Source: Flickr user peddhapait.
With the stock market in nearly nonstop rally mode over the past five years, investors did not need to look far to uncover an abundance of growth stocks. But not all growth stocks are created equal. While some could still deliver extraordinary gains, others appear considerably overvalued and could burden investors with hefty losses.
What exactly is a growth stock? Though it's arbitrary, I'll define a growth stock as any company forecast to grow profits by 10% per year or more over the next five years. To decide what's "cheap," I'll use the PEG ratio, which compares a company's price-to-earnings ratio to its future growth rate. Any figure around or below one could signal a potentially cheap stock.
Here are three companies that fit the bill.
1. Goodyear Tire & Rubber (GT 1.15%)
The tire business is generally perceived as being not very exciting, but Goodyear Tire & Rubber is trying to change the tune of investors by burning rubber all over Wall Street's estimates.
Source: Goodyear Tire & Rubber.
Six years ago Goodyear Tire & Rubber was a mess. Car sales in the U.S. were down by roughly 35% during the Great Recession, and to make matters worse China was at the same time targeting overseas manufacturers by installing a tariff on foreign tires in the world's largest auto market. It was the perfect storm for Goodyear.
But, my how times have changed, with the company surpassing Wall Street's consensus in eight of the past nine quarters.
In Goodyear's fourth-quarter report, released just last week, it announced $1.7 billion in operating income, a new record, and it marked the fourth straight year that Goodyear has delivered at least $1.25 billion in operating income, also a new record. While there has been an increase in new and used tire demand since the Great Recession, three primary factors have led to its big share price rebound.
Source: Goodyear Tire & Rubber.
First, Goodyear has done an exceptional job of controlling its costs. New labor contracts with its union workers, along with job cuts and lower rubber costs, have helped boost margins for Goodyear. Secondly, Goodyear has done a great job of emphasizing its higher margin premium tires. In fact, as my Foolish colleague Maxx Chatsko pointed out in November, Goodyear is expanding its manufacturing capabilities for high-end tires between 2015 and 2017 to meet the unexpectedly strong demand. Lastly, Goodyear's focus on returning capital to shareholders through share buybacks and a dividend has lifted its shares.
Moving forward, Goodyear will look to capitalize on high-end customers as well as a push into high-growth emerging markets. For investors, they're getting a company that's valued at just eight times forward earnings and which is slated to grow its bottom line by 11% per year over the next five years. In other words, I'd suggest that there's plenty of tread left on this cheap growth stock.
2. Deutsche Bank (DB -1.03%)
It's not often you'll find a foreign money center bank in the growth stock column these days, but given the amount of pessimism baked into shares of Germany's Deutsche Bank it could be a cheap growth stock worth looking into.
Source: Deutsche Bank.
Obviously, Europe has some challenging times to work through, and the majority of those challenges aren't going to disappear overnight. These include getting the EU and Greece on the same page, as well as supporting other member nations such as Spain and Portugal on their road to recovery. Because of notoriously high debt levels pervasive throughout much of the EU, growth in the region could be tepid throughout the remainder of the decade. Clearly, this has investors worried about Deutsche Bank's growth prospects and the credit quality of its current assets. Not to mention, potential litigation against the company could wind up costing it a pretty penny.
Still, there are plenty of positives for growth-oriented investors to focus on.
For starters, Deutsche Bank's investment banking division, which is known for juicy margins, performed particularly well. Deutsche was a standout in that its fixed income and trading revenue rose while a majority of its peers saw substantial declines due to market volatility. Although Wall Street may not be fond of Deutsche Bank's reliance on its investment bank operations, these results could demonstrate that perhaps investors have been wrong to assume it can't outperform its peers in this category.
Source: Deutsche Bank.
Also, the quality of Deutsche Bank's assets continues to improve. It practically cut the amount it set aside from problem loans in half from the year-ago period, and it's been able to reduce its exposure to riskier derivatives without hurting its bottom-line results.
Lastly, its valuation is reasonably cheap. Deutsche Bank is valued at just 57% of its book value and is also trading below its tangible book value, signaling just how worried investors are about Europe's growth prospects. Historically, these are attractive levels with which to pick up bank stocks that are expected to be around for the long haul. Add in a 3% dividend yield and I believe you have a long-term winner!
3. Con-way (NYSE: CNW)
Lastly, I'd suggest investors seeking out growth stocks take a long look at trucking and logistics company Con-way.
Similar to the tire and banking business, there's not a lot of glory in the freight and logistics business. Con-way isn't going to surprise Wall Street with 20% top-line growth without an acquisition because its business tends to be reliant on the overall health of the U.S. economy. But, that doesn't mean this boring business isn't paying big dividends for investors.
Source: Con-way, Facebook.
Despite a 2.3% decline in revenue for its truckload business in the fourth quarter, operating income for the segment rose by 20%. This is primarily because falling diesel fuel costs and other expenses are working in the company's favor. Best of all, the company cited a driver shortage as the primary reason that revenue fell, implying that truckload demand could improve if it simply can attract the right talent.
Con-way's two other segments also saw notable gains due to improved operating margins. The company's Menlo operations delivered a better-than-doubling in its Q4 operating income as warehouse-management service margins rose, while its freight segment saw tonnage, revenue per hundredweight, and its operating ratio all head in the right direction. All together it implies that Con-way has excellent pricing power, which is good news for investors in a growing economy.
Between 2014 and 2016 Con-way's EPS is projected to grow from $2.32 to $3.31, implying a forward P/E of less than 14 and a PEG ratio of around one. As long as the U.S. economy remains on track and oil prices remain well off their summer highs Con-way has an opportunity to really surprise investors.
