Mark Perkins sends: Growth. The market loves it and sometimes it makes value investors like myself nervous. It’s not hard to find these high growth stocks in the market - they sell for high multiples because investors are willing to pay for that growth and then some, and seemingly gain never-ending momentum. Just because they are “expensive” doesn’t make them bad investments though.
Sometimes you can buy a stock with high valuations and strong growth and make a great investment. Google (GOOG) and Stryker (SYK) are two such companies. Google has been dominating the internet since its IPO while maintaining growth in excess of 50% a year - though that is finally slowing somewhat. Even while the stock has traded around 50x earnings, shares are up 500% since going public. Stryker, a medical products and orthopedics manufacturer, has sported an average PE ratio over 30x for the past 5 years while the stock has more than doubled over that time. The company has been successful in its business, which is increasingly benefited from an aging U.S. population.

Paying multiples higher than the companies growth prospects can set up a situation for failure, however. Great performance is often “baked in” to a stock with rich valuations. One slip up in quarterly earnings or some fluke bad news and the stock tanks as people realize it never was worth that much to begin with.
Starbucks (see all on SBUX), as I examined last week, has seen its price fall as growth prospects deteriorated. While the market hasn’t been kind to Starbucks of late, it isn’t entirely unforgiving: it has just been announced that Howard Schultz will be coming in as CEO replacing Jim Donald, and the stock has risen 9%. If Starbucks is to succeed it must re-invigorate its brand, which has done so much for it over the years, and find a way to compete in a fast growing industry. It is hard to compete when your coffee quality is constantly being challenged, so perhaps now is a good time for rival coffee chains like Caribou Coffee (CBOU) and Peete’s (PEET) to increase their marketing and brand recognition in order to make a serious run at challenging Starbucks.

In the hunt for the best growth stocks it is good to find ones that sell for low multiples relative to expected growth. Price to earnings growth ratios (PEG) can give a thumbnail valuation on discounted growth. Famous portfolio manager Peter Lynch (Cullen notes: a Boston College guy) who kept delivering exceptional returns would use such an analysis. He generated returns for investors even as his Fidelity Magellan fund kept growing, disproving the conventional wisdom that the larger your capital base the harder it is to get great returns. Here are two small-cap stocks that might fit the bill.

ADAM (ticker: ADAM), an online health management company is expected to grow over 30% in each of the next 5 years; the stock trades for 24x earnings giving it a PEG under 1. They have been boosting guidance and blowing out quarterly numbers.

VCG Holding Corp. (VCGH), owns adult nightclubs and maintains a profitable business model catering to affluent customers. Revenues are expected to grow 125% next year, with earnings growth coming in at 75%. The stock trades for 25x earnings with a PEG below .5

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Mark on Caribou (CBOU).

Disclosure: Author is long Stryker (SYK)