find a more attractive and rational entry point than they typically
find at the IPO. With our next look at Priceline we will show
how profitable this kind of patience can be.
Next, let's take a look at Priceline after they became a
profitable business in 2003. Here we find that earnings
growth has averaged over 60% per annum, and has been extremely
consistent since calendar year 2005. There are two additional
things to take notice of. Number one, Mr. Market has
historically priced Priceline at a premium PE in excess of 30,
however, this valuation is only half its actual earnings growth
rate (the blue line = normal PE). Second, we see that the company
has achieved this remarkable growth without needing to take on any
long-term debt.
In contrast to investing in Priceline at its IPO, let's take a
quick look at Priceline and the returns they generated for
shareholders after they became a profitable enterprise in calendar
year 2003. The same $1000 investment on December 31, 2002 would
have grown to $64,803, which translates into an exceptional
compounded annual rate of return of almost 54% per annum.
Furthermore, notice how this extraordinary record was achieved by
shareholders without receiving even one penny in dividends.
As a final statement on Priceline, we must remember that as
investors we can only buy the future and not the past.
Consequently, based on the fact that the consensus of 24 analysts
reporting to Capital IQ expects the company to continue growing at
20% per annum, indicates that the company may be fairly priced
today. However, this also means that future expectations for
profit, although appearing quite attractive, will not come close to
their historical average.
F5 Networks Inc. (
FFIV
)
Our final example looks at F5 Networks Inc., a leading provider
of application delivery networking technology. There are several
lessons regarding investing in growth stocks that we believe this
fast-growing technology enabler can teach us. First of all,
we see another example of the extraordinary benefit provided from
investing into a company with a powerful earnings record.
Additionally, this company also teaches us a thing or two about
valuation, and finally provides lessons on intelligently dealing
with volatility.
From the earnings and price correlated graphic below we see that
F5 Networks has generated earnings growth averaging 29.8% since
calendar year 2005. Furthermore, we can clearly see that the
company's stock price, although generally tracking earnings, has
experienced extreme bouts of high volatility on more than one
occasion.
But even more importantly, we see the importance of trusting
fundamentals over stock price movement, because every time stock
price deviated from fair value over or under, inevitably it returns
to fair value. We believe this validates our thesis that
price volatility will only hurt you when you overreact to it while
simultaneously refusing to acknowledge intrinsic value based on
fundamentals. We believe there are two performance measurements for
every stock. The first is price volatility, which can't be trusted,
and the second is fundamental value, which in truth matters most.
Unfortunately, most investors ignore fundamental value as they are
fixated on fickle price.
When you look at the performance that this high growth company
has generated for shareholders, we once again see a high
correlation between return and earnings growth, adjusted for
valuation. In other words, it is only because the company is
currently trading at a discount to its historical earnings
justified valuation that has caused its 20.8% compounded annual
return to be less than its 29.8% earnings growth achievement.
Summary and Conclusions
Our primary objective with this series of articles is to
illustrate the truth that there is a lot of value in this
market. With this part 2, we focused on high-growth stocks
that were constituents of the S&P 500 that are currently
trading at fair value based on their earnings potential.
Although many of the stocks on our master list of 17 are currently
trading at above-market PE ratios, we think the valuations are
justified based on the earnings power of these extraordinary
growers. This teaches us a lesson that valuation is a
relative concept. In other words, a company with an
extraordinary potential for growth is worth more than a company
with a lower potential for growth.
The companies that we have featured in this article appear to be
attractive high-growth candidates for the aggressive investor
seeking maximum capital appreciation. However, this statement is
based on a combination of the company's historical operating
history, coupled with consensus estimates for future growth.
Furthermore, because these numbers are significantly higher than
average, the notion of greater risk should be kept firmly in
mind. On the other hand, the old adages that no risk, no
return, also come into play. The bottom line is that although
we feel this is an excellent list of S&P 500 constituents with
high growth potential, additional due diligence is highly
recommended.
Disclosure:
Long AAPL, V, GOOG, MA & NOV at the time of writing.
Disclaimer:
The opinions in this document are for informational and educational
purposes only and should not be construed as a recommendation to
buy or sell the stocks mentioned or to solicit transactions or
clients. Past performance of the companies discussed may not
continue and the companies may not achieve the earnings growth as
predicted. The information in this document is believed to be
accurate, but under no circumstances should a person act upon the
information contained within. We do not recommend that anyone act
upon any investment information without first consulting an
investment advisor as to the suitability of such investments for
his specific situation.