With the stock market in nonstop rally mode over the past five years, an investor doesn't need to look far to uncover an abundance 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 forecasted 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. Methanex (NASDAQ:MEOH)
Since I don't give the chemical sector nearly enough attention, let's lead off this week's cheap growth stock candidates with methanol producer Methanex.
Two headwinds are currently working against Methanex and have pushed it very near a 52-week low. First, growth uncertainty in Europe and slowing growth in Asia are concerns for investors, as the company's success is largely dependent on continuing global economic growth. Falling oil prices are the other concern, as methanol is blended into gasoline. If oil prices are falling, it's possible that drillers will cut back on production, meaning fewer gallons of gasoline to be blended and refined.
While these concerns are real, they're unlikely to come to fruition anytime soon. For starters, lower oil prices have led to dramatically lower gasoline prices. The laws of supply and demand would imply that consumers will be more willing to drive, and gasoline consumption will only increase. This will make it difficult for U.S. shale producers to cut back on production meaningfully over the coming months. In other words, Methanex's contribution to energy-related applications should remain consistent.
Further, methanol pricing has actually strengthened in recent months. Since the summer of 2013, methanol futures pricing has risen by nearly 14% following an 18-month downtrend. Rising methanol prices should yield better pricing power for Methanex, and it also means the company could theoretically sell less product and still net similar profits due to higher margins.
Although Methanex is forecast to earn just $4.26 per share in 2014, its EPS is projected to nearly double to $8.09 by 2017. This equates to a forward P/E in 2017 of just six and a PEG ratio of well below one. So long as we don't have a major global recession, Methanex and its 2.2% yield could be an attractive pickup for growth investors.
2. ON Semiconductor (UNKNOWN:ONNN.DL)
If you seek the breeding ground of growth, look no further than the technology sector. ON Semiconductor makes semiconductor components for a variety of electronic systems.
The concern investors need to keep in mind with most technological-component suppliers is that the pricing curve on these products tends to drop over time as operational efficiency and product advancement improve. In sum, these products tend to be commoditized, and margin growth can be difficult unless a company remains on the leading edge of the innovative curve. Luckily, ON Semiconductor is on that leading edge.
Critical to ON Semiconductor's success is the company's recent purchase of Aptina Imaging for $400 million in cash this past summer. The move will boost ON's imaging sensor division, which is capable of growing at a much faster pace than a number of other product segments due to growing sensor demand in the automotive and smartphone industries.
ON Semiconductor is also doing what it can to attract all the right investors. In December the company's board of directors approved up to $1 billion in share buybacks to be made over the course of the next four years. It also targeted a return of 80% of its free cash flow to these buybacks, less debt repayments. Shareholder incentives such as this, as well as ON Semiconductor's focus on high-growth areas like imaging sensors, are what attracted David Einhorn's Greenlight Capital to take a position in the stock during the third quarter.
Like Methanex, On Semiconductor needs a steady economy to thrive, and the 5% GDP growth generated by the U.S. economy in the third quarter will more than suffice. With EPS expected to grow by a double-digit percentage over the intermediate term, and ON Semiconductor valued at less than 12 times forward earnings, I'd certainly be willing to classify it a cheap growth stock worth looking into.
3. Summit Midstream Partners (NYSE:SMLP)
Lastly, I'd suggest growth investors consider dipping their toes into the midstream energy infrastructure arena and taking a good look at the relatively new Summit Midstream Partners as a rapidly growing but cheap stock.
Little explanation is likely needed as to why Summit Midstream Partners is well off its highs. Energy prices and commodities have taken it on the chin since summer, so speculation has it that drillers will simply cut back on their production, meaning less need for transmission and storage of assets. Since September, Summit Midstream Partners has lost more than a third of its value.
However, I suspect this midstream company is largely misunderstood and could be an attractive growth stock worth buying right here for three particular reasons.
First, the need for energy infrastructure is only growing, even if oil prices and natural gas prices are temporarily falling. Energy infrastructure is where the bulk of capital expenditures will be spent on energy throughout the remainder of the decade, making midstream companies like Summit a necessary middleman between drillers and refiners.
Second, Summit focuses solely on natural gas. Although oil has traditionally been the higher-margin item, natural gas has exhibited far less volatility recently, which I suspect won't adversely impact its production. Furthermore, lower natural gas prices could wind up increasing demand and the desire for utilities to make the switch to cleaner-burning natural gas and away from coal. The end result should be consistent natural-gas production from drillers.
Finally, the contracts that Summit has laid out with natural gas producers are long-term in nature. In other words, Summit can expect a certain level of production to head its way on a quarterly and annual basis, making it pretty easy to plan its capital expenditures, meet its debt obligations, and pay shareholders a substantial dividend (which is currently over 6%!).
With its growth not expected to slow anytime soon, Summit Midstream Partners is a cheap growth stock primed for a rebound.