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October 22, 2011 - Best Growth Stocks for the Long Haul - By Zacks Investment Research
By: Bill Wilton
Buy growth stocks!
Who cares about value?
Successful investors care...that's who.
No matter how much a company is expected to grow earnings, you will lose if you overpay for the stock. Peter Lynch is living proof. He is best known for crushing the market with a concept known as GARP (Growth At a Reasonable Price). He realized that overpaying for a stock would cause 1 of 2 negative things to happen:
1) You will take on too much risk given the potential reward, which leads to underperformance.
2) Stocks priced for perfection tend to unravel quickly once the big growth rates are not going to be realized. This leads to getting slaughtered.
Okay. But how do I go about valuing these growth stocks?
My first piece of advice is stop relying on the P/E ratio...sort of. That's because it only takes into account one year's worth of earnings, and we want stocks that are going to flourish for the long haul.
The key is to find value relative to the long-term growth, which is easily accomplished with the PEG Ratio. You get there by dividing the stock's current P/E ratio by its long-term projected growth rate. The result is a ratio that allows you to compare any two stocks' relative values no matter how much they are expected to grow earnings.
For example, you have 2 stocks: Stock A has a PE of 24 and Stock B's is 15. Stock B looks like the cheaper stock to most investors.
Now what if I told you Stock A will grow at 30% per year and B will grow just 10%? That gives Stock A an attractive PEG of 0.8 while Stock B has an inflated 1.5. Long story short: be sure to use PEG to find undervalued growth stocks.
It can't be that easy. Can it?
You're right. There is much more than just the PEG ratio to consider. Once you have a stock that looks fairly valued (a PEG near 1.0), the key is to find out if the projections are feasible. One quick reference tool is the Price-to-Sales ratio (P/S).
You see, earnings can be tweaked and inflated by a creative accounting staff. However, sales are much more cut and dry. You sold it or you didn't. If there is a big discrepancy in perceived value between the PEG and the P/S, you need to dig deeper.
One great clue is the statement of cash flows. If a company isn't generating cash through its day-to-day business (operating cash flow), then the odds of them hitting those earnings targets, let alone staying in business, are pretty slim.
Additionally, you may need to dissect the profit margin, ROE and any number of other financial metrics to get the true story of an aggressive growth company.
Sounds like a lot of work.
It can be. There is no such thing as a free lunch. So, roll your sleeves up and dig in. Anyone can see how much a company's earnings are supposed to grow this year. But the great investors are willing to put in the extra effort to find stocks that have earnings and, more importantly, share prices that will surge for years to come.
You will find most of the resources needed to analyze aggressive growth stocks on free websites like Yahoo Finance and Zacks.com. However, it will still require many hours of work each month to help pick the best stocks.
So let me offer you an easier way.
Our Home Run Investor service is an exciting long-term investment approach. It narrows down the strongest Zacks Rank stocks to the few that have exceptional potential to blast through the normal one-to-three-month profit zones. These are companies that could continue to generate positive earnings surprises quarter after quarter and see massive upside to stock prices.
Bill is our Zacks aggressive growth expert. He is the editor of the highly successful Zacks Small Cap Trader and the new Home Run Investor.