With the stock market in nonstop rally mode over the past five years, an investor doesn't need to look far to uncover an overabundance of growth stocks. Unfortunately, not all growth stocks are created equal. While some could still lead investors to extraordinary gains, others appear considerably overvalued and could wind up burdening investors with hefty losses.
What exactly is a growth stock? Though arbitrary, I'm going to define a growth stock as any company forecasted to grow profits by 10% per year or more over the next five years. For the context of "cheap" I'll be using the PEG ratio, which examines the relative cheapness of a company's growth price-to-earnings ratio compared to its future growth rate. Any figure around or below one would constitute a cheap stock.
Here are three companies that fit the bill.
1. Phillips 66 (NYSE:PSX)
It's been a rough year for practically all energy stocks, but it's been exceptionally tough on oil drillers, midstream storage and transporters of oil, and oil refiners.
Phillips 66, for instance, has shed a quarter of its value ($12 billion) in just three months. There is some degree of logic to the drop as the refining sector could eventually see producers delivering less oil since crude prices are no longer as advantageous. But, I suspect many investors are overlooking the surprising benefits that lower oil prices could potentially bring Phillips 66.
For starters, rapidly falling oil prices historically tend to widen crack spreads, or the margin that refiners net from choosing whether to produce refined crude or break it down into other petroleum components. The environment we're in now is conducive to sizable refining profit growth which is good news for Phillips 66 since it nets nearly 30% of its revenue from its refining business.
Yet other segments will also benefit from falling oil prices, including the company's petrochemicals business and its marketing and specialties segment. Lower oil prices mean lower input costs for these divisions. Sure, it could mean slower revenue growth, but higher margins should lead to sizable profit growth.
Also, don't discount the possibility that low oil prices could lead to a demand surge. Remember, it's been five years since we've seen oil at these levels and consumers, businesses, and global governments may jump at the opportunity to increase petroleum product usage. Consumers may choose to take a road trip now, while cheaper oil prices could reduce transport and heating costs for many businesses worldwide. Further, we may even see oil producers boost production just to maintain some stability in cash flow which could be even better news for refiners like Phillips 66.
With a projected five-year growth rate of 14%, a 3% dividend yield, and a single digit P/E, I suspect growth seekers could certainly do a whole lot worse than Phillips 66.
2. United Rentals (NYSE:URI)
If there's been one standout in the rental service industry since the Great Recession, arguably United Rentals would take the cake. As its name would imply, the company owns and leases heavy-duty equipment primarily to construction and industrial companies within North America.
I believe United Rentals found itself in the right industry at the right time following the Great Recession. With credit lending standards tightened and businesses afraid to spend their cash on hand, turning to leasing, a considerably cheaper option upfront, made a lot of sense. As the construction industry has largely rebounded United Rentals and its shareholders have basked in the benefits.
In the company's third-quarter earnings report it delivered a 130 basis point increase in return on invested capital to 8.4%, a 70 basis point improvement in its time utilization to 71.5%, and a whopping 15.6% increase in rental revenue. More importantly, it reaffirmed its full-year outlook which includes a 4.5% increase in full-year rental rates. What this shows investors is that United Rental has strong pricing power since businesses simply don't want to go out and buy this equipment for themselves.
It's worth taking into consideration future lending rates as well. With the Federal Reserve's economic stimulus now over it's possible that we could start witnessing lending rates rise beginning in 2015. Higher lending rates may further discourage businesses from financing equipment purchases and give United Rentals even better pricing power than it has now.
Looking ahead, United Rentals is on pace to double its EPS between 2013 and 2016 and is currently trading at just 10 times Wall Street's 2016 EPS forecast. Considering the dynamics and pricing of construction equipment, United Rentals appears to be a smart and cheap growth stock that investors should consider.
3. Lannett (NYSE:LCI)
It's pretty amazing that Lannett can still be considered cheap considering that its shares gained more than 500% in 2013, but it speaks to the amazing growth potential for generic drugs over the long term.
Within the United States the cost of prescription drugs are on the rise for a myriad of reasons. Some of these include higher research and development costs, legal expenses, and marketing costs, but it's also reflected in the fact that insurers tend to accept high innovator drug costs and the United States is hands-down the biggest consumer of pharmaceutical products. One way regulators are trying to keep costs down is by encouraging the development of generic drugs.
A generic drug developer like Lannett sells its drugs for just a fraction of the cost (10%-20%) of the brand-name drug that they're replacing. The result is it leads to smaller margins for generic producers than innovator companies.
However, what these companies lack in margin they more than make up for in volume. Generics are taking on an increased role in our nation's pharmacies, and consumers are opting for them in greater numbers since they're cheaper and their effectiveness is on par with brand-name drugs. As baby boomers retire in greater numbers, and the Affordable Care Act pushes the rate of uninsured even lower making it easier for people to see their doctor, it's possible Lannett's top and bottom lines could surge.
The company's latest quarterly report headlined this "surge" potential with a doubling in year-over-year revenue to $93.4 million and a boosted full-year gross margin forecast.
Boasting a PEG ratio of just 0.7, a forward P/E of 13, and $151 million in net cash, seemingly everything is going Lannett's way at the moment. It's a cheap growth stock investors will want to dig more deeply into.
Sean Williams has no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen name TMFUltraLong, track every pick he makes under the screen name TrackUltraLong, and check him out on Twitter, where he goes by the handle @TMFUltraLong.
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