More Cheap Growth Stocks for a Tough Market

• ByTim Melvin, RealMoney.com Contributor
• On 8:00 am EST, Monday December 15, 2008

In Friday's article I talked about one of the two models I played around with back in 2005 that produced remarkable results over time. One was a growth-stock model that produced some interesting names worth paying attention to as the market moves lower. The second screen was a combination of growth components and value criteria.

The working theory in developing this approach was to find profitable companies that were reasonably valued on the basis of earnings and asset values. They also had to own twice as much as they owed. The companies had to have grown moderately over the past five years, and the analysts and research services that followed the company had to feel it would grow reasonably in the future. The specific criteria used were a price-to-earnings ratio less than 12, price-to-book-value of less than 1.5, a debt-to-total-capital ratio less than 50% and expected and historical growth of 5% annually.

I ran the screen through my quick and dirty back-test on Friday and found that it still handily outperforms the market. More importantly, coming off of significant market bottoms, it produced spectacular returns. It was also obvious to me that you have to approach this screen with a macro and market view in mind, or else it could get you into trouble. There was a tendency in good times to cluster in industries trading at a low multiple of peak earnings, a potential recipe for disaster. In early 2007, for example, the list was clustered with financial stocks and homebuilders. If you followed the screen blindly, the results would have been unpleasant, to say the least.

Still, although the stocks have been volatile, the returns have been very good over the long run. We have seen stock prices fall 40% as measured by the S&P 500 this year, and this model does very well in a recovery market, so it's worth looking at the companies that make the list. As my current macro and market views remain somewhat negative, I am going to be very selective, and as always lately, move slowly and start small.

The current screen includes a lot of insurance companies. These companies have been battered in 2008 as a result of investment losses, poor underwriting and a soft insurance market. Some of them, however, are worth a further look. HCC Insurance is one such company. It sells group life and health insurance as well as property and casualty insurance. It also operates in specialty markets such as officer's and director's indemnity insurance, aviation packages and surety and credit bonds.

HCC's management appears to be very good at the underwriting side of the business and has a combined ratio in the mid-80s. Even with hurricane losses in the third quarter, the combined ratio for HCC was just 88%. The company has had investment losses, but they are miniscule compared with those of some of its competitors. The company is using its strong balance sheet and weak markets to make acquisitions that allow it to expand its markets.

Met Life is a company I have talked about before, and it makes the list as well. The company is having a tough year as a result of its enormous exposure to the financial markets. Investment income and overall earnings are going to be down for the company this year. However, its sales are still going strong, particularly in key international markets. International revenue is expected to double from 12% to reach 25% over the next few years.

MetLife's operating earnings next year are expected to be $3.60 to $4 a share. The company is also in good shape financially in spite of investment losses. Analysts estimate the company has over $3 billion in excess capital. Met Life is the largest life insurance company in the U.S. and is gaining market share globally. When you combine these factors with the company's strong balance sheet, this stock should be a core holding for years to come, and I would be buying on weakness.

A couple of other old favorites made the current list of cheap growth stocks. I have owned Helen of Troy at least five times in the past five years, and it is currently at levels that make it an interesting purchase candidate once again. The Bermuda-based company develops and markets hair products and accessories as well as foot products. Its line of hairdryers, curlers and brushes includes some of the best names in the industry, including Vidal Sasson and Revlon. As a result of the company's low cost structure and strong relationships with discount stores, Helen is having a good year. At current levels, the stock is cheap.

Foot Locker is another favorite that shows up on the list. The shoe retailer has been hit as hard as all the other retailers, but it will be profitable this year. Going forward, store closures and a new relationship with Under Armour could be growth drivers.

There is something for everyone is the current screen results. If you agree that oil is probably going to be higher next year, then ConocoPhillips is a cheap growth stock that could help you benefit from the price rebound. Loews Corporation offers exposure to oil and gas, pipelines and the insurance business. If you believe there will be a continued trend toward outsourcing, then MPS Group is a good way to play it.

Although the market and economy are weak right now, I believe we will see a recovery over the next several years. Focusing on safe, cheap growth stocks is one way to benefit from that recovery.

Buzz up!