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. But 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 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 be using the PEG ratio, which compares a company's price-to-earnings ratio to its future growth rate. Any figure around or below one signals a cheap stock.
Here are three companies that fit the bill.
1. Archer Daniels Midland (NYSE:ADM)
One the simplest and smartest ways to seek companies with strong growth prospects is to look for business tied to basic-needs goods and services. Archer Daniels Midland fits that bill perfectly, as it's involved in the food processing business, and the demand for food around the globe is only set to increase.
On the flip side, ADM's processing services are necessary to feed a growing population. As my Foolish colleague Maxx Chatsko noted in August, one of ADM's primary advantages is its heavy investment in synthetic biology, which could, as he puts it, "move food production out of the field and into much more efficient platforms."
ADM also isn't afraid to spend on new innovations or to purchase growth, as it did with its $3 billion WILD Flavors acquisition, which should improve its reach in Europe and bolster its working relationship with smaller businesses. ADM also recently announced a deal to sell off its chocolate business, signaling to investors its intention to focus on its core businesses of corn processing, soybean processing, and agricultural services.
Given ADM's expected 2013-2017 EPS growth rate of nearly 15% and its valuation of only 15 times forward earnings, this appears to be a cheap growth stock that long-term investors should have on their radars.
2. Tata Motors (NYSE:TTM)
Want another easy way to find cheap growth stocks? Try focusing on companies that are positioned to succeed in emerging markets like India.
India's Tata Motors is a great example of an automaker poised to succeed, as it sells compact and inexpensive vehicles for first-time buyers, as well as Jaguars and Land Rovers for upper-income individuals, who are often unfazed by global economic fluctuations.
On the high-end side of the business, the company's Range Rover Sport continues to sell extremely well, and it just may propel Tata's 2015 North American Land Rover/Range Rover units sold beyond 20,000. For context, there were only 11,300 units sold in North America in 2009, so the brand has come a long way in a short amount of time.
The F-Type remains Jaguar's main attraction, although total units sold will probably dip to around 16,500 in North America from around 18,200 last year, when the new F-type was introduced. However, this is still a nice improvement from the 12,800 units sold in 2009 and could signal that interest in the Jaguar brand is slowly improving.
Tata Motors' stand-alone auto business struggled a bit in its latest quarter, showing unit sale declines of nearly 16%, which it blames on high lending rates and "constrained financing" in India. However, I'd suggest this hiccup is nothing more than temporary: India's middle class is thriving, and the country expected to undertake a multidecade infrastructure boom.
According to a 2011 report from Booz & Company, India is projected to surpass the U.S. auto market by the mid-2030s. The report also notes that it won't be just a quantitative increase in auto sales that will drive this growth, but a qualitative one as well, signaling that residents of India are growing their wealth and buying more expensive and high-margin vehicles.
With a forward P/E of less than nine and PEG ratio well below one, Tata Motors is a cheap growth stock investors should be closely monitoring.
3. Tesoro (NYSE:ANDV)
While most oil-related stocks have taken it on the chin in a big way in 2015, refiners like Tesoro have welcomed oil's plunge, at least temporarily, with open arms.
The 50% drop in crude oil prices since the summer has set into motion a number of positives for Tesoro. For starters, it has widened the crack spread, or the margin refiners receive from taking crude products and "cracking" them into refined products like gasoline and heating oil. When oil prices are rapidly falling, crack spreads are usually widening, meaning better margins for Tesoro.
Also consider that lower prices for gas and heating oil mean consumers have more disposable income. This could have the effect of encouraging consumers to use their cars more and turn their thermostat up just a little bit, ultimately improving the demand for refined products. Drillers may want to cut back on production, but it's possible that consumer demand may simply not let them.
Investors shouldn't discount the role that Tesoro Logistics (NYSE:ANDX) could play for Tesoro as well. Tesoro owns a 35% stake in Tesoro Logistics, which allows Tesoro to benefit from Tesoro Logistics' long-term partnerships and the need for transmission, storage, and shipping terminal needs for crude, natural gas, and natural-gas liquids. Middlemen like Tesoro Logistics should remain healthfully profitable even with crude at $55, adding an extra bonus for Tesoro shareholders.
This cheap growth stock could have plenty of room left to run even higher, with its EPS expected to more than triple between 2013 and 2017.