Now is a fantastic time to be a value investor, and it's an even better time to be a growth investor. Super investors such as Warren Buffett, Joel Greenblatt, and Ken Fisher did well buying growing companies for rock-bottom prices. These guys weren't just buying outrageously cheap stocks. They bought growth potential on the cheap.

But how do you find them?
My favorite method for finding cheap growth stocks is to use the PEG ratio. The PEG ratio tells you how much you are paying for the expected long-term growth. If a company has a PEG of 1, then for each point of growth you are paying one times earnings. But if growth expectations are higher than the price-to-earnings ratio, the PEG dips below 1 and you are getting more bang for your buck!

Now, the fun part
With that said, here are three cheap stocks with great growth potential. These stocks have:

  • Expected five-year growth rates above 5%.
  • P/Es below 20.
  • PEGs below 0.8.
  • Top ratings (four or five out of five stars) from our community of investors.
 

5-Year Growth Rate

2010 Expected P/E

PEG Ratio

CAPS Rating (out of 5)

A-Power Energy Generation Systems (Nasdaq: APWR)

20%

8.2

0.40

****

China Security & Surveillance Technology (NYSE: CSR)

18%

5.3

0.30

*****

Chimera Investment (NYSE: CIM)

8%

5.1

0.65

****

Each of these companies is dirt cheap, below 10 times expected 2010 earnings. We'll take a look at each in detail.

A-Power Energy Generation Systems
A-Power manufactures distributed power generation systems, allowing companies and buildings to produce their own power and lessen their reliance on the grid. If countries ever start giving renewable energy the same level of subsidies that they give fossil fuels, this company will take off. Even without 10 times the current level of subsidies, A-Power will do well. The company recently entered into a strategic partnership with Baoding Huide, a Chinese manufacturer of wind turbines. The partnership will allow A-Power to use its strong brands to capitalize on the production and technology of Baoding Huide. At eight times earnings, A-Power is definitely worth further research.

China Security & Surveillance Technology
As you should expect, China Security & Surveillance is a China-based provider of electronic surveillance systems. China Security is trading for just shy of five times this year's earnings. Another positive is that insiders own roughly 20% of the company's stock.

So why so cheap? Wall Street hates companies with lumpy earnings, and CSR is as lumpy as it gets. This is partly because the security systems market is so small, and competition has been increasing from major players such as General Electric (NYSE: GE) and Honeywell International (NYSE: HON). Another reason is that the company has little recurring revenue (it relies heavily on government contracts), so it must go out and find new customers constantly. At this cheap price, though, some analysts are turning bullish on the company.

Chimera Investment
Chimera is a real estate investment trust that was spun off Annaly Capital (NYSE: NLY); it invests in distressed mortgages. Chinera has an absurdly high dividend yield of 17.8%, enough to make anyone skeptical of it. If government lending rates stay low and the mortgage market doesn't take another huge blow, then Annaly is a sure winner. On CAPS, buzzworthy1 gave his insider view of the mortgage industry and how Chimera fits into it:

Having worked in the mortgage industry for 7 years, I know a thing or two about mortgages and how they are valued. I can tell you that non-agency RMBS is currently out of favor, and [Chimera] is able to take advantage of this and purchase these assets at a deep discount. Since Agency MBS is guaranteed by Fannie, Freddie, FHA, and the treasury via taxpayers, these assets are typically traded at or close to par. [Chimera's] managers (top management selected by Annaly, another well run Mortgage REIT that actually invests in Agency MBS), [Chimera] is able to buy adjustable rate mortgages significantly below par giving them instant capital gains. I worked a couple of hedge funds in the past restructuring these deals if needed and to get rid of these assets [Chimera] can easily write down balances on negative equity mortgages and assist the homeowner in refinancing and having the loan "bought out" by another lender. Granted, mortgages are garbage right now, but [Chimera] can pick top quality credit tiers in the securities they purchase. If RMBS were to take another hit, [Chimera] could suffer significant losses via writedowns but not losses like they sustained in 2008 since they have deleveraged since then. Every investment is not without risk, which is exactly why if you buy [Chimera], you should have a stoploss. Since [Chimera] profits from the positive spread or carry between short term and longterm rates, the next couple of years should be handsomely profitable for [Chimera]. [Chimera] borrows on the short end of the yield curve and lends out at higher rates with average coupons of ~6%. Given the massive issuances of US Treasuries and the Fed's heavily bloated balance sheet, mathematically rates on the long-end of the yield curve are bound to rise sooner than later. [Chimera] is benefitting from the Fed's extended low interest rate policy.

Finding value
So are these beaten-down growers worth a look, or are their growth prospects illusory? Join our Motley Fool CAPS community to get more analysis on the above ideas, create your own list of undervalued growers, or even weigh in with your own expert opinion. Best of all, it's absolutely free. If only the same were true with investing.

Dan Dzombak enjoys Modern Warfare 2 too much, but he does not own any of the stocks in this article. The Motley Fool disclosure policy thinks of itself as undervalued.