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What is the first thing you would expect from a growth stock? How about earnings growth, or sales growth, or simply some form of an increase? Is it possible to find high-growth stocks when year-over-year earnings growth rates are sliding?

How to Find Uncommon Growth Stocks

To answer this question, we need to look to the forward PE ratio. In Wan-Ting Wu’s paper, The Forward P/E Ratio and Earnings Growth (2007), some odd findings were made. Most people are familiar that high forward P/E stocks generally expect higher growth overall than lower forward PE stocks. Immediately you would think high forward P/E stocks would produce superior returns. But then we have the problem of not just higher growth, but whether the stock in question is fairly priced today.

The conclusion reached was that high forward P/E stocks might be mispriced if you consider average return based on risk. The risk is high when factoring in high volatile earnings growth and a larger-than-normal percentage of losses. You get a basket of stocks, which in some cases have higher growth, and in others have higher losses. If you average them out, you are left with a fund that underperformed. Low forward P/E stocks also had their share of problems of distressed firms and missed earnings. Keep in mind: These are simply averages, as you can find stellar high forward P/E stocks as well as low forward P/E.

Forward P/E ratios correlate well with sales growth in the short-term, or long-term earnings growth of five to 10 years. So using forward P/E ratios to find short-term picks with a high reliability of strong earnings growth, on average, does not statistically provide superior or strongly correlated results.

The odd finding was that stocks with a couple of years' worth of negative earnings growth -- that counter-intuitively had high forward P/E ratios -- did deliver strongly correlated earnings growth, compared to their high forward price-to-earnings ratio.

So to lower our risk and improve our chances of finding a high-earning stock over the short-term, we will pick from:

  • Stocks with forward PE greater than 30
  • Negative diluted earnings growth over past 12 months, one-year, and two-year windows
  • 12 months EPS greater than 1
  • Share price greater than $5

(Note that this contrarian investing style is much different than the Joseph Piotroski F-Score method, which requires his profit metrics to grow between years.)

Growth Stocks That Are Not ... But Soon Will Be … Maybe

Company

Ticker

Alexion Pharmaceuticals, Inc.

ALXN

Echostar Corp.

SATS

WebMD Health Corp.

WBMD

Edwards Lifesciences Corp.

EW

Tortoise Energy Capital Corp.

TYY

Sears Holdings Corp.

SHLD

Genco Shipping & Trading Limited

GNK

*Note that Forward P/E calculated using FY 2012 expected earnings.

*TYY has a dividend yield of 5.5% and is a closed-end equity fund. If you like dividend stocks, you may want to look at these three companies with raised forecasts.

Looking Closer at Edwards Lifesciences Corp.

Let’s take a closer look at EW to see what the driver behind growth might be. Now negative growth does not necessarily mean the stock is a turkey. It is unlikely that a company is going to achieve year-over-year growth without some breathers.

Sales have grown year after year when looking back over at least seven years. If you look at annual diluted EPS from continuing operations, you might see what is happening:

  • 2007 – 0.93
  • 2008 – 1.10
  • 2009 – 1.95
  • 2010 – 1.83

So a massive spike in earnings in 2009 led to a negative earnings growth in 2010. Does that mean this stock is a dud? Hardly! The EPS for FY 2013 is expected somewhere between $3-4.80. The growth rate over the long-term is listed as 25.78% per year on Yahoo, but another source gives a wider range of 23-89%. Now the 89% must be a mistake, as I doubt any company can almost double its size year after year.

Still, this stock has some seriously high-growth potential and the year’s worth of negative growth may actually help scare away a few investors as they contemplate negative growth and a high-momentum price. If the earnings growth kept strong the entire while, perhaps the stock would be trading at even higher multiples thus adding risk, lower long-term returns, and providing support for Wan-Ting's paper.

This is a high-growth stock that had one year abnormally pop, making the next year look lack-luster. It is a great growth pick worthy of its high P/E.

Examining GNK

Other companies like Genco Shipping are another story. Analysts are unsure how this tipsy business will fare. For 2012 the estimates range from -$4.75 annual EPS to almost $3.00 to the plus. The 2013 year is even more extreme with a range of -$6.00 to $3.42 in the positive. No doubt the forward P/E is based on an average of the gamut of forecasts.

Since the price is roughly one-third of book value and revenue growth has remained strong, there is some floor below the share price despite the price falling in half over the past year.

This stock has received some upwards price forecast revisions, and if you are looking for a potentially undervalued stock, being a contrarian investor of course, there are a few reasons why GNK is worth the high forward P/E. The extreme standard deviation is giving a misleading number.

Do I like this stock as a high-growth pick? No, but you can see why the forward P/E is so high due to a ridiculous range of forecasts and the average is flat. Lack of clear forecasting is making this one trade at odd P/E ranges, but intrinsic value is making this look undervalued. This isn't some high-growth slam-dunk, but a case of a stock being beat-up and nobody is too sure where it is going.

Doing Your Due Diligence

Should you climb aboard a stock with a high forward P/E that has trailing negative earnings growth simply because it has those two criteria? No. But what you can do is use that as a starting point to seeing why investors are pricing the stock so high despite decelerating growth.

  1. Is it simply that the stock is cooling from growth to value pricing?
  2. Is there high cash or book value providing support for prices despite a drop in earnings?
  3. Is the declining earnings growth expected to turnaround two or three years later due to a new product, FDA drug, or potential big client?

Make no mistake, this is not a Buffettology scanning method. Finding uncommon growth stocks using declining numbers is a contrarian method of finding stocks that maybe -- just maybe -- were disregarded by some because of too much focus on trailing earnings growth. In other cases, like Sears Holding Corporation, it makes me wonder why the stock isn’t much, much lower already.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: 7 Very Uncommon Growth Stocks