Sometimes conventional wisdom is just downright wrong…
For example, let’s take a quick look at the way most investors apply the concept of “valuation” to their trading decisions.
As a general rule, conventional investors like to buy stocks with cheap valuations, and they avoid stocks that have high price to earnings (PE) ratios.
On the surface, the concept makes sense. If you pay a premium price for a stock, you have more risk of a decline in price, and less potential appreciation for your investment.
For decades, financial academia has told us to “buy cheap and sell dear” – causing too many investors to miss out on some of the best growth opportunities available. This is because growth opportunities typically trade with lofty valuations as investors bid the stock higher in anticipation of future earnings growth.
The key to success when investing in growth stocks is to look at two key components:
- How robust is the fundamental growth of the underlying company?
- How will future investors react to the growth characteristics of this company?
You see, ultimately the academics are correct… Stocks will eventually trade in line with their long-term earnings profile.
But during the early growth stages of successful companies, the stock price can remain significantly above traditional “fair value” metrics for a long period of time. The question is whether the company “grows into” its inflated stock price, or if the stock eventually declines to match the fundamental picture.
Today, I want to take a quick look at Five Below Inc (NASDAQ:FIVE), a teen retail growth stock that is trading with a lofty valuation but plenty of potential for future growth.
Robust revenue and EPS growth
Five Below Inc (NASDAQ:FIVE) is a specialty retail chain, catering primarily to teen and pre-teen girls, selling accessories priced at $5.00 or less. The concept is an interesting blend between the fashion retail industry (which has seen a significant amount of growth) and the discount retail industry (also an attractive sub-industry).
As the father of five pre-teen girls (yes, you read that right), I can vouch for the allure of these low-priced novelty shops.
In many ways, the teen and pre-teen retail market is broken into two primary categories. The premium stores – like Abercrombie & Fitch Co. (NYSE:ANF), The Gap Inc. (NYSE:GPS), and True Religion Apparel, Inc. (NASDAQ:TRLG) – cater to affluent shoppers with virtually unlimited budgets.
For example, a quick search for True Religion jeans yields a pricing list with some priced at several hundred dollars. The high pricing has resulted in fat margins for the company, with last quarter’s gross margin coming in above 60%.
As a side note, True Religion just announced that they are being acquired by Tower Brook Capital Partners, so it will not continue to trade as a public company.
On the other side of the continuum, there are more economical chains such American Eagle Outfitters (NYSE:AEO) and Urban Outfitters, Inc. (NASDAQ:URBN) which offer quality trends at more reasonable prices.
Urban Outfitters has a much more reasonably priced product line, and appeals to more mainstream budget-conscious shoppers. As a result of lower prices, the company has tighter margins. In the most recent quarter, Urban Outfitters posted a 36.8% profit margin. This was obviously well below True Religion, but with the company’s broader reach, profits still beat expectations.
As a general rule, it is easier for the chains to grow revenue because they have a wider base of potential customers (the budget-conscious) to market to.
In the case of Five Below Inc (NASDAQ:FIVE), the company has used its attractive prices to grow revenue AND earnings over the past year, and the most recent commentary from management looks very attractive.
After a rough start to the first quarter, sales picked up sharply allowing Five Below Inc (NASDAQ:FIVE) to raise estimates for first quarter earnings.
More importantly, the company is on track to open 60 new stores this year, as it expands into new geographic markets and broadens its overall footprint.
Assuming the company’s merchandising strategy continues to appeal to customers, Five Below Inc (NASDAQ:FIVE) should be able to exceed analyst EPS estimates of $0.67 this year and $0.90 next year.
Estimate / Valuation growth: A virtuous cycle
There is a phenomenon for growth stock investors that I like to call the Estimate / Valuation Virtuous Cycle. The cycle works like this…
As a growth company reports increases in both revenue and earnings, analysts begin to upgrade their estimates for the company. We see this in many industries as a concept evolves and catches more and more attention. Historical examples of these earnings estimate revisions include the mighty Apple Inc. (NASDAQ:AAPL), Chipotle Mexican Grill, Inc. (NYSE:CMG), salesforce.com, inc. (NYSE:CRM) and many many more…
Institutional and retail investors see earnings estimates being revised higher, and they instinctively place a premium valuation on the stock. It makes sense for investors to pay this “growth premium” because future earnings are expected to be so much higher in the future.
With both of these forces working together (higher estimates and inflated valuations), traders can capture triple-digit returns very quickly.
For example, take a company that is currently expected to generate $1.00 per share and trading with a forward PE of 15 (the stock would be trading at $15.00 per share).
