Investing in growth stocks can be tricky. Many are expensive, with valuations sometimes based more on optimism than a realistic analysis of the business and its growth prospects. High-flying growth stocks can and do collapse, leaving massive losses for investors in their wake.
You have to be an optimist to invest in growth stocks, but too much optimism can ruin your returns. To help you out, some of our contributors have identified three growth stocks that look like good deals, priced at reasonable levels given their growth and, in one case, featuring a solid dividend. Here's why you should take a look at Facebook (NASDAQ:FB), Kulicke and Soffa Industries (NASDAQ:KLIC), and A. O. Smith Corp. (NYSE:AOS).
A small-cap growth stock
Tim Green (Kulicke and Soffa Industries): There's little question that demand for semiconductors will continue to rise. That growth may be erratic -- this is a cyclical industry, after all. But with chips showing up in an expanding number of objects, and with the increasing need for powerful processors to fuel artificial intelligence workloads, all signs point to long-term growth.
One way to bet on the semiconductor industry is to invest in companies that make the equipment necessary to manufacture chips. My favorite, and the only one I own, is Kulicke and Soffa Industries. Kulicke and Soffa specializes in equipment used to connect semiconductor components to their packaging. The company is a leader in the wire bonding market, and it also has a presence in advanced packaging equipment.
Kulicke and Soffa's growth has been inconsistent in the past, and it will likely remain that way in the future. That's just the reality in any cyclical business. The company's profits fluctuate as well, with some years vastly better than others. But Kulicke and Soffa has lost money in only one year in the past decade (in 2009), and its gross margin has remained surprisingly steady. Even during the bad times, the company has no trouble muddling through.
Unlike many growth stocks, Kulicke and Soffa doesn't have a lot of optimism baked in. If you back out the net cash on the balance sheet, the stock trades for just 6.5 times the average analyst estimate for 2018 earnings. One thing to note: Earnings can jump up and down, so the stock probably isn't quite as cheap as it seems. But it's hard to claim it's expensive.
Kulicke and Soffa isn't a clean growth story, given the cyclical nature of its business. Revenue and earnings may very well tumble temporarily if the industry goes through a downturn. But if you're searching for a growth stock trading at a reasonable price, Kulicke and Soffa deserves a look.
Look beyond the eye-catchers
Neha Chamaria (A. O. Smith): Successful investors do not shy away from owning stocks in lesser-known industries because they know boring can be beautiful. After all, there's a reason why a company like A.O. Smith,which manufactures water heaters, has seen its market capitalization soar from less than $2 billion to $10.6 billion in just 10 years.
Like a typical growth stock, A. O. Smith has been growing its earnings and cash flows at a strong pace and has consistently earned double-digit returns on equity and invested capital in recent years. That's the kind of power that boring yet essential products like water heaters can sometimes have.
That's not all: A. O. Smith is also a solid dividend growth stock, having increased its dividends for 26 consecutive years and grown it at a compound rate of 25% in the past five years, with the latest boost coming at 29% this past January.
While aftermarket is a strong growth driver for A. O. Smith in North America, countries like China and India offer real growth potential as a booming middle class drives demand from consumer durables. For perspective, the company's sales from China hit $1 billion last year and contributed a whopping 35% to its total revenue. Sales from that country have grown at a compound rate of 21% in the past decade, reflecting the massive potential.
With A. O. Smith targeting double-digit growth in sales and earnings per share for fiscal 2018, you know there's a lot of steam left in this multibagger stock.
The poster boy for growth stocks
Rich Smith (Facebook): What makes a stock a growth stock? Strong projected earnings growth, of course. But what makes a growth stock a potentially successful investment?
I'd argue it's growth at a reasonable price -- and that's why I think Facebook is worth considering.
I know the objections. Facebook has trust issues. It also costs a lot -- $176 a share, and more than $500 billion across its 2.4 billion shares outstanding. And, yes, I agree that by traditional metrics, Facebook stock does look a bit expensive. Its $17.8 billion in trailing earnings, divided into its $511 billion market capitalization, yields a P/E ratio of nearly 29, which seems pricey even for a stock pegged for 24% annual earnings growth over the next five years.
Look a little closer, though, and Facebook turns out to be a good deal cheaper than first meets the eye. Its free cash flow is $18.7 billion, while its $44 billion cash hoard lowers its ex-cash market cap (i.e., enterprise value). Result: Valued on enterprise value and free cash flow, Facebook's EV/FCF ratio is only 25 -- a pretty reasonable price for a 24% grower that's dominant in its industry.
Plus, Facebook just reported a quarter that featured 63% earnings growth, even in the face of less-than-flattering headlines. With margins marching higher and revenue continuing to roar, I think Facebook's best growth days may still be ahead of it.
Neha Chamaria has no position in any of the stocks mentioned. Rich Smith has no position in any of the stocks mentioned. Timothy Green owns shares of Kulicke & Soffa Industries. The Motley Fool owns shares of and recommends Facebook. The Motley Fool has a disclosure policy.