A natural instinct of all investors is to search for cheap companies, but is it a beneficial instinct? In fact one of the commonest mistakes investors make is to buy companies that appear cheap, but in reality have stopped growing and are therefore to be avoided.
Companies to buy are those with cheap valuations relative to their profit growth potential. A good guide as to expected growth is the price-earnings ratio of a business. It shows investors a company's market value expressed as a multiple of its current earnings. In other words the price-earnings equals reality plus expectation, which can vary with sentiment.
On that basis companies suffering from weak sentiment or low expectations relative to their prospects should make for some of the best buys going. Here are a few to consider.
New Zealand-based online marketplace Trade Me Group Ltd (ASX: TME) has moved into the vertical classifieds of retail estate, jobs and cars very successfully in the last few years. About half its business involves eBay style goods trading for entrepreneurial Kiwi users of the website, while the other half involves the vertical classifieds. The latter is the growth half and it has plenty of potential if able to mirror the runaway growth of its trans-Tasman classified cousins like SEEK Limited (ASX: SEK) or Carsales.com Limited (ASX: CRZ).
The website is wildly popular in New Zealand and this gives it an all-important competitive advantage, benefits of the network effect and opportunity to deliver new products. Growth should come, and selling for $3.59 the price-earnings is 18 with potential for excellent returns over a five-year time horizon.
Flight Centre Travel Group Limited (ASX: FLT) is one of the most remarkable growth businesses on the ASX. Its blend of physical stores and online sales has delivered worldwide growth for it, with more than 2,500 stores across 11 countries. Earnings growth is forecast around 10% for the next three years and with organic and consumer travel growth likely long-term continuities, Flight Centre's price-earnings of 20 may yet come to be a bargain.
Paints, home improvement and building products company DuluxGroup Limited (ASX: DLX) posted an 18.2% growth in profits in its last financial year. It has been expanding through acquisitions and the recent purchase of Alesco has brought an increased presence in potentially profitable new construction and infrastructure markets. Net debt to EBITDA stands at 1.95 times, but that's manageable and the acquisition should be earnings accretive soon enough.
Dulux is also committed to building a profitable Chinese business over the medium to long term, and with defensive earnings streams and a solid growth runway, the high price-earnings seems justifiable given the outlook for growing profits.
Foolish takeaway
Cheap companies often get cheaper as problems mount or competitive headwinds take their toll. Investors should look to find fast-growing companies at reasonable prices. Trade Me looks the pick of the above at current prices, although Flight Centre is a phenomenal global business with quality management and the capacity to keep climbing higher.
