3 surprising bargain stocks ... and 3 to avoid

Dynamic growth typically comes at a premium price. But we studied this year's list of fast-growing companies and found a trio of undervalued names worth betting on and a troika to steer clear of.

By Jon Birger, contributor

Like flowers sprouting through concrete, growth companies continue to rise in spite of the sickly economy. Consider that this year our annual 100 Fastest-Growing Companies 47 companies with average annual revenue growth of 30% or better over the past three years, and 83 companies with average annual earnings growth of 50% or better.

The Fastest-Growing list is always a window into what's happening in global business, and the 2011 version is no different. With the stock market slumping and the possibility of a double-dip recession looming, perhaps it was inevitable that both a pawnshop operator, EZCorp ( No. 66), and a collection agency, Encore Capital ( No. 40), would make an appearance.

Much more heavily represented, thankfully, are companies that reflect two of the dominant economic trends of the past 15 years: our irrepressible demand for new technology and the aging of the baby boomers. Indeed, nearly half of the 100 Fastest-Growing companies hail from either the technology sector (31 companies) or health care (19 companies).

As always, it's important not to make the mistake of automatically equating "fastest growing" with "best investments." This list may reveal a lot about macro trends, but it is not a foolproof tool for identifying micro value in the stock market. The view is by definition backward-looking -- based as it is on the past three years' worth of revenue growth, earnings growth, and shareholder return. And there are precious few companies like Apple ( No. 21) that manage to continually rocket past expectations. So if you're scanning the list for promising stocks, don't focus solely on companies with the best growth trajectories. Consider how much you're paying for that growth. As of Aug. 29, the stocks of the 100 companies on the list had an average price/earnings ratio (based upon trailing four quarters' earnings) of 23 -- nearly double the 12 P/E of the S&P 500, according to Baseline.

Investors have a habit of ignoring such warnings. They regularly shell out premium prices for hot growth stocks, limiting their own upside in the process -- and exposing themselves to steep downside risk. But that doesn't mean there aren't surprising bargains lurking on our list. To find them, we crunched numbers, analyzed company documents, and grilled investors and industry analysts. Ultimately we found three stocks that look like winners. The companies are well positioned to continue growing, and the shares are priced low enough that one bad quarter shouldn't tank your portfolio. As a bonus, we've identified three stocks to avoid -- either because their valuations seem inflated or because the businesses may have already peaked.


Last updated September 20 2011: 3:36 PM ET
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Our annual roster of high performers reveals the promising saplings that are rising in a difficult economy and some stalwarts that deliver year after year.

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