Three cheap growth stocks to buy now

When buying stocks, it is important not to overpay for a company’s growth potential, says professional investor Neil Hermon. So he looks for smaller companies that have a sound business model, strong management, a high return on capital and growing market share. Here, he tips three such stocks to buy now.

Each week, a professional investor tells MoneyWeek where he'd put his money now. This week: Neil Hermon, director, Pan-European Smaller Companies, The Henderson Smaller Companies Investment Trust plc.

As an investor, it is important not to overpay for a company's growth potential. So we buy growth at the right, or ata reasonable, price. Fundamentally, that means we are bottom-up stock investors looking to invest in good-quality companies at the right valuation level. We also want our investments to have certain key characteristics. These include a sound business model showing such traits as good market position, high return on capital and growing market share. We also look for strong management. This is critical for smaller companies, where success can be highly dependent on key individuals. We like sound financials, particularly a strong balance sheet and good cash flow and, finally, positive earnings momentum.

In the last 18 months we have looked to exploit the high growth being enjoyed by the emerging economies in Asia and Latin America. That's in part because the British consumer faces many headwinds, including raised taxation, higher fuel and food costs, government spending cuts and public-sector redundancies. That is not to say there are not good British domestic companies around, but many are finding decent returns difficult to generate.

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My first stock is Oxford Instruments (LSE: OXIG). This company manufactures high-technology tools for the industrial and research markets. We first became involved in 2007 on the back of the appointment of a new management team. It set an ambitious target of doubling sales and improving margins by 10% over the next five years. It aimed to do this by cutting costs, rationalising production and improving the commercial nature of the business. Although the global recession of 2008 affected that plan, the company enjoyed a very good recovery in 2009 and 2010 led by strong demand for its products from China. It has now set itself new targets of achieving continued strong organic growth while further improving margins. It has also made a couple of sensible complementary acquisitions. Earnings estimates look too low and the company is well placed to enjoy rapid growth.

My second tip is E2V Technologies (LSE: E2V). This company produces electronic components, such as sensors and tubes. The company had a poor recession, entering the downturn with an over-indebted balance sheet and unprepared for a decline in demand for its products. However, it has since experienced a strengthening in the management team, a rights issue to restore financial strength and an ambitious restructuring plan. With these measures in place, E2V has made a very strong recovery and looks set for further strong growth on the back of new products. The shares still look cheap and on less than ten times this year's earnings are well set to continue to outperform.

My final choice is Carphone Warehouse (LSE: CPW). This company, through a joint venture with Best Buy Inc, owns 50% of the Carphone Warehouse retail operations in Europe, 50% of the Big Box electrical retailing roll-out and 25% of Best Buy Mobile, the US mobile-phone retail operation. It also owns 47% of Virgin Mobile in France and some property interests. The retail operations in Europe offer strong growth through increased smartphone and tablet penetration. But the real excitement is Best Buy Mobile, which has taken a 5% share of the US market and is poised for further dramatic growth in a huge market. It has the potential to drive strong earnings in the medium term.