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5 great, cheap growth stocks and a tool to find more
Finding undervalued gems in this rangebound market is a chore. Here are some names to get you started -- and my Ultimate Valuation Tool to guide your own work.
By Jim Jubak
Sprinkled through this range-bound and frustratingly directionless market are a handful of great growth stocks selling for prices that I think qualify as cheap.
In this column, Im going to name five. And Ill explain how to use my Ultimate Valuation Tool to find more great growth stocks at cheap prices for yourself.
But I should caution you that this tool works only for growth stocks (and not for cyclical or value stocks) and only for investors interested in buying and selling on fundamental value. It isnt meant to replace technical analysis, and it isnt useful for short-term trading.
Step 1: Calculate fair value or target price
My Ultimate Valuation Tool uses the current extreme volatility in earnings projections to separate truly cheap growth from growth thats too expensive because future earnings for that stock are too uncertain. Let me show you how it works using Cisco Systems (CSCO, news, msgs) as an example.
Start with your favorite earnings-based method for calculating either fair value or target price. Im going to use fair value since online calculators for figuring it are readily available and because the method easily incorporates uncertainty in your final target price.
Using the fair value calculator at zRoundTable.com, for example, I plug in my best estimates for Cisco Systems earnings growth rates for three periods: one to three years (15.7%), four to six years (10%) and seven to 10 years (8%). Dont worry about uncertainty yet. Just come up with the best estimates you can. For this example, I started with the current Wall Street consensus estimate for earnings growth over the next five years and then marked it down for future years when Ciscos size and already-hefty market share make growth likely to slow. (You can find the Wall Street consensus earnings-growth rate by getting a quote for a stock on MSN Money then clicking on Earnings Estimates on the left side of the page and then Earnings Growth Rates.)
Next, estimate a market rate of return for the next 10 years to use as the discount rate. I happen to be what Sam Stovall, the chief investment strategist at Standard & Poors, calls a single-digit bull": Stocks will go up, but annual returns are likely to be 8%, not the 10% or better theyve returned over the long haul.
Then, set your own hurdle rate: Given what you know about the risk of investing in Cisco, what kind of potential return would you like to see before you take that risk? For me, I set my Cisco hurdle at 20%. (Its important to set the hurdle rate for an individual stock now, before you complete the fair-value calculation, so that you arent tempted to fit the hurdle to the fair value in order to confirm your pre-existing prejudices toward buy or sell.)
Finally, put in todays price and the trailing 12-month (that is the already reported) earnings per share and hit the calculate button.
As of Sept. 28, that produced what I call an Original Fair Value of $23.07 and a projected return of 27.7%.
Cisco doesnt measure up
Step 2: Compare that projected return to your hurdle rate. If it is lower than the hurdle, the stock doesnt pass even this simple test. You may want to trade it on its technical chart, but you dont want to buy it on its earnings and growth fundamentals. If it is higher than the hurdle, move onto Step 3.
Step 3: Compare the stock youre analyzing, Cisco Systems in this case, to a benchmark stock youve picked for its rock-solid earnings predictability in the past and, to the best of your judgment, for the next 10 years. My current benchmark stock, for example, is PepsiCo (PEP, news, msgs) because the combination of soft drinks and salted snacks gives it a strong growth path.
And Wall Street reflects that predictability in its earnings estimates. The most optimistic and the most pessimistic of the 14 Wall Street analysts that have issued earnings projections for 2005 differ by just 5.6%. The high estimate for 2005 is $2.64 and the low estimate $2.50.
Step 4. Establish an uncertainty factor: Divide the percentage difference between the high and low estimates for the stock (Cisco) by the percentage difference between the high and low estimates for your benchmark stock. Multiply that number (The Uncertainty Factor) by the original discount rate. So, the high earnings estimate for Cisco Systems is $1.06 for the fiscal year that ends in July 2006. The low estimate is 94 cents. The spread is 12.8%. Thats 2.3 times the 5.6% spread for my benchmark PepsiCo. I multiply the original discount rate by that 2.3 to get a new discount rate of 18.2% for Cisco Systems.
Step 5: Recalculate fair value using the new discount rate and compare it to your original hurdle rate for this investment. Leave all your original estimates of earnings growth alone and change only the discount rate. Plugging that 18.2% discount rate into the fair-value calculator at zRoundTable.com produces a fair value for Cisco Systems of $11.24. If you were to buy Cisco Systems at the Sept. 28 price of $18.07, you would be paying almost 61% more than the stocks current fair value.
How to spot opportunity
The Excel spreadsheet Ive attached here is customized for this analysis, but you can learn a lot about Cisco or any other stock by looking at how changes in key variables alter the fair-value calculations. For example, if everything else remained the same, but the low Wall Street estimate moved up to 98 cents from 94 cents, that would lower the Cisco uncertainty factor to 1.5 from 2.3 and lower the discount rate to 11.7%. Fair value climbs to $17.49. Cisco still isnt a buy, but its much closer to break-even.
My Ultimate Valuation Tool, like other systems, says that when the gap between high and low estimates closes, its often a buy signal. For example, right now Sysco (SYY, news, msgs) doesnt make my cheap-great-growth-stock cut because theres just too much uncertainty surrounding its earnings growth over the next year, thanks to recent margin pressure cutting into earnings. But if the gap between high and low estimates starts to close because the most pessimistic analysts raise their estimates by even four cents a share, then Sysco starts to look like a buy according to the Ultimate Valuation Tool. The small change thats needed in the low analyst estimate to make Sysco a buy marks this stock as one to watch.
The Ultimate Valuation Tool also helps explain the current market lethargy. Uncertainty has an incredible power to depress stock returns, as calculating fair value in this way shows. Cisco isnt a compelling investment because of the degree of uncertainty about its growth rate, even in the near term. An end to the current period of extreme earnings uncertainty would push up the fair value of Cisco and all other stocks that are currently laboring under the weight of earnings uncertainty.
5 to watch
Now for my five cheap great growth stocks.- American International Group (AIG, news, msgs) shares have fallen 12% since April on news that the U.S. Department of Justice is investigating one of the companys subsidiaries. None of the news has any real effect on the companys growth prospects. It certainly hasnt shaken Wall Streets confidence, because the difference between high and low estimates is about as tight as it is at PepsiCo. All the bad news has done is drive down the price until AIG trades at an 80% discount to fair value, according to my calculations.
- Cuno (CUNO, news, msgs) makes the list because it combines very solid growth (15%, 13% and 10%, respectively) with very high certainty. The high and low analysts differ by just 1.8%, even less than in the case of PepsiCo. I dont think you should lower the discount rate below 8%, or whatever your projection for average annual return on equities might be over the next decade. But even with that discount rate, Cuno is trading at a 38% discount to fair market value. (Five analysts follow Cuno. I think thats the lowest number that will work in this system.)
- L-3 Communications Holdings (LLL, news, msgs) succeeds where other technology stocks fail because, while it may be growing at half the rate of the high-tech rockets, its defense and security business give its earnings growth a predictability that the average technology stock cant match. The difference between high and low Wall Street estimates for the company is just about 8% at a time when Broadcom (BRCM, news, msgs) is showing a 63% high/low difference and Intel (INTC, news, msgs), a 51% difference.
- Middleby (MIDD, news, msgs) looks like a copy of CUNO: very solid growth of 15%, 12%, and 8%, plus a high degree of certainty among the five analysts that follow the stock. They differ by just 6.6%. The Wall Street consensus projections of growth are likely to be low on this one since Middleby has racked up 47% growth annually over the last five years. Id call that icing on the cake. Middleby current trades at a 51% discount to fair value.
- PepsiCo. Dont forget the stock that started this all. Right now, PepsiCo is trading at a 33% discount to its fair market value.
Dont get carried away by the size of the discounts to fair value that Ive listed for these five stocks. Theres no law that says the market must recognize fair value on a particular schedule or even at all.
Finding the right discount rate
The disconnect between the fair value of stocks like these and their current market price, in my opinion, is a reflection of investors continued belief in annual stock-market returns above 10%.
I used a discount rate of 8% because I believe thats a reasonable estimate of likely equity returns over the next decade. If you set the discount rate higher, paradoxically, that lowers the fair value for stocks like these. In other words, if stock returns are12% annually over the next decade, then steady, predictable growers -- the great growth stocks that Ive listed above -- wont seem as valuable to investors as they will if stocks are struggling and double-digit earnings growth is harder to come by.
Most investors, whatever they say, are still expecting returns above 10% -- if they pick the right stocks. If, or when, those expectations come down, stocks like the five Ive recommended here will move toward the fair values Ive calculated. Thats not likely to happen overnight or even in a year. But if the stock market works the way I think it will over the next few years, those discounts to fair value will gradually shrink.
These five stocks are bets that were looking at a decent, but not spectacular, stock market in the years ahead.
New developments on past columns
What I would pay for Google
Ive got to take my hat off to Wall Street analysts: Theyre so brazenly shameless about Google (GOOG, news, msgs) that its almost entertaining. Or it would be if real money wasnt at stake. Remember how Wall Street talked down Googles initial public offering price? Management was immature. The search market was maturing. Orders for the stock from institutions were soft. Comments like that, repeated over and over again, forced Google (and its investment bankers) to cut the price of the IPO. After initially announcing a range of $108 to $135, Google finally went public in auction at $85 a share. So now that Wall Street and its clients own the shares they bought at $85, what do they think Google is worth? Heath Terry, an analyst at Credit Suisse First Boston, recently set his target price at $145. Mary Meeker, the lead Internet analyst at Morgan Stanley, values the stock at $132. Morgan Stanley and Credit Suisse First Boston were the lead underwriters in Googles IPO.
Get ahead in this range-bound market
I guess nobody really believed those analysts estimates for Micron Technology (MU, news, msgs). After the market closed on Sept. 29, the company reported earnings of 14 cents a share for the quarter that closed on Sept. 2. Wall Street analysts had been expecting 21 cents a share. Revenue also came in a little light at $1.19 billion, up 34% from the same quarter in 2003, but below the $1.23 Wall Street was looking for. So did the stock crash after this 33% earnings miss? Did it plunge? Tumble? Stumble? Flop? No way. At noon the day after the bad news, shares were down just 14 cents or about 1.2%. After weeks of bad news and warnings from chip makers from Texas to Taiwan, everybody expected that Micron Technology wouldnt meet the official Wall Street projections. I think this reaction, or lack of it, to this bad news is a truly positive development for the technology sector. When stocks stop falling on bad news, it means investors have become about as pessimistic as theyre going to get. And thats usually the sign of a long- or short-term bottom for a sector.
Editor's Note: A new Jubaks Journal is posted every Tuesday and Friday.
E-mail Jim Jubak at jjmail@microsoft.com.
At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: Micron Technology, American International Group, Middleby and PepsiCo. He does not own short positions in any stock mentioned in this column.
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