By David Sterman
For half a decade, investors have been waiting for the economy to start generating faster growth.
The fact that GDP growth has failed to live up to the optimism you see at the start of each year explains why analysts often issue bullish new earnings per share (EPS) forecasts, only to ratchet them down over time.
We've seen that trend play out many times in this current earnings season. Analysts project lofty forward estimates, and then the company dampens those hopes by issuing guidance that is below the consensus.
Yet some companies are able to buck that negative cycle, delivering robust quarterly results and making a credible case for strong future profit growth. I screened the 1,500 companies in the S&P 400, 500 and 600 to look for companies that topped recent profit forecasts and also saw their 2014 and 2015 profit outlooks boosted.
I then narrowed down the group to include companies that are expected to boost per-share profits by at least 20 percent in 2015 and again in 2016. Only 20 companies made the cut. Yet simply making the grade isn't good enough.
Some of these stocks also sport very high price-to-earnings (P/E) multiples -- based on 2016 profit projections. Unless these companies are poised for continued torrid profit growth beyond 2016, then their shares are vulnerable to a reset of the multiple once investors look beyond the next couple of years.
These seven stocks appear at least fully valued, if not overvalued, in the context of 2016 P/E multiples. You could argue that companies such as Facebook
) and Netflix
) will generate great profit growth in 2017 as well, but we really don't know if that will be the case. Companies like these can engage in a phase of explosive growth for quite some time, and then growth sharply slows. Just ask Microsoft
) or Cisco Systems
). (Microsoft owns and publishes Top Stocks, an MSN Money site.)
Still, there is another group of companies that meet these same high-growth criteria yet trade for much more reasonable forward multiples. Such multiples may reflect the fact that profit growth will slow in 2017 and beyond, but it's too soon to know that. A firming economy may help these companies stay on the leading edge of profit growth. What's notable about this group is that they don't all toil in the same industries and are therefore benefiting from a wide range of trends that are boosting growth.
To be sure, the appeal of some of these stocks needs to be qualified. For example, homebuilder PulteGroup
) won't deliver on analysts' lofty growth forecasts if the housing market doesn't get going in 2014 and 2015. And for big biotech firms like Gilead Sciences
), a long-term robust drug pipeline is essential if the company is to effectively offset patent expirations on key drugs in coming years.
One of my favorite companies in this group, Harman International
), is only marginally appealing in the context of 2016 P/E multiples. Harman is doing great engineering work in the field of acoustics, which I discussed earlier this month
. Harman would be a great stock to buy on a pullback, but the 150 percent gain from the 52-week low gives pause.
Profit growth now, sales growth later
The projected profit growth for AK Steel
) is quite unusual. After all, demand and pricing for steel remain in a funk, which explains why revenues are expected to grow at a low single-digit pace over the next few years. The profit gains are coming almost exclusively from better cost management.
AK Steel's management had no choice but to curtail costs. The company generated negative $355 million in free cash flow in 2012 and another negative $174 million in 2013. The cost cuts should fuel moderately positive free cash flow this year and more than $350 million by 2016, according to Merrill Lynch, which has a $9 price target on the stock.
The low forward P/E suggests that the cost-cutting moves have not yet resonated with investors. "We believe that the market has not priced this benefit and see the current stock price level as a good entry point," note analysts at Goldman Sachs, who carry a $10 price target, representing 45 percent upside. If and when demand and pricing for steel rebound, then price targets and profit forecasts will move yet higher.
When a surprise is not a surprise
Either financial services firm Investment Technology Group
) has been setting an extremely low set of expectations -- or analysts have repeatedly been too negative about the company's business trends. How else can you explain why ITG has exceeded quarterly EPS forecasts by an average of 30 percent over the past four quarters?
Every time it happens, analysts boost their forward profit views by a modest amount, setting the stage for the next beat-and-raise cycle. This is another company that is parlaying tepid sales growth into robust profit gains, thanks to a focus on improving margins. As the company noted in a recent press release: "Our focus on improving the performance of our product groups led to significant reductions in infrastructure costs. These efforts paid off, resulting in a 350 percent increase in our 2013 adjusted net income as compared to 2012."
Part of the EPS gains are coming from an ongoing share buyback program that has already shrunk the share count by 17 percent in the past four years. Still, shares remain at very reasonable forward multiples simply because financial market transactions remain below levels seen back in the past decade.
As a result, this stock is actually lower than it was five years ago, compared with a triple-digit gain for the S&P 500 in that time. The brightening forward profit outlook should help to reverse that underperformance.
Risks to consider: Expectations of robust profit growth would be derailed if the U.S. economy took a turn for the worse. And at this point, it's unclear where the economy is headed.
Action to take: Looked at another way, these companies are poised for terrific profit growth in a so-so economy. Assuming the U.S. economy finally hits its stride in coming years, these profit powerhouses are poised to continue. And in some instances, the forward P/E multiples imply ample room for expansion, helping to fuel solid long-term gains.
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