It seems like I've been writing only about dividend growth stocks for what seems like forever. Therefore, I felt it would be a refreshing change to alter my focus from dividend income to pure unadulterated growth. Although I'm a major proponent of investing in dividend growth stocks, unlike many of my fellow dividend growth investor friends, I am also a big believer in the benefits of investing in non-dividend paying growth stocks with the potential for generating a higher total return.
The equity universe is broad and multifaceted. Since there are so many different types of stocks that investors can choose to invest in, I often get frustrated when I read or listen to opinions making broad statements regarding either the perils or merits of investing in common stocks in the general sense. I especially get agitated when these over-generalized discussions attempt to stereotype all stocks as being risky. The truth is that the risks of investing in common stocks are also as broad and multifaceted as are the various categories of common stocks themselves.
Furthermore, I also find it troubling when I hear over-generalized statements purporting to forecast what the future returns of common stocks are going to be. For example, the widely touted "new normal" forecast of Bill Gross describing what he calls an era of lower returns based predominantly on his views of the U.S. and his belief in its diminishing clout in the world economies. But alas, Bill Gross is not alone; there are untold numbers of articles penned every day painting a negative picture of the U.S. economy and the future of common stocks. Warren Buffett shared his thoughts on the subject, found here.
What I believe these prognosticators fail to consider is the unique nature and ability of an individual company to generate returns that can widely differentiate from the equity asset class at large. Since I am a believer in building stock portfolios one company at a time, I tend to sympathize with legendary investors such as Warren Buffett, Peter Lynch and others that steadfastly encourage us to ignore macroeconomic forecasts, which they believe, as I do, are virtually impossible to accurately predict anyway. Instead, I focus my attention on trying to understand as much as I can about the specific business I am looking at, and its individual and unique prospects for future growth.
To put this in more simple terms, it may or may not be true that the future growth of our economy might, in fact, fall from a traditional 3% to 4% growth rate to a lower 2% to 3% growth rate. However, it will also be true that many companies will continue to enjoy very fast individual rates of growth in spite of a slowing economy, if it were to become a true prophecy. Consequently, this article will be the first in a series of articles looking at individual growth stocks with significantly above-average prospects for growth.
Another thing that continuously frustrates me about the investment industry is how imprecise it can be with its definitions of important terms. A second frustration of mine comes from the muddy labels behind the application of statistical analysis based on faulty or inaccurate descriptions of important terms and concepts. For example, the over-generalizing of equity investing into either value investing or growth investing. I feel that this is one of the most abused and misunderstood concepts of investing in common stocks that is also prolifically written about and debated.
To put this into perspective, there is a famous Warren Buffett quote where the "Oracle of Omaha" emphatically states that "growth and value investing are joined at the hip." He goes on to explain that he would never invest in any company that he didn't believe would grow, and that he would never be willing to pay more than it's currently worth. It's further alleged that based on this quote, the venerable investor, Peter Lynch, developed a hybrid strategy known as Growth At a Reasonable Price, or more commonly known as GARP.
Since this article is concerned with growth stocks, I intend to be very precise in how I define a growth stock. In fact, I will offer several definitions in order to clarify the concept of what a growth stock actually is.
If a company shows a history of consistently or regularly increasing earnings, then in the strictest sense, it can be called a growth stock. This would be true whether it grew at 1%, 5%, 10%, 15%, 20%, 30% or more. As long as earnings are growing, no matter what the rate, the company is, by the strictest definition, a growth stock because the business is growing. Obviously, 1% or 2% growth rates are not what people normally imagine when they think of a growth stock. Most people would envision much faster rates of growth, but the fact is that growth is growth no matter how fast or slow.
Therefore, in order to add precision to the concept of what a growth stock is, I will break the category down into several sub definitions based on each specific company's rate of earnings growth. The purpose of this exercise will be to illustrate how vastly different growth stocks can be. Hopefully, this will illuminate the truth behind how unfair it is to lump them all into one broad basket. Not only is it true that all growth stocks are not the same, but the magnitude of the differences are truly profound. The power of compounding at higher growth rates produces extraordinary differences in shareholder returns.
Now, here is the most important part of clarifying the definition of a growth stock. In my mind, the true definition of a growth stock has little or nothing to do with its stock price movement. Stock price movements are side effects of what true growth is really about. When I speak of growth stocks, I am talking about businesses that are capable of consistently increasing their earnings at various rates of growth. I will categorize them based on both their historical and future prospects for growth. But generally speaking, a true growth stock, at all levels of growth, is defined as a company that generates shareholder value through a mostly consistent growth of its profits (earnings). In other words, it is the growth of the business that I'm concerned with.
Growth Stocks Defined
The major categories of growth stocks can be broken down as follows: I define companies growing earnings at rates of 5% per annum or less, as slow growth, or low growth stocks. Most utilities fall into this category. Faster growing companies that grow their earnings from 5% to 15% per annum, I define as moderate growth stocks. Most blue-chip dividend stalwarts such as Coca-Cola (NYSE:KO), 3M (NYSE:MMM), Procter & Gamble (NYSE:PG), etc. will be found here. Very fast growing companies that grow their earnings 15% to 25%, I will define as fast growers. Super-fast or hyper-growth stocks will be defined as any that can consistently grow at rates of 25% or better.
This series of articles will review very fast and super-fast growth stocks, which I feel are the most exciting and perhaps the truest categories of growth stocks. With this first article, I will look at super-fast earnings growth of 20% or better, past and future. In my next article, I will cover fast-growing companies (growing earnings 15% to 20% per annum). EDMP is an acronym for Earnings Determine Market Price, which is what I believe to be the foundational principle underpinning where performance is derived for all common stock investing, in the long run. In other words, long-term returns are derived based on the success of the underlying businesses' ability to generate earnings and cash flows.
In contrast, there is also an evil twin sister EDMP, where Emotions Drive Market Price in the short run. It is this evil twin sister that often causes inefficiencies and the miss pricing of an individual company's stock over short periods of time. But perhaps most importantly, earnings, or more generally stated, the fundamental strengths of the business which truly create its value are enduring. On the other hand, the emotional responses of individual investors creating short-term price volatility are fragile and fleeting. Consequently, I believe it makes more sense to trust fundamentals than it does to trust investor sentiment.
10 Super-Fast Growth Stocks
Although there will be a few exceptions, for the most part, super-fast growth will typically be found with smaller and younger companies. In concert with this last statement, the reader should also consider that the risks associated with investing in young, fast-growing stocks are typically greater than with investing in more established and larger enterprises. However, consideration should also be given to the higher returns that these riskier enterprises may offer.
Furthermore, the prudent investor in super-fast growth stocks must pay careful attention to the price or valuation they pay. Super-fast growth stocks will often command very high valuations relative to those awarded to the average more established common stock. However, there are both limits and sensible rules that can, and should, be applied. For starters, and as a general rule of thumb, super-fast growth stocks can be considered at fair value if their P/E ratio is equal to, or preferably below, their earnings growth rates. This rule of thumb applies to historical growth, but more importantly to forecast future growth. Therefore, the prudent investor should consider both past and expected future growth before making an investment.
With the above said, identifying super-fast growth stocks, where earnings growth has exceeded 20% per annum, is not that challenging. On the other hand, finding super-fast growth stocks at fair valuation is another matter altogether. Because these companies will often have great performance track records, investors will often become overly enthused. As a result, truly fast-growing enterprises are more often than not overvalued. Therefore, I had to search very hard to find 10 prospective candidates that seemed worthy of deeper scrutiny based on reasonable current valuations.
The following portfolio review lists 10 super-fast candidates organized in order of highest to lowest estimated total future return. In order to make the top 10 list, each candidate had to meet several criteria, each of which is reflected in the portfolio review. Each candidate's current P/E ratio had to be more or less in alignment with its historical earnings growth, but more importantly less than its estimated future EPS growth. Furthermore, each candidate had to show performance that was significantly greater than the average company (the S&P 500) over the past decade or during the timeframe measured (note on the annualized performance column that several of the companies did not possess a full 11-year track record).
A Specific Review Of The 10 Super-Fast Growth Stocks
The following will detail the earnings and price correlations and relationships, plus the performance these relationships generated, on each of my 10 small to mid-cap super-fast growth candidates through the lens of F.A.S.T. Graphs™, the fundamentals analyzer software tool. Note how highly-correlated the total annual return is to the company's earnings growth rate. This provides clear evidence that Earnings drive market price (EDMP) in the long run. On the other hand, when the price deviates from the orange earnings justified valuation line, over or under, we see clear evidence of the evil twin sister (EDMP), where Emotions drive market price in the short run. Moreover, also notice how price inevitably moves back into alignment. The longer and more consistent the record of earnings is, the more accurate my previous statement is.
Since these are all fast-growing stocks, the orange earnings justified valuation line represents a P/E ratio that is equal to each of the companies' calculated earnings growth rates. Consequently, the orange line represents the theoretical fair value of each company over the past decade (since 2003 or shorter if the company was in public in 2003). However, as with all rules, there are exceptions, which is why each graph provides a calculated normal P/E ratio (the blue line). It's important to note that the slope of the blue line will equal the company's earnings growth rate; however, the multiple of earnings may be different.
Since these are mostly young and small, but very fast-growing companies, I will provide a brief commentary on how I interpret their respective earnings and price correlated graphs. Since these companies are offered as potential candidates for further research, I will let the sub industry classification presented in the FAST FACTS to the right of the graph suffice as a brief description of the company's business.
Dresser-Rand Group, Inc. (NYSE:DRC)
Dresser-Rand Group has only been public since August 31, 2001. Nevertheless, we see a high correlation between the company's stock price and its earnings growth since that time.
Regarding performance since Dresser-Rand went public; we see the typical overvaluation as an IPO resulted in long-term performance being lower than the company's operating earnings growth. However, we also see that in spite of the headwinds of overvaluation, that this company's long-term performance was significantly above-average since it went public.
As to the future for Dresser-Rand, 16 analysts reporting to Standard & Poor's Capital IQ expect growth to continue at over 30% per annum for the next five years. As a cautionary note, a cross-check with Zack's shows 9 analysts forecasting Dresser-Rand's five-year earnings growth rate at 18%. It's kind of interesting that approximately half the number of analysts expect half the earnings growth rate. It's imperative that prospective investors validate which growth rate they would believe. However, even the 18% growth rate would make Dresser-Rand an attractive long-term investment if it were to come to pass.
Acacia Research (NASDAQ:ACTG)
Acacia Research is an interesting case because the company has only been generating earnings since fiscal 2010. However, earnings growth has been substantial since it has been earning money.
It is interesting to see that Acacia Research has generated an annualized rate of return of almost 25% per annum over the past decade which correlates very closely (30.6% earnings growth versus 24.9% annualized rate of return) to the company's earnings growth rate.
(click to enlarge)Five analysts reporting to Standard & Poor's Capital IQ expect Acacia Research to keep growing earnings at over 20% per annum over the next five years. This would imply an extremely attractive long-term investment if these earnings were to manifest as forecast.
Rosetta Resources Inc (NASDAQ:ROSE)
Rosetta Resources has generated earnings growth averaging over 23% per year since it went public in February 2006. However, the reader should note that earnings collapsed during the great recession, but have been recovering very strongly ever since.
Since Rosetta Resources is in the oil and gas exploration and production industry, like most of its peers, its stock price appears currently below fair value. Nevertheless, the company's record since February 28, 2006 has substantially outperformed the S&P 500.
The consensus of 17 analysts reporting to Standard & Poor's Capital IQ expect Rosetta Resources' five-year average earnings growth rate to exceed 25% per annum. Consequently, if this earnings growth rate was to manifest, today's prospective investors would be buying future earnings very cheaply.
United Therapeutics Corp (NASDAQ:UTHR)
United Therapeutics is a biotechnology company with a very strong record of average earnings growth since 2003. Although the company did experience some earnings weakness during the great recession, earnings recovery ever since has been extremely strong but has not as of yet been reflected in the company's stock price.
Even though shares appear undervalued today, United Therapeutics' long-term performance has been substantially higher than the S&P 500 -- once again providing evidence that business results have more to do with the individual company than they do based on macroeconomic factors.
The consensus of 10 analysts reporting to Standard & Poor's Capital IQ expect United Therapeutics to grow earnings over 24% per annum for the next five years. In a similar vein, the consensus of approximately 9 analysts reporting to Zacks expect the next five years earnings growth to exceed 29% per annum. In either case, the blended current P/E ratio under 12 would indicate an extremely undervalued growth stock.
Altisource Portfolio Solutions (NASDAQ:ASPS)
Luxembourg-based Altisource Portfolio Solutions has a very interesting earnings and price correlated graph. Since the company went public in August 2009, earnings growth has averaged an astounding 74.9% per annum. However, take out the growth for 2009 and the company still averaged earnings growth exceeding 50% per annum. However, it should also be noted that has typically applied a normal P/E ratio of 17 to the company shares, which is approximately where it sits today.
Even though the market has applied a normal P/E ratio of 17, which is significantly below this super-fast growing company's earnings growth rate, long-term performance has approximated earnings growth. This is because the slope of the blue line on the graph is the same as the orange earnings growth rate line. Therefore, since the normal P/E ratio has consistently tracked at 17 times earnings, the company's annualized rate of return has been 65% per annum.
Going forward, the consensus of two analysts reporting to Standard & Poor's Capital IQ expect Altisource Portfolio Solutions to grow earnings at 20% per annum going forward. Although this is significantly below their historical average, it still represents a significantly above-average growth rate. However, prospective investors would need to exercise their own judgment regarding the future return potential that Altisource Portfolio Solutions may be capable of providing.
GeoSpace Technologies Corp (NASDAQ:GEOS)
GeoSpace Technologies Corp is a fast growing mid-cap operating in the energy exploration sector. Once again, we see some weakness during the great recession followed by accelerating growth thereafter. Nevertheless, the company's average operating earnings growth rate has exceeded 44% per annum.
Once again, we see that performance for GeoSpace Technologies Corp shareholders has been exceptional at 34.5% per annum versus only 7.4% for the same timeframe for the S&P 500.
The consensus of seven analysts reporting to Standard & Poor's Capital IQ expect GeoSpace Technologies Corp to continue growing earnings at 20% per annum over the next five years. Consequently, the shares appear reasonably priced with the current blended P/E ratio of 17.7.
Computer Task Group, Inc (CTGX)
Computer Task Group has produced a very consistent record of earnings growth averaging over 26% per annum since 2003. But most importantly, the earnings and price correlation for this small IT consulting company is undeniable.
Once again we see an example where long-term performance is closely correlated with the company's historical earnings growth rate, only adjusted by moderate undervaluation. Perhaps the most interesting aspect of this earnings and price correlated graph is how the relationship becomes more meaningful for a company with a long history of consistently earnings growth.
The consensus of five analysts reporting to Standard & Poor's Capital IQ expect strong earnings growth at over 22% per annum for the next five years.
Credit Acceptance Corp (NASDAQ:CACC)
Credit Acceptance Corp offers a very interesting earnings and price correlated graph. Earnings growth has been consistent and strong averaging over 27% per annum. However, since this company is in the finance industry, we see that the market has consistently applied the normal P/E ratio (the blue line) of 11.8 to its shares. Once again, remember that although the P/E ratio of the blue line is 11.8, its slope is equal to the 27.1% earnings growth rate.
Consequently, even though Mr. Market has consistently applied a discounted valuation to Credit Acceptance Corp shares, long-term performance has been exceptional and closely correlated to earnings growth.
The consensus of two analysts reporting to Standard & Poor's Capital IQ expect Credit Acceptance Corp to continue growing earnings at 15% per annum over the next five years. Since this is significantly below their historical norm, it seems logical that this growth achievement could be attained.
First Cash Financial Services (NASDAQ:FCFS)
First Cash Financial Services is another consumer finance mid-cap company with a strong and consistent record of earnings growth averaging over 20% per annum. However, in this case the market seems willing to apply a higher normal P/E ratio to its shares. When interpreting these graphs, it's important to understand that they provide facts rather than dictate how the facts should be interpreted.
Because the shares of First Cash Financial Services were significantly undervalued at the beginning of the timeframe measured, long-term shareholder annual returns of over 30% have exceeded the company's 20% earnings growth rate. However, much of that performance must be attributed to the PE expansion plus the earnings growth rate that has occurred since 2003.
The consensus of 11 analysts reporting to Standard & Poor's Capital IQ forecast a 18% five year earnings growth rate. To me, this is more of the same for this high-quality mid-cap consumer finance company.
Bio Reference Labs (NASDAQ:BRLI)
Bio Reference Labs, my final example, has a very consistent historical record of earnings growth averaging over 21% per annum. For most of this timeframe, price is very closely correlated to and tracks earnings.
The close correlation of price-to-earnings has generated shareholder returns of 22.9% per annum, which are roughly in sync with the company's operating earnings growth rate of 21.2%.
The consensus of five analysts reporting to Standard & Poor's Capital IQ expect Bio Reference Labs to continue growing earnings at over 17% per annum over the next five years. This above-average forecast growth rate can be purchased at an approximately average market multiple PE of 15.8.
This article has provided a list of 10 super-fast small to mid-cap growth stocks with significantly above-average historical performance records, and high consensus expectations for the future. However, this list offers only prime candidates for a more comprehensive due diligence for those investors willing to take the risk of investing in high-growth, high-return opportunities.
Although I've not yet completed the necessary due diligence that would make me comfortable enough to invest in any of these selections, based on the preliminary essential fundamentals at a glance presented by each respective F.A.S.T. Graph™, they all appear to be fairly valued candidates worthy of the time and effort to do so. The key to long-term successful investment in any of these enterprises will be validating earnings forecasts and monitoring future earnings growth.
I would also like to direct the reader's attention to the operating earnings growth rates (located in the green box In the FAST FACTS to the right of the graph) achieved by each of these companies and to contrast that with the overall growth of the economy during the same time. Clearly, these companies' results were not dependent on macro economic factors, but instead on the specific an individual merits of each of their respective business models. Consequently, negative opinions about the growth of the economy would not have been relevant to the specific situations.
Summary and Conclusions
To put the astonishing records of these 10 super-fast small to mid-cap growth stocks into perspective, I'm including the 11-year performance results of three blue-chip dividend stalwarts, Colgate-Palmolive (NYSE:CL), Coca-Cola and Johnson & Johnson (NYSE:JNJ). When you compare the records of these blue-chip to the records of the super-fast mid-caps, the merits of taking the risk to own them becomes readily apparent.
Johnson & Johnson
I have often been asked if there was a way to identify super-fast earnings growth early enough to invest in it, or could it only be done in hindsight. Frankly, I think the answer is yes and no. Personally, I like to see the establishment of a record before I invest. Therefore, I only included companies that had at least some track record of earnings growth in this article. However, the reader should understand that many companies showed up on my screens that possessed high forecast future growth rates but only had very short histories of earnings growth. Although I excluded these companies accordingly, there were some interesting examples that showed up.
With my next article, I will present a group of companies that still possess high-growth rates, but not as high as what I presented here. Moreover, most will have longer histories to judge them by. Let me conclude by stating that both this group of companies, and the next group, are offered as candidates with high potential growth. However, in all cases they are offered as potential research candidates. Nevertheless, although the risks are high, the future rewards could be extraordinary and well worth the time and effort to research them deeper.
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.