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Many investors run in fear from high PE stocks. The initial gut reaction is that they are too highly priced with shares trading at lofty earnings multiples.

Some try to compare the PE with the future growth prospects (PEG) to see if growth expectations and price to earnings are similar. Still, when looking at the international market, growth stocks underperform as borne out by the Fama and French 3 Factor Model. (Oddly enough, if you believe in an efficient market, then the lower global returns on growth stocks would actually indicate that they are lower risk investments.)

If you like potentially high growth stocks (determined by their forward P/E ratios) with higher rewards (and higher risk if you follow the efficient market theory), then follow this little nugget by Wan-Ting Wu who wrote the paper, "The Forward P/E Ratio and Earnings Growth" (2007).

Finding the Link Between High Forward P/E and Earnings Growth
Here is what the paper reveals: high forward P/E ratios do not correlate strongly to high subsequent earnings growth. However, when current earnings growth is negative, the high P/E ratio was correlated to future earnings growth.

Lets break this down.

  • Forward P/E ratios are when you estimate annual earnings and divide this into the current price. It lets you compare today's price to a future earnings estimate. If the forward P/E is low, this may imply a bargain or some major risk factor. A high forward P/E usually is indicative of a growth stock. A high current price in relation to low earnings expectations would naturally seem like a high risk venture. Perhaps the stock is ready to bring on the earnings growth despite what analysts are forecasting. But as Wan-Ting Wu discovered, this isn't the case … at least not in the following five years. High forward P/E stocks in general didn't deliver the goods.
  • But, if you find a stock that has a high forward P/E ratio, which may indicate a glamour stock, and is currently experiencing negative earnings growth, then you may rightly anticipate high future earnings growth. This was the gem of the paper.

Why is this so? I speculate that one reason may be:

The stock is currently in negative growth territory. You'd expect the price to be much lower in relation to the forward P/E. However, informed investors may be propping the stock up while uninformed investors have fled. This may be one of the few tip-offs that the stock is looking at future growth contrary to analyst estimates. There are many other reasons why this may also be true.

27 Unusual Growth Stocks

Company

Ticker

AboveNet, Inc.

ABVT

AeroCentury Corp.

ACY

Alleghany Corporation

Y

Cincinnati Financial Corporation

CINF

Cyberonics, Inc.

CYBX

Diamond Foods, Inc.

DMND

DynaVox, Inc.

DVOX

Endurance Specialty Holdings

ENH

EOG Resources, Inc.

EOG

Equinix, Inc.

EQIX

Everest Re Group, Ltd.

RE

Greenhill & Co., Inc.

GHL

IBERIABANK Corporation

IBKC

Mead Johnson Nutrition CO

MJN

MicroStrategy Incorporated

MSTR

Monsanto Company

MON

Morningstar, Inc.

MORN

NRG Energy, Inc.

NRG

Peet's Coffee & Tea, Inc.

PEET

Powell Industries, Inc.

POWL

Questar Corporation

STR

RenaissanceRe Holdings Ltd.

RNR

Silicon Laboratories

SLAB

Stericycle, Inc.

SRCL

Transatlantic Holdings, Inc.

TRH

United States Cellular Corpora

USM

White Mountains Insurance Group

WTM

*A few stocks were excluded from the list due to being already reported on in the article called "7 Very Uncommon Growth Stocks."

Actionable Entry Points

1. GHL is making a new 52 week low. It has broken through support of $60, with the next support range around $52.50. The dividends currently exceed earnings, which can negatively erode share value. The earnings are expected to climb back up quite high over the next couple of years. Time will tell and I'm nervous about the short-term price action on this one.

2. If you like to trade high-momentum stocks, those that have greatly outperformed last year, then take note of the following stocks: CYBX, MSTR, DMND, ABVT, MJN, and SRCL. The momentum anomaly that is backed by much empirical data is that stocks which outperformed the market during the trailing 12 months will continue to ‘beat the market' over the succeeding 12 months. Stocks down over the past 12 months are SLAB, GHL, DVOX, and ACY.

3. Low debt can allow a stock to position a stock very well to make excess gain. One report noted that smaller stocks (in the S&P 500 test sample) with low debt ratios actually made market excess gains of 80% over three years. You can read about the strategy here in the Seeking Alpha article, "Does Debt Financing Affect Future Stock Price Performance?" Stocks on the above list with very low "debt to equity" or low "long-term debt to equity" are the following: PEET, CYBX, MSTR, POWL, ABVT, MORN, and SLAB.

4. If you want to follow the French Fama 3 Factor Model, you will want to select the small value stocks in the bunch. Small value stocks internationally outperform large and growth stocks, thus if we pick tiny market caps and low price to book ratios we might see a larger upside reward at the cost of higher risk. These stocks fit the small value profile: ACY, DVOX, IBKC, POWL, and ENH. Be wary of stocks that consistently disappoint in the earnings department such as POWL. They have announced earnings over the last 3 quarters with large negative earnings surprises.

5. Keep a close eye on earnings announcements coming up: USM on May 6th, DVOX and ACY on May 11th, as well as DMND on May 27th. PEET recently beat the street while MSTR disappointed.

Wrap Up
While there are many other actionable entry points, these are a few to get you on your way if you like growth stocks with higher odds of future earnings growth. This is a very broad filter, so you should dig into each stock if you are thinking of investing in it based on the "high forward P/E - negative earnings growth" approach.

I have also found stocks trading at very high multiples with negative earnings growth with absolutely nothing propping it up. Perhaps in these cases it is a growth stock in decline mode where investors have not reacted quickly enough to a negative outlook.

The point is this: start with a broad filter such as this and then do your homework ... there are always unworthy stocks that slip into every scan.

Source: Anticipating Earnings Growth With 27 High Forward P/E Stocks