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While undervalued stocks can do well in bull or bear markets, it is especially important to consider the potential risks in a bear market. For now, we don't know if a bear market is beginning, but we do know that nervousness seems to be the dominant trend in the markets. Words from the Federal Reserve can send the Dow Jones Industrial Average down by hundreds of points in a day, so risk needs to be the primary consideration in investment decisions.
Risk can be controlled in a number of ways. One approach is to invest only a small amount of money. By using call options, risk is limited to the amount paid for the option and it is possible to buy calls at very cheap prices. Yet the gains can be substantial.
Looking for potential winners, we found three stocks trading with PEG ratios less than 1 and with options that could rise in value before the end of the year.
The PEG ratio compares the price-to-earnings (P/E) ratio of a company to its earnings growth rate. Companies that are growing earnings faster than average should be trading with P/E ratios that are higher than average. Slow-growing companies should have below-average P/E ratios.
The PEG ratio makes it possible to compare the P/E ratios of fast and slow growing companies and find true stock market bargains. Many analysts believe the P/E ratio should equal the earnings growth rate, which would make a PEG ratio equal to 1 fairly valued.
First on our list of potential winners is educational toymaker LeapFrog Enterprises (NYSE: LF) with a PEG ratio of 0.86.
LF introduced a new toy called the LeapReader to help children learn to read, which is attractively priced at less than $50. LeapReader buyers will then need to buy the books and songs to be loaded onto the device. Books are priced at $13.99 and up, so LF should profit from sales for years to come as youngsters fill their LeapReader with new content.
Based on the PEG ratio, LF could be worth about $12.50 per share. Call options expiring in December with a strike price of $10 would be worth at least $2.50 if LF reached the target price.
Recommended Trade Setup:
-- Buy LF Dec 10 Calls at $1.25 or less-- Do not use a stop-loss (invest only an amount you can afford to lose)-- Set price target at $2.50 for a potential 100% gain in six months
Next on our list is Ebix (NASDAQ: EBIX), which provides software solutions to insurance companies, with a PEG ratio of 0.33. This is a high-risk stock, and the SEC is questioning the company's accounting. Goldman Sachs (NYSE: GS) recently walked away from a deal to acquire the company for $20 a share. Assuming the allegations are true, EBIX could owe a significant amount of money in back taxes.
But if the concerns raised by the SEC are completely dismissed, December $10 calls on EBIX could be worth as much as $10. It is likely that the stock is worth somewhere between $10 and $20 a share, and our estimate is the company is worth at least $16, which is only 8 times its earnings before taxes.
EBIX calls are very risky but offer a potentially high payout for a small amount of money.
-- Buy EBIX Dec 10 Calls at $2 or less-- Do not use a stop-loss (invest only an amount you can afford to lose)-- Set price target at $4 for a potential 100% gain in six months
Our third pick is organic food distributer SunOpta (NASDAQ: STKL) with a PEG ratio of 0.36. This stock could double in price before trading at a PEG ratio of 1.
The company has reported earnings growth averaging 14% a year in the past five years, and analysts expect growth to average 30% a year in the future. We think the stock should be trading between $10 and $12 a share, yet is trading under $8.
December calls with a strike price of $7.50 could double in value before the end of the year.
-- Buy STKL Dec 7.50 Calls at $1.50 or less-- Do not use a stop-loss (invest only an amount you can afford to lose)-- Set price target at $3 for a potential 100% gain in six months
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