The work of Wan-Ting Wu with his 2007 paper titled, "The Forward P/E Ratio and Earnings Growth," was so unusual that I wanted to devote another article to finding growth stocks based on his conclusions. (Original article with 15 other stocks here)
This paper found that, in general, forward P/E ratios are good indicators of increasing revenue over short term windows up to five years. This seems odd since the ratio is based on earnings, but it correlates strongly with revenue forecasts. When looking at large earning horizons of 5 - 10 years, he then found the forward P/E ratio to have a strong parallel relationship to earnings.
Other implications of his study were that high forward P/E stocks had a higher level of missed profits and overall less than expected earnings. Using a valuation model of Present Value of Expected Dividends, Wan-Ting Wu indicates that these high forward P/E growth stocks are overvalued (by this valuation standard).
The Exception to the Rule for Picking High Growth Stocks
The one exception he found is this: When high forward P/E stocks are experiencing periods of negative earnings, there is a very strong correlation to short-term earnings than when earnings growth is positive. The idea is that when comparing high-growth stocks with large forward P/E ratios, the ones with negative earnings growth are more fairly valued and consistent to the near term earnings expectations.
This is odd indeed to pick our high growth stocks from negative growth companies. But the high forward P/E indicates that informed investors must feel this stock has large expectations since share price is being propped up by someone despite the declining earnings growth.
Scanning for High Growth Stocks in All the Weird Places
Here is our scan setup:
- Forward P/E greater than 35.
- Share price over $2.
- Current volume over 500,000.
- Negative EPS growth for the year.
- Negative EPS growth quarter over quarter.
The Unusual List of Potentially High Earners
- RSC Holdings (NYSE:RRR)
- ATP Oil & Gas (ATPG)
- Atlas Energy (NYSE:ATLS)
- Avalon Bay Communities (NYSE:AVB)
- Biomed Realty Trust (NYSE:BMR)
- AU Optronics (NYSE:AUO)
- Equinix (NASDAQ:EQIX)
- Concur Technologies (NASDAQ:CNQR)
Details Worth Noting
- Some of these stocks obviously have a high short ratio (article on high short ratio stocks here)as hawkish traders push them down while negative earnings reports come out. ATPG has a float short 40%, EQIX a float short 15%, CNQR is over 16%.
- Insider selling is the norm except for ATPG, ATLS, and BMR, but the volume of such trading is largely negligible.
- The only stock that is listed with a buy or better recommendation as reported by Financial Visualizations is RRR. (Growth Stocks Analysts Love found here)
- AUO and BMR have the lowest price to book ratio of 0.89 and 1.03 respectively. RRR has a negative book value.
- AVB and BMR pay dividends at 3.11% and 3.73% respectively – both of which are REITs.
Although I have read the paper over and cannot see any flaws, it’s such an odd concept that I would still tread these waters carefully. Still, for some who like contrarian investing, there could be some highly profitable growth stock picks in the pile, provided you get aboard before the boat takes off.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.