Undiscovered, undervalued growth stocks can be Wall Street’s biggest winners. These are the kind of stocks that have everything an individual investor could hope for. Growth stocks should increase in value as earnings grow. Undervalued stocks should have low risk since the stock’s valuation is low. Undiscovered stocks are too small for the large funds to buy. Large funds need the company to grow so that it can be a meaningful part of its portfolio. When they discover the stocks, they push the price up benefiting small investors who were able to trade ahead of the funds. Let’s look at each of these characteristics in a little more detail.
Growth stocks are companies that are growing earnings rapidly. As earnings grow, the stock price should grow as well. Let’s consider a hypothetical company trading at $10 a share with earnings per share (EPS) of $1 and expected EPS growth of 25% a year. The price-to-earnings (P/E) ratio for this stock is 10. Next year, when EPS are $1.25, the stock would be worth $12.50 if the P/E ratio stays at 10. The year after that, with EPS of $1.56 and a P/E ratio of 10 the stock would be worth $1.56.
Valuation can be measured in a number of ways. The P/E ratio is a popular valuation tool but we need a way to determine when the P/E ratio is undervalued. The PEG ratio provides a way to do that. The PEG ratio compares the P/E ratio to the EPS growth rate. A stock is considered fairly valued when the PEG ratio is less than 1. This tool recognizes that a fast-growing tech stock should have a higher P/E ratio than a slow-growth consumer staples company that pays a high dividend.
There are thousands of mutual funds, hedge funds, pension funds and other investors looking for growth and value. The problem is most of these funds are large with billions of dollars of assets under management. If you are managing $5 billion, you can’t usually look at smaller companies that trade less than 500,000 shares a day. To make a meaningful contribution to your performance, you need to buy a large number of shares and if you do that in low-volume stocks, you will move the price against yourself. When you’re buying 1 million shares, you will push the price up. When it’s time to sell, your million share order will push the price down. This increases trading costs and lowers profits.
As individual investors, we don’t face this problem. We can buy small companies because any profit is meaningful to us. We can control our trading costs by using limit orders to enter and exit trades, since our orders won’t be market moving. This gives us an advantage compared to the big funds – we can buy stocks they haven’t discovered yet.
To identify undiscovered, undervalued growth stocks, we looked for small cap stocks with low trading volume (indicating they were undiscovered); low PEG ratios indicating they were undervalued; and fast growth with expected EPS growth of 25% or more this year and next. Just to be extra safe, we also required each company to have enough assets on its balance sheet to meet its short-term obligations. We did this by requiring companies to have a current ratio greater than 1.
Just three stocks met our requirements.
Golden Entertainment, Inc., (Nasdaq: GDEN) is a gaming company focused on distributed gaming and casino and resort operations. Distributed gaming involves installing and operating gaming devices that are similar to slot machines in certain non-casino locations, such as grocery stores, convenience stores, restaurants, bars and liquor stores primarily in the greater Las Vegas metropolitan area. Its gaming brands include PT’s, Sierra Gold and Sean Patrick’s. The company also operates the Rocky Gap Casino Resort in Flintstone, Maryland, and three casinos in Pahrump, Nevada, including the Pahrump Nugget Hotel Casino, Gold Town Casino and Lakeside Casino & RV Park.
Revenue has grown steadily from $26 million in the fiscal year that ended in 2010 to $255 million in the past twelve months, an average growth rate of more than 30% a year. EPS have grown about 12% a year over that time. One analyst follows the firm and expects growth to average about 15% in the future after rapid gains in earnings this year and next. To be conservative, we will use the lower growth rate to value the stock with the PEG ratio. Based on expected EPS of $1.26 next year, GDEN is worth $18.90 a share according to the PEG ratio, about 50% higher than the current price.
The long-term price chart shows $18.90 is a realistic target. GDEN traded higher than that in 2007.
Action to take: GDEN is a buy with a 3 to 6-month price target of $15.09 based on the chart pattern and a long-term target of $18.90 based on the fundamentals. Short-term support at $9.16 provides a stop level.
Hudson Technologies, Inc. (Nasdaq: HDSN) is a refrigerant services company. The company sells reclaimed and new refrigerants to customers and provides refrigerant management services which include laboratory testing to ensure everything is operating correctly. HDSN also provides decontamination and recovery services that are performed at a customer’s site using a proprietary system.
The fundamentals are similar to GDEN’s with rapid sales growth and now approaching a sustainable earnings growth rate. HDSN’s sales have increased an average of 13.3% a year, from $24.2 million in 2010 to $85.8 million in the past twelve months. Two analysts have published long-term estimates of EPS growth. One targets 20% growth and the other believes 25% growth is attainable. Using the midpoint of 22.5% and next year’s expected EPS of $0.39, HDSN is worth about $8.75 per share, more than 150% above the current price.
The long-term chart confirms significant gains are likely.
Momentum, shown with then stochastics indicator, recently turned bullish. Previous signals have identified significant price moves. HDSN should be expected to encounter resistance near $4.64, a price that has provided resistance three times in the past. This is about 36% higher than the recent price.
Action to take: HDSN is a buy on a move above $3.50, a resistance level on the weekly chart. The short-term price target is $4.64. A stop could be placed at $3.10, an important support level on the daily chart.
Semiconductor Manufacturing International Corporation (NYSE: SMI) provides integrated circuit (IC) foundry and technology services at 0.35-micron to 28-nanometer. SMI is also engaged in the development of its own wafer manufacturing process technologies for specialty products, such as power management IC, complementary metal-oxide semiconductor (CMOS) image sensors (CIS), electrically erasable programmable read-only memory (eEEPROM), radio frequencies IC (RF) and wireless connectivity and other sensors.
Despite the cyclical nature of the semiconductor industry, SMI has grown its sales steadily with gains in six of the past seven years and an average growth rate of 7.8%. The company has increased earnings in four of the past seven years, an admirable performance given the ups and downs in the industry. Most analysts believe the industry is bottoming now and expect several years of growth. Analysts following SMI expect EPS of $0.42 next year and growth averaging 15% after that, implying a value of $6.30 for the stock, a gain of 50% from the current price.
The weekly chart shows the stock could be bottoming after an extended decline.
Action to take: SMI is a buy at $4.35 or above on confirmed strength. Consider a stop at $3.75, the 52-week low which should offer support. The short-term price target of $4.95 is about 13% above the recommended entry level. Traders should consider trailing their stop to give the stock time to deliver a large gain rather than selling at the profit target.
These three stocks are all small right now, but if they meet earnings expectations they could deliver large gains as they reach levels where Wall Street’s biggest fund managers can buy them.