This is part two of a series on investing for growth, part one can be found here.
One of my primary objectives for preparing this series is to dispel some of the common myths that many investors hold regarding investing for growth. For example, many believe that growth stocks are, by definition, riskier than dividend paying stocks. Although there is some truth to this, I believe this concept is overblown.
One commonly measured metric for measuring risk is beta. At its core, beta is a measure of volatility which is also referred to as systematic risk. More simply stated, it is a measurement designed to reflect whether or not a given stock is more volatile than the general market. A baseline beta of one reflects the market. Therefore, a stock with a beta less than one indicates that it is less volatile than the market, and a stock with a beta greater than one would indicate that it is more volatile than the market.
More volatility is assumed to be synonymous with more risk, and many investors are led to believe that growth stocks have higher betas than dividend paying stocks. In truth, there are many growth stocks that have betas lower than the general market, and conversely, some that have betas higher than the general market. I will list the betas of each of the 10 examples that I will be presenting in this article next to their title. The results may surprise many readers.
There is another myth, or at least a great over-generalization, that dividend paying stocks outperform non-dividend paying stocks. Once again, the true answer is that it really depends on the individual stocks. Some non-dividend companies (stocks) are really terrible businesses, which is why they don't pay dividends in the first place.
On the other hand, there are many true growth stocks that don't pay a dividend but are excellent businesses, and therefore, excellent investments as well. I will be reviewing 10 excellent true growth non-dividend paying stocks in this article. To put it bluntly, a true growth stock will generally create a significantly higher total return than most dividend paying stocks, even if dividends are reinvested. Of course, the true growth stock has to be purchased at a reasonable valuation for this to happen. However, it is quite common that true growth stocks will be priced far above their earnings justified valuations by the market. Therefore, investors need to be careful to avoid the hype and focus on true value instead.
This leads me to a few words about another myth relating to growth stocks. Many investors believe that high-growth stocks simultaneously carry high PEs, and again, higher risk. This particular myth does have some truth based on the fact that companies that are growing at rates that are much faster than the market, are logically worth more than the average company due to the power of compounding. This is why I believe that the PE equal to the growth rate formula for valuing growth stocks (companies with above 15% earnings growth) is an appropriate gauge for fair value.
Consequently, a P/E ratio that is equal to the company's earnings growth rate would indicate fair value, even though it may be higher than the market multiple. This higher valuation is due to the fact that companies that are growing earnings at rates that are multiples of the rates that the general market is growing at will generate significantly more future earnings than the average company, again, thanks to the power of compounding. Therefore, in the long run, wise investors who are investing in these high-growth stocks are often buying future earnings much cheaper than the future earnings of average companies with lower entry-level PEs.
This article will review 10 established above-average growing businesses that I believe are also fairly valued today, or very close to becoming fairly valued, if there were any correction in the market at all. None of these stocks pay dividends, however, they all have achieved significantly above-average historical growth, and most importantly, they are all expected to produce significantly above-average future growth, at least over the next five years. Consequently, investors interested in earning above-average long-term returns might want to dig deeper into these selections.
10 Fairly Valued High-Growth Stocks
In order to make my top 10 list of high-growth stocks, each candidate had to meet several logical criteria. First and foremost, I searched for companies with historical earnings growth rates that were exceeding 15% to 20% per annum. In addition to the velocity of the company's earnings growth, I also looked for a high degree of consistency, and the ability to continue growing regardless of the economic environment, including during recessions. I was willing to accept some minor weakness during recessionary times, but not complete earnings collapses.
The following portfolio review lists my top 10 fairly valued growth stocks listed in alphabetical order. Although each of these selections appears to be an attractive long-term investment capable of generating above-average returns, a few of these examples are fully valued to moderately overvalued currently. On the other hand, based on the possibility that current estimates may also be conservative, I included them in my top 10 list. In other words, I would either be looking for a minor pullback or for their high earnings growth to exceed current estimates, and therefore, justify current valuation. More simply stated, I think these are all candidates worth looking further into.
A Detailed Look At The Top 10 Growth List By The Numbers
As usual I will rely on F.A.S.T. Graphs™, the fundamentals analyzer software tool, to provide "essential fundamentals at a glance" on each of my top 10 selections. Please keep in mind that each of these selections is offered as candidates for a more comprehensive research and due diligence process. However, I will provide brief commentary on each, based solely on what their respective F.A.S.T. Graph™ reveals. Also, as I previously stated, I have presented the beta on each selection along with their introduction (all beta figures taken from Google Finance).
AutoZone, Inc. (NYSE:AZO): Beta .32 Below-Market
AutoZone has produced a very consistent record of earnings growth averaging over 21% per annum. Nevertheless, it is also a fact revealed by the earnings and price correlated graph below, that the market has historically valued this company at a discount to its earnings growth. The reader should also note that the company carries a lot of debt, but does generate substantial cash flows to mitigate this risk.
Even though AutoZone has been historically priced at a discount to its earnings growth rate, its total annualized rate of return of 19.4% per annum closely correlates to its earnings growth. Consequently, this business, with its powerful record of consistent growth, has substantially outperformed the S&P 500.
The consensus of 22 analysts reporting to Standard & Poor's Capital IQ, expect AutoZone to grow earnings at 14.8% per annum over the next five years.
Catamaran Corp. (NASDAQ:CTRX): Beta .54 Below-Market
Remarkably, even though Catamaran Corp. has produced a powerful record of earnings growth averaging over 40% per annum, the company's beta is only .54. Catamaran Corp. did experience a drop in earnings during the great recession; however, the company did remain highly profitable. Furthermore, post recession earnings growth has been nothing short of spectacular as it accelerated to over 60% per annum growth since fiscal 2009. Nevertheless, the company's current P/E ratio at 42.3 is in alignment with their historical earnings growth.
Since going public at the end of June 2006, Catamaran shareholders have enjoyed an annualized rate of return of 52.2%, which correlates to the company's earnings growth rate enhanced by modest undervaluation existing when the company first went public.
The consensus of 22 analysts reporting to Standard & Poor's Capital IQ forecast Catamaran to grow earnings at 25% per annum over the next five years. Consequently, even though the company is reasonably priced based on its historical earnings growth, it would appear to be moderately overvalued based on expected future growth. However, due to the power of compounding, the 25% per annum future growth rate would still offer prospective investors a strong annualized rate of return.
On the other hand, over the shorter run, there is the risk of a temporary price drop. Even if that were to occur, if you apply a growth rate multiple of 25 to the consensus $1.86 for fiscal 2013 earnings per share, you would get a fair value of $46.50. This is only moderately below the company's current quotation. My point being that fair valuation can be more generously thought of when dealing with very fast-growing companies.
Cognizant Tech (NASDAQ:CTSH): Beta 1.12 Moderately Above-Market Neutral
Cognizant Technology Solutions has one of the most consistent long-term records of earnings growth of any company you would ever find. Moreover, the company has no debt and appears to be significantly undervalued based on its long-term historical record of earnings growth.
Thanks to operating earnings growth exceeding 38% per annum, long-term shareholders in Cognizant have been rewarded with an annualized rate of return of 31.5%. It's important to recognize that this long-term rate of return has little or nothing to do with either the return of the stock market during this time, nor the economic growth of the United States and/or the rest of the world. Perhaps this is a clue as to why Warren Buffett and others encourage us to ignore political and economic forecasts.
Since the F.A.S.T. Graphs™ research tool is a dynamic tool, I thought it would be revealing to look at Cognizant since calendar year 2008 (the great recession). Earnings growth, although still significantly above-average, has slowed to just over 22% per annum. This explains why the company appears so undervalued when looked at on the earnings and price correlated graph going back to 1999. Based on more recent history, Cognizant still appears to be undervalued, but nowhere near as much as it does on the longer-term graph.
To further illustrate, and perhaps more greatly appreciate the power of earnings growth, shareholder returns since the beginning of calendar year 2008 for Cognizant have still been superior to the overall market.
The consensus of 13 analysts reporting to Standard & Poor's Capital IQ forecast Cognizant to grow earnings at 18% per annum. Although I consider this forecast to be conservative, it nevertheless justifies today's current valuation.
Express Scripts Holding Co. (NASDAQ:ESRX): Beta 1.05 Market Neutral
Express Scripts Holding Co., among other things, is a pharmacy benefit management company, with a long record of above-average earnings growth exceeding 30% per annum. The drop in earnings for fiscal 2012 is attributed to a one-time $.67 nonrecurring charge. Excluding the one-time charge, operating earnings growth would have been approximately 12%. Also, operating cash flow was very strong in fiscal 2012.
Express Scripts Holdings Co. represents another example of a company with powerful growth that produced returns for shareholders that far exceeded either economic growth and/or the returns on the average stock as represented by the S&P 500. In other words, the level of the stock market has had little to nothing to do with investing in Express Scripts Holding Company.
The consensus of 23 analysts reporting to Standard & Poor's Capital IQ forecast Express Scripts' five-year earnings growth rate at 15% per annum. However, based on their historical record and the powerful demographics underpinning their core businesses, I believe these estimates could prove to be very conservative. However, if they were proven to be true, then this company would be moderately overvalued today. On the other hand, thanks to the power of compounding long-term potential returns could still be substantial. Once again, it may prove beneficial to be somewhat liberal with valuation on a company with significantly above-average prospects for growth.
Fossil Inc. (NASDAQ:FOSL): Beta 1.81 High
Fossil Inc has generated a very strong long-term record of earnings growth averaging 18.9% per annum. However, due to the nature of their business, an occasional cyclicality with their earnings does manifest. On the other hand, there are some very interesting lessons in valuation that I believe this company's price history reflects. You can see a strong negative reaction during the great recession which caused the price to drop significantly below its earnings justified valuation (the orange line). However, we also see how it quickly recovered.
But perhaps the most interesting aspects of their price history are the large spikes of overvaluation that occurred in 2011 and 2012. In both cases, price quickly reverted back to earnings justified levels, providing clear evidence of market inefficiency on both occasions.
However, in spite of some pretty scary bouts of price volatility, long-term shareholders in Fossil Inc were rewarded in almost perfect correlation with the company's long-term record of earnings growth. Another piece of evidence that earnings determine market price in the long run.
The consensus estimates of 14 analysts reporting to Standard & Poor's Capital IQ expect more of the same for Fossil Inc with a five-year estimated earnings growth rate estimated at 17.5% per annum. This number is consistent with the company's historical results, and justifies today's current valuation, if proven to be true.
Hibbett Sports Inc. (NASDAQ:HIBB): Beta 1.06 Market Neutral
Hibbett Sports Inc represents a quintessential example of a long-term earnings and price relationship. Monthly closing stock prices (the black line on the graph), have clearly tracked the company's earnings growth over time. During the few cases where the price disconnected either above or below the earnings justified valuation (the orange line), it quickly moves back into alignment.
Once again, we see that operating earnings growth and shareholder returns are highly correlated. But as we've also seen with our other examples, there is very little correlation between Hibbett Sports Inc shareholder returns relative to the overall market returns, as represented by the S&P 500, over the same time frame.
The consensus of 13 analysts reporting to Standard & Poor's Capital IQ forecast Hibbett Sports to grow at 16% per annum. Consequently, the stock appears to be moderately overpriced on that basis. However, due to the high rate of expected growth, Hibbett Sports would still be a good investment at these levels. On the other hand, it might be prudent to wait for a better entry level.
Laboratory CP of America (NYSE:LH): Beta .62 Low
Laboratory Corp of America is currently trading at a below-market PE ratio, yet it possesses above-market historical earnings growth averaging over 19% per annum. However, if I were to present a six-year graph as I did with CTSH above, LH would appear fairly valued.
In spite of Laboratory Corp.'s current low valuation, long-term shareholders were richly rewarded with a total annual return of 25.9% versus 3.1% for the S&P 500. Once again, we see the power of above-average earnings growth generating significantly above-average returns.
Laboratory Corp. of America is the only example in this group with forecast earnings growth below 15% per annum (AZO is forecast at 14.8% rounded to 15%). However, I do believe that these estimates could be conservative.
LKQ Corp (NASDAQ:LKQ): Beta .86 Neutral to Low
LKQ Corp represents a quintessential example of what I look for in a growth stock. Notice how earnings continued to advance prior to, during and after the great recession. Also, notice how over the long-term stock price has tracked the company's long-term earnings record.
As a result of LKQ Corp.'s consistent and strong record of earnings growth, long-term shareholders were rewarded orders of magnitude better than shareholders in a passive index fund would have been. This is a classic example of how a powerful, fast-growing, non-dividend paying stock will greatly outperform even the best dividend growth stock and the general market at large.
The consensus of 12 analysts reporting to Standard & Poor's Capital IQ forecast LKQ to grow earnings at 20% per annum over the next five years. Consequently, the shares appear moderately overvalued based on current forecasts. However, considering their impeccable long-term record, the consensus forecast may prove conservative.
Middleby Corp. (NASDAQ:MIDD): Beta 1.64 High
Middleby Corp. has produced a solid record of historical earnings growth averaging over 31% per annum since 1999. Although the company did have a modest hiccup during the great recession, earnings recovery since has been back on its normal track.
Long-term shareholders in Middleby Corp. were rewarded with an annualized rate of return that highly correlated to the company's long-term record of earnings growth. Once again we see an example of a fast-growing business rewarding shareholders far in excess of economic growth or stock market averages.
The consensus of 7 analysts reporting to Standard & Poor's Capital IQ forecast Middleby to grow earnings in excess of 19% over the next five years. Consequently, Middleby shares appear within the fair value corridor defined by the five orange lines on the graph.
Priceline.com (NASDAQ:PCLN) Beta 1.28 Moderately High
The long-term earrings and price correlated graph on Priceline provides an interesting insight into the dangers of investing too early in a hyped IPO. As you should see from the monthly closing stock price line (the black line on the graph) Priceline's price spiked initially after their IPO release before collapsing over the next year and a half back to its earnings justified level. This further validates my belief in waiting nine months to a year or more before investing in a hot IPO no matter how much I believe in the company's long-term future.
Here is a classic example of how overpaying for even the best of companies can destroy potential returns. Even though Priceline grew earnings in excess of 63% per annum, the massive overvaluation during the initial IPO reduced returns to mere average numbers.
This next graph reviews Priceline after its initial overvalaution moved into better alignment with the company's operating potential. The operating earnings growth rate on this company remained the same as we saw with the 15-year graph, however, as we will soon see, the effect of better valuation on long-term returns is extraordinary.
By simply waiting for Priceline shares to move into better alignment with the company's earnings potential, long-term shareholder returns went from average to extraordinary. However, it should also be interesting to note that Priceline did not generate any real earnings until 2002. Consequently, even in calendar years 2001 and 2002, Priceline was actually overvalued, however, due to the incredible power of compounding, long-term shareholders would have achieved an annualized return of 44.8% per annum.
The consensus of 28 analysts reporting to Standard & Poor's Capital IQ forecast Priceline to grow earnings at 20% per annum over the next five years. Consequently, Priceline appears reasonably valued at today's levels.
Summary and Conclusions
When reviewing very fast-growing companies, the rules of fair valuation still apply. However, due to the power of compounding, very fast-growing businesses will generate significantly higher levels of future earnings than slower-growth businesses. As a consequence, investors can actually pay slightly more than earnings justify for a very fast-growing company and still generate an attractive long-term rate of return. The reason this is important, is because it is difficult to find very fast-growing companies that can be bought at the strictest definitions of fair value.
It should also be pointed out that as companies get bigger; their earnings growth rates are likely to slow down a bit. Therefore, the reader should have noticed that most forecasts for this group of stocks were lower than the company's historical achievements. Future purchases should be based with a greater emphasis placed on the future than on the past. However, I believe a lot of credit should be given to a company with a long history of above-average earnings growth. Therefore, I believe there is room for high-quality fast-growing companies to be included in portfolios designed to fund retirement during the accumulation phase.
Nevertheless, there are limits to how much overvaluation a prudent prospective investor should be willing to take. Of the 10 sample companies reviewed in this article, 3 or 4 of them could be, under the strictest definitions of fair value, considered moderately overvalued. However, none of the samples in this article are what I would consider dangerously overvalued. However, this does present a dilemma of sorts. Do you take the risk of waiting for a better valuation to manifest, only to be left out of the upside? Or do you go ahead and purchase them now, with a commitment to buy more if the price does happen to fall short term?
I believe these are questions that only each individual investor can answer for themselves. On the other hand, I believe that very fast growth is a rare and precious attribute, and therefore, worthy of some moderate overvaluation. But again, there are limits. In the next and final part three of this series on growth stocks, I will present examples where I believe dangerous overvaluation is manifest. In honor of my Mother, after all, last Sunday was Mother's Day, I always try to honor her rule of not saying anything if I can't say something nice. However, since I am so adamantly averse to overvaluation, I feel it is my responsibility to provide insight into its dangers to my readers.
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.