In part one of this series we introduced the notion that in all markets whether bear or bull, there will always exist individual stocks that are fairly valued, overvalued or undervalued. In this same vein we argued that it’s a market of stocks, not a stock market.

For those who missed it, here’s a link to part one. To put this into context, we are simply suggesting that the discerning investor can always find bargains if they are willing to look and do their homework.

[ad#Google Adsense 336×280-IA]However, we should also add that bargains can come from many different types of equities.

Therefore, this and the following articles in this series will look at bargains that can be found within various equity classes.

In this part two, we will look for bargains in high-growth stocks.

Although this may be the riskiest equity asset class of all, it is also the most profitable, as long as sound and prudent investing principles are adhered to.

High Growth Stocks Defined

One of my favorite quips is about Tennessee Ernie Ford leading his church’s choir when he allegedly said: “everyone turn to page 26 and sing along with me, but if you don’t have page 26 then sing page 13 twice, because we all need to be on the same page.” Therefore, as it relates to this article, in order for us all to be on the same page, we need to share a common definition of growth stocks, before a fair and impartial analysis can be conducted.

Consequently, for purposes of this article, we define growth stocks as follows: In order to be considered a growth stock, the company must have a history of growing their earnings in excess of 15% per annum, while simultaneously possessing a forecast expected future growth rate of at least 15% or better. For companies that possess these levels of past and future growth, we will utilize a PEG (PE equals growth rate) formula to calculate fair value. The valuation theory being applied states that companies possessing these significantly above-average growth rates deserve a premium valuation over slower growing peers.

The premium valuation concept presented above represents one aspect of why growth stocks, under our definition, possess higher risk than blue chips. First of all, achieving these high levels of growth are not only rare, but also extremely difficult to accomplish. Consequently, it is a challenge for companies to maintain high rates of growth, and this challenge is amplified the bigger the company gets. Therefore, we offer this very important caveat. Regarding growth stocks, it is even more imperative to focus on future growth over historical growth, than it is for any other equity class.

There is a second factor related to the above caution and that is the importance of valuation. Typically, Mr. Market will ask the prospective investor to pay a higher valuation (PE ratio) to buy a growth stock than most other equity categories. Having to pay a higher valuation for above-average growth is usually not only necessary, but also rational to a point. In fact, due to the high rates of potential growth, coupled with the power of compounding, means that above-average rates of return can be achieved with growth stocks, even if you pay a little more to buy one than you should. In other words, the compounding power of rapid earnings growth can bail you out from an aggressive purchase over time.

On the other hand, one of the most common mistakes investors make with high-growth stocks is overpaying for them. This usually occurs because of the hype that often leads to hysteria which tweaks the greed response. Companies with extremely high rates of growth can for a time attract significant investor interest leading to incredible short-term momentum. Consequently, a rapidly rising stock price can excite investor greed to the point of irrational behavior. One place where this psychological response is often seen is with hot IPOs. Later in this article we will present a vivid example of how dangerous this can be.

High Growth Stocks in the S&P 500

This series of articles is oriented to dealing with the wide diversity of equity classes that make up the S&P 500. Therefore, we are only going to concern ourselves with high-growth stocks that are constituents of the S&P 500. Of course, this also means that there are many very high-growth stocks that will be excluded from this discussion. Consequently, what follows is by no means presented as a comprehensive list of high-growth stocks.

Moreover, and most importantly, the following tables comprised of high-growth stocks in the S&P 500 also had to meet the hurdle of reasonable valuation. As a result, there were several S&P 500 growth stocks that did not make the cut. In other words, the following tables look at S&P 500 high-growth stocks that appear to be at or near fair value based on expected future rates of growth. S&P 500 growth stocks that we believe are overvalued were not included.

We have listed 17 S&P 500 high-growth stocks that met our criteria and we have organized them based on capitalization and earnings growth rate. Interestingly, all of the S&P 500 high-growth stocks that made our list are large-cap companies. Our first table reports on seven companies with earnings growth rates exceeding 20% per annum (The reader should note that both the 15-year historical EPS growth rate and the estimated 5-year EPS growth rate are both in excess of 20% in table 1). Our second table covers 10 additional S&P 500 growth stocks with historical and estimated growth rates in excess of 15% per annum.

Both of the following tables provide a summary of important fundamental measurements. The first two columns list historical earnings growth, followed by forecast EPS growth rates. The next two columns are focused on valuation by showing the historical normal PE followed by the current market PE. Then we provide debt levels and sector, followed by annualized historical performance, and finally, an estimate of future potential compounded annual rates of return. (It is important to note that the reader should understand that any companies on the list with poor historical returns (highlighted in red) can be assumed attributed to beginning overvaluation).

Analyzing S&P 500 High-growth Stocks Through the Lens of F.A.S.T. Graphs™

Next we’re going to evaluate several examples from our list of S&P 500 high-growth stocks in value, utilizing the F.A.S.T. Graphs™ fundamentals analyzer software tool. This exercise will serve the dual purpose of allowing us to analyze the fundamental value of each company and to illustrate and elaborate on several of the points previously presented in this article. Furthermore, although we believe that the following analysis provides a comprehensive evaluation of the fundamentals underpinning each of these examples, additional due diligence is recommended.

Cognizant Technology Solutions (CTSH)

Cognizant Technology Solutions is a leading provider of custom information technology, consulting and business process outsourcing services. The following earnings and price correlated graph on this quality company depicts a quintessential example of a true growth stock. Not only has earnings growth averaged 38% per annum, the consistency of the growth has also been extraordinary. This rate of growth is very rare, as few companies are capable of growing this consistently fast.

Furthermore, notice how stock price (the black line on the graph) has closely tracked earnings (the orange line on the graph) up through calendar year 2007, but has since deviated (see red circle). This long-term picture of the earnings and price relationship clearly alerts us that something has changed since 2008. The first reaction of course would be that the great recession of 2008 made an impact. However, upon further review we discover that the recession did impact stock price for sure, but we also see that earnings growth continued to advance nicely, thereby suggesting that this company was clearly recession resistant.

On the other hand, a glance at the bottom of the graph (see yellow highlights) shows that the earnings growth rate, although continuing to be strongly above average, had slowed down. However, thanks to the dynamic nature of the F.A.S.T. Graphs™ research tool, we can run a graph since 2008 (the recession), and analyze this inflection in earnings growth and the impact it had on price and valuation. However, before we do, let’s take a look at performance since calendar year 1999 in order to illustrate just how powerful a return generator that a high-growth stock can be.

When we calculate the performance that Cognizant Technologies has produced for its shareholders since calendar year 1999, we see a stunning example of the incredible power of compounding, and the incredible economic benefit it can provide. A simple $1000 investment in Cognizant’s stock on December 31, 1998, and held till now would have turned a $1000 initial investment into over $54,000 today. Comparing this more than 33% per annum compounded rate of return from this S&P 500 constituent to the S&P 500 itself, clearly illustrates just how powerful the return that this growth stock has produced.

A quick glance back at the historical earnings and price correlated graphic above shows that the company was reasonably priced with a PE ratio of just under 40, or only slightly above its 38% per annum earnings growth rate on December 31, 1998. Remember, the formula used to value high growth stocks is the PEG (PE equals growth rate) formula. Consequently, even though the company appears undervalued during the later years based on its historical growth which averaged 38% per annum, the compounded rate of return it provided shareholders is highly correlated to its long-term earnings growth.

Next, and as promised, let’s use the dynamic feature of F.A.S.T. Graphs™ and look at Cognizant Technologies since the beginning of calendar year 2008 (the great recession). Here we discover that our research tool has recalculated the company’s earnings growth rate and simultaneously provides a more recent iteration of fair valuation. Since calendar year 2008, Cognizant’s earnings growth rate has fallen from averaging 38% per annum to averaging 22% per annum.

Nevertheless, although this is still significantly above-average earnings growth, it does imply a valuation adjustment. Consequently, by applying the PEG ratio valuation because earnings growth is over 15%, we see that the market has been rationally valuing the company at its adjusted growth rate since 2008. Therefore, although it is useful to see how powerful this growth stock has been since 1999, it is also both imperative and useful to evaluate it based on its more recent history. This explains why the price was not tracking its long-term earnings growth rate during the latter years on the long-term earnings and price correlated graphic above.

When we review the performance of Cognizant since calendar year 2008, and consider that it was moderately overvalued with a PE ratio above 25 relative to an earnings growth rate of 22%, we continue to see evidence of the strong returns that a high growth stock can provide. Furthermore, this also illustrates that you can moderately overpay for a high-growth stock, and still generate a significant long-term rate of return.

Astute investors who purchased Cognizant on December 31, 2007, would have more than doubled their money, averaging approximately a 15.7% per annum return. When you compare this to investing in the S&P 500 Index, the value of owning a high-growth stock bought at a reasonable valuation is vividly revealed. Remember, that even though Cognizant was moderately overvalued, the power of compounding earnings growth during and through the great recession, allowed the company to provide its shareholders very attractive and highly above-average returns.

When we turn our attention to the future, we discover that expectations are high that Cognizant Technologies can continue to grow earnings at a very high rate of growth. The consensus of 21 analysts expect the company to continue growing at approximately 20% per annum, and therefore, the current PE ratio of 21 would imply that the company is reasonably priced based on its expected high future growth. However, the reader should remember the caveats mentioned above regarding the difficulty of achieving such a high rate of growth. Here the concept of risk versus reward comes into play.

Priceline.Com Inc. (PCLN)

The long-term graphic on Priceline.com provides a lot of lessons on investing in general, but most importantly, on investing in growth stocks specifically. Additionally, the importance of investing at sensible valuations is clearly articulated. Furthermore, we can use this example to reflect on lessons to be learned when investing in IPOs, as promised earlier in this article.

Priceline.com went public on April Fools’ Day 1999; however, investing in its initial public offering was no joking matter. From the graph below we can see that for the first month after its IPO, Priceline.com’s stock price almost doubled in value. However, for the next 20 months or so following its price peaking, the stock fell from a high of over $974 per share to a low of $6.38 per share. Furthermore, it should be pointed out that there were no earnings being generated by the company at this time to support its high price.

When you calculate Priceline.com’s performance since its IPO to current time, we discover how devastating overvaluation can be to long-term performance. Even though the company eventually began earning money (its first earnings occurred in 2002), and even though its long-term rate of earnings growth has been extraordinary, long-term shareholder performance has been rather anemic. This week performance is attributed solely to its stock price being irrationally priced by the market at its IPO. With no earnings to buoy the stock price, a fundamental collapse was inevitable.

One of the valuable attributes of the F.A.S.T. Graphs™ research tool is the ability to go back in time and focus on historical periods in order to learn from the past. The following graphic looks at Priceline over the historical timeframe 1999 to 2003. This time period covers the company from its IPO to its first years of generating a profit. From this perspective, the collapse in stock price following the first three years or so after its IPO are easily understood and justified. In other words, hype and hysteria eventually gave out to sound fundamental value.

When you measure the company’s price performance from its IPO in 1999 to year-end 2003, we see just how devastating overvaluation can be. A $1000 investment in Priceline at its IPO would have generated a compounded 50% per annum loss on its shareholders behalf, thereby turning the original $1000 investment into a mere $35.98.

The moral of this story is to not invest in IPOs no matter how enticing (think Facebook) unless the company’s initial earnings support the stock price. Since the company is going to trade for a long time, the patient investor would more often than not find a more attractive and rational entry point than they typically find at the IPO. With our next look at Priceline we will show how profitable this kind of patience can be.

Next, let’s take a look at Priceline after they became a profitable business in 2003. Here we find that earnings growth has averaged over 60% per annum, and has been extremely consistent since calendar year 2005. There are two additional things to take notice of. Number one, Mr. Market has historically priced Priceline at a premium PE in excess of 30, however, this valuation is only half its actual earnings growth rate (the blue line = normal PE). Second, we see that the company has achieved this remarkable growth without needing to take on any long-term debt.

In contrast to investing in Priceline at its IPO, let’s take a quick look at Priceline and the returns they generated for shareholders after they became a profitable enterprise in calendar year 2003. The same $1000 investment on December 31, 2002 would have grown to $64,803, which translates into an exceptional compounded annual rate of return of almost 54% per annum. Furthermore, notice how this extraordinary record was achieved by shareholders without receiving even one penny in dividends.

As a final statement on Priceline, we must remember that as investors we can only buy the future and not the past. Consequently, based on the fact that the consensus of 24 analysts reporting to Capital IQ expects the company to continue growing at 20% per annum, indicates that the company may be fairly priced today. However, this also means that future expectations for profit, although appearing quite attractive, will not come close to their historical average.

F5 Networks Inc. (FFIV)

Our final example looks at F5 Networks Inc., a leading provider of application delivery networking technology. There are several lessons regarding investing in growth stocks that we believe this fast-growing technology enabler can teach us. First of all, we see another example of the extraordinary benefit provided from investing into a company with a powerful earnings record. Additionally, this company also teaches us a thing or two about valuation, and finally provides lessons on intelligently dealing with volatility.

From the earnings and price correlated graphic below we see that F5 Networks has generated earnings growth averaging 29.8% since calendar year 2005. Furthermore, we can clearly see that the company’s stock price, although generally tracking earnings, has experienced extreme bouts of high volatility on more than one occasion.

But even more importantly, we see the importance of trusting fundamentals over stock price movement, because every time stock price deviated from fair value over or under, inevitably it returns to fair value. We believe this validates our thesis that price volatility will only hurt you when you overreact to it while simultaneously refusing to acknowledge intrinsic value based on fundamentals. We believe there are two performance measurements for every stock. The first is price volatility, which can’t be trusted, and the second is fundamental value, which in truth matters most. Unfortunately, most investors ignore fundamental value as they are fixated on fickle price.

When you look at the performance that this high growth company has generated for shareholders, we once again see a high correlation between return and earnings growth, adjusted for valuation. In other words, it is only because the company is currently trading at a discount to its historical earnings justified valuation that has caused its 20.8% compounded annual return to be less than its 29.8% earnings growth achievement.

Summary and Conclusions

Our primary objective with this series of articles is to illustrate the truth that there is a lot of value in this market. With this part 2, we focused on high-growth stocks that were constituents of the S&P 500 that are currently trading at fair value based on their earnings potential. Although many of the stocks on our master list of 17 are currently trading at above-market PE ratios, we think the valuations are justified based on the earnings power of these extraordinary growers. This teaches us a lesson that valuation is a relative concept. In other words, a company with an extraordinary potential for growth is worth more than a company with a lower potential for growth.

The companies that we have featured in this article appear to be attractive high-growth candidates for the aggressive investor seeking maximum capital appreciation. However, this statement is based on a combination of the company’s historical operating history, coupled with consensus estimates for future growth.

Furthermore, because these numbers are significantly higher than average, the notion of greater risk should be kept firmly in mind. On the other hand, the old adages that no risk, no return, also come into play.

The bottom line is that although we feel this is an excellent list of S&P 500 constituents with high growth potential, additional due diligence is highly recommended.

— Chuck Carnevale

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Source: FAST Graphs

Disclosure: Long AAPL, V, GOOG, MA & NOV at the time of writing.