I have a confession to make: I have an awfully hard time
buying growth stocks.
Every investor has a preferred style, and I seem to be
hardwired for value. Give me a low P/E, a fat margin of
safety, a great management team working in an ignored corner
of the market, a little bit of dust and grime ... that's what
makes me happy.
Anything else ... well, let's just say that the story had
better be
reallygood.
But while working on another article, I ran across some
data that reminded me of something important:
Sometimes, stocks with high price-to-earnings ratios can
still be bargains.
Screen for value
andgrowth potential
I use a variety of different screens when I'm looking
for stock ideas, but one of my favorites looks for a low P/E
ratio, low debt, and a high return on equity, a
quick-and-dirty rough indication of management effectiveness.
It's a rough approximation of famed hedge fund manager Joel
Greenblatt's "Magic Formula" for turning up value stocks. I
like it because it works well with the screener on
Motley Fool CAPS, which lets me fold in screens for
high CAPS ratingsand the like.
That screen is a great way to turn up value ideas. But
it's not a good way to turn up value-priced
growthideas, and that is often where the market's
biggest opportunitieslie. For that, I recently turned to
a useful screening tool I learned from fellow Fool Rich
Smith, The "price-to-free-cash-flow-to-growth" ratio is a
variation of the PEG ratio popularized by legendary
Fidelity manager Peter Lynch.
You can check out Rich's fuller explanation of
price-to-free-cash-flow-to-growth here, but in a
nutshell: Free cash flow is a quick indicator of a company's
profitability and financial health. Dividing the stock price
by free cash flow, and then dividing
thatby analysts' consensus estimate of future
growth, gives us a way to screen for companies that are (a)
cheap, (b) healthy and profitable, and (c) expected to grow
significantly in future years.
Wouldn't you like to own a few of those?
I sure would. But my usual screens miss a lot of those, as
you can see from the chart below. I generally look for a P/E
under 15 and a return on equity over 20% or so, and none of
these companies qualify. Most aren't even close.
But using Rich's metric -- he looks for a
price-to-free-cash-flow-to-growth ratio of 1 or less,
although I did include one stock that was a tiny bit over --
these all look like strong possibilities:
Stock
CAPS Rating
P/E Ratio
Long-Term Debt/Equity
Return on Equity
Price / Free Cash Flow
P/FCF / Growth*
Comtech Telecommunications (Nasdaq:
CMTL)
****
18.6
0.32
7.9%
12.13
0.44
Nuance Communications (Nasdaq:
NUAN)
****
333.8
0.48
0.2%
15.56
0.89
China Life Insurance (NYSE: LFC)
***
42.3
0
10.6%
8.62
0.34
Perfect World (Nasdaq: PWRD)
***
27.0
0
38.3% Continued... |