These Expensive Stocks Are Worth a Look

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 really good.

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 and growth 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 ratings and 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 growth ideas, and that is often where the market's biggest opportunities lie. 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 that by 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%

14.80

0.48

Riverbed Technology (Nasdaq: RVBD  )

***

51.0

0

9.3%

19.38

0.72

VMware (NYSE: VMW  )

****

62.8

0.19

10.7%

21.19

1.08

Validus Holdings (NYSE: VR  )

*****

15.0

0.01

6.7%

8.78

0.35

Source: Motley Fool CAPS, Finviz.com. ^Growth is a consensus estimate of earnings growth over the next five years.

Now, these are just names grabbed from some screener results. As with all screener results, think of them as a place to start your research, not as recommendations. But if I were going to start with any of those, I'd take a look at Validus Holdings, an insurance company.

Sure, Validus' return on equity is relatively low, but there could be lots of reasons for that. I like the low price-to-free-cash-flow number, the relatively low P/E, and the anticipated 25% growth in earnings per share over the next five years. And I'm also drawn to the strong positive following among CAPS players, which suggests that there's a good story there.

Still, we should obviously do a lot more research before buying. But do spend some time playing with these screens -- and if you'd like to check out some similar stock ideas all neatly researched and presented, I encourage you to take a free trial of the Motley Fool Hidden Gems service. Even if you decide not to subscribe, you get 30 days to read through, review, and act on all of the ideas -- and if nothing else, you'll learn an awful lot about finding growth opportunities on the cheap. Just click here to get started.

Fool contributor John Rosevear once spent a whole day sitting in the doorway of Peter Lynch's office (and yes, he was there -- long story). He has no position in the companies mentioned in this article. Perfect World and VMware are Motley Fool Rule Breakers recommendations. Nuance Communications is a Motley Fool Hidden Gems selection. Motley Fool Options has recommended writing puts on Perfect World. Try any of our Foolish newsletters today, free for 30 days. The Motley Fool has a disclosure policy.


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