Seven Growth Stocks Chosen to Let You Sleep at Night: a YCharts Series
Investing in popular growth companies is always tricky business, but lately, it’s been downright heartbreaking. Green Mountain Coffee Roasters (GMCR), which tripled its share price in the first part of 2011, lost most of those gains in the months since. Netflix (NFLX) went from $225 a share to about $63 in the past year, and once brag-worthy MAKO Surgical (MAKO) fell from $39 to $17 in a matter of weeks. Oh sure, Whole Foods Market (WFM) continued to march upward, but a couple of investments in those doomed social media IPOs like Facebook (FB) or Groupon (GRPN) could make one quickly forget about that nice story.
For investors who want in on the growth game but prefer less melodrama in their portfolios, YCharts suggests creating another genre: sane growth. In our estimation, a sane growth portfolio would be packed with companies that manage decent sales gains but maintain a few safety valves typically missing in popular growth stocks: like reasonable share price valuations and earnings commensurate with revenues. In fact, right now looks like an especially good time to invest in sanity over popularity.
Picking a winner among popular growth stocks is particularly difficult now. Joblessness and underwater mortgages in the U.S.; an economic slowdown in China; and a currency crisis in Europe – all those issues make sustaining high growth a tall order for any company. It also makes accurately valuing high growth companies quite iffy, as anyone involved in those overpriced social media IPOs can attest. But none of these difficulties has made growth stocks much cheaper. Overall, share valuations remain relatively high.
Now, as always, companies experiencing high revenue growth trade at far higher valuations than the rest of the market. Those losers above fell for a wide variety of reasons, but they all had one thing in common before their crises: high share valuations. The social media IPOs of recent years managed price to sales ratios at times well into double digits. Others were trading between 3 and 20 times sales before their big falls. By contrast, Apple’s (AAPL) price to sales ratio has never, ever, been above about 6.5.
Valuations like that, particularly when paired with high price-earnings valuations, predict what one would happily call insane growth. The price is justified and investors get quite rich if revenue and earnings actually grow as fast as expected. LinkedIn (LNKD), for example, trades for an incredible 15 times sales. Today’s share price will look like a bargain if the company really increases sales more than that amount because the share price should run up too. If there’s any sign that the company can’t achieve that goal – perhaps a missed earnings report – punishment will be brutal. Disappointing expectations of insane growth almost always results in big share price drops.
Companies practicing sane growth, on the other hand, usually get a little more leeway for errors. That’s because their growth is backed by rising earnings, cash and solid fundamentals. Demanding these backstops actually hurts growth rates – you can ramp up sales a lot faster if you don’t insist on making profits on them – and that tends to keep their share price valuations reasonable. But you might be surprised at how many companies manage double-digit revenue growth with sanity.
With the mission of reducing risk, YCharts looked around for growing companies with sane data. We set the YCharts Stock Screener to find companies that reported sales growth of at least 10% over the past 12 months and at least that rate of retained earnings growth. We insisted on an historic price to sales ratio of less than 1.5. To weed out companies with weak balance sheets, we looked only at companies that received at 7 or higher from YCharts Pro for fundamentals. As an added safety, we considered only companies with market caps of at least $2.5 billion.
Of course, no screen can take the risk out of investing. But it can decrease the chances that an investment will turn into a Green Mountain disaster without warning. Here and in following articles is a sample of what we found:
Redbox operator Coinstar should be out of business by now, since DVDs were supposed to have gone the way of 8-track tapes long ago. Instead, the company holds a monopoly-level market share in a business that remains stronger than anyone predicted.
Redbox machines dole out DVD and video game rentals for coins in thousands of stores ranging from gas stations to pharmacies. Business has been good as video stores died and budget conscious consumers ditched their monthly Netflix DVD subscriptions in favor of $1.20 a day Redbox rentals. Coinstar has bought up competitors in the kiosk business. Coinstar’s revenues grew some 34% in the past 12 months, and its profits have soared.
Shareholders have had a grand ride too, as the share price has more than doubled in five years. In the first six months of 2012 alone, the price was up more than 50%, as seen in this stock chart.
The inevitable death of the DVD keeps valuations on Coinstar shares much lower than they would normally be on a company with such fast growth. With a market cap of about $2.1 billion, Coinstar’s price to sales ratio hovers around one, and its PE ratio is about 10 after a recent decline in the stock.
Investors are betting that the company will invest in some other low-cost kiosk technology when the DVD run is done. Coinstar already operates some 20,000 coin-counting kiosks that take money for turning coins into bills. It signed an agreement with Starbucks (SBUX) in June to build thousands of coffee dispensing kiosks.
Six more articles on growth stocks will be published in coming days.