Investing — Growth — Value
GARP Investing, One Strategy to Rule Them All ?
Discover the subtle mix of growth and value approaches and how it could fit with your portfolio for stock investing.
Value investors look for companies trading below their intrinsic value. Conversely, growth investors focus on companies with above-average growth prospects. Between these two approaches lays the GARP investing, namely the “growth at a reasonable price”. This style combines value and growth mindsets to offer the best of both worlds. Let’s take a look!
Value or Growth ? A longstanding rivalry
Often opposed to each other, like the two sides of the same coin, value and growth investing each have pros and cons.
Value investing: the Graham and Buffett’s school
Value investing focuses on the financial fundamentals of a business. Theorized by legendary investor Benjamin Graham, value investing was later popularized by Warren Buffett through his conglomerate Berkshire Hathaway. Put simply, value investing seeks to answer a single question: What is this stock really worth today?
To reply to this question, a value investor will calculate the intrinsic (or book) value of the stock. He/she explores the underlying assets and earnings of the company to determine if the share trades at a discount from its intrinsic value (price < book value). By taking advantage of this under-valuing situation, a value investor anticipates a return to normality, that is, an erasure of the discount (price = book value), while pocketing some profits.
Value investing heavily relies on Graham’s concept of “safety margin” explained in his «Security Analysis» book. It’s a simple representation of the discount: the larger the margin, the more attractive the investment will be.
However, beware of value traps, stocks that trade at a discount for good reasons. Sometimes, low prices, discounts and low valuation multiples are totally justified, for example because the company is not financially sound.
Growth investing: the Price & Fisher’s School
Now, let’s talk about growth investing. These investors select stocks with above-average growth compared with their industry or the overall market. Thomas Rowe Price Jr. is considered as the father of growth investing. We should also mention Philip Fisher, author of the excellent book «Common Stocks and Extraordinary Profits», an investment classics about the growth mindset.
Growth investors look for young, early companies with high growth potential compared to their competitors. Here, it’s all about investing early enough, with strong convictions regarding the future, and let yourself be carried away for as long as possible. The question here is: What will this stock be worth in 5 to 10 years?
Of course, it can be risky: all rely on growth expectations, often with valuation premium (price > intrinsic value). If growth doesn’t meet expectations, risk of losses becomes greater. Also, young & premature business models involves a high risk of failure. Not everyone is able to become a giant such as Apple or Amazon!
Which style to choose? Value or Growth?
As you may have guessed, what is good for you depends on numerous parameters, specific to each of us. The growth investor looks to the future, while the value follower studies the present moment. Note that mixing both strategies could perfectly fit to a balanced portfolio.
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Another approach would be to find a balance between safety margin and growth expectations. This is where GARP investing lies.
GARP Investing: invest like Peter Lynch
GARP stands for “Growth At a Reasonable Price”. That is, finding companies that have the potential to increase their profits in the future, but that are not overpriced right now. Put simply, growth-oriented investing, cheered up with value principles flavor. Don’t get us wrong, GARP investors always looks for earnings growth. However, by limiting the price they are willing to pay, they also limit the risk of their investment, giving themselves a comfortable margin of safety. Growth, but not at all costs!
Peter Lynch is perhaps the investor who best represents GARP investing mindset. He is the one who really developed this concept. His famous book “One Up On Wall Street” paves the way of one of the most important tools in GARP investing : price/earnings-to-growth (PEG) ratio.
The PEG Ratio, the beating heart of GARP strategy
The PEG ratio of a company is its Price-to-Earning (P/E) ratio divided by the growth rate of earning per shares (EPS). The latter can either be past (trailing EPS) or future (forward EPS). For growth purposes, future growth EPS rate is usually used. PEG ratio links the current valuation of a company to the future growth of its profits.
Let’s take a closer look at this PEG formula to understand its benefits.
A high P/E ratio is often seen as a sign of overvaluation: a P/E of 8 means that you are willing to pay $8 for every dollar of annual income. This is an indication of how expensive the action is. But as with much financial statistics, this ratio can be misleading when used alone. Indeed, a high P/E could also mean that earnings are expected to rise sharply in the coming years, something highly desired by growth investors.
This is where the PEG ratio makes sense, as it incorporates earnings growth into the decision-making process. It moves beyond the P/E ratio, just by dividing it by the expected growth rate of earnings. Then, a high growth rate will result in a lower PEG ratio. And the lower the PEG ratio, the more the stock will be considered undervalued based on its earnings forecasts. This is the Grail of GARP investing: a stock that should grow, but currently trading at a reasonable price/valuation.
Let’s take an example. It’s basic mathematical principles, don’t run away:
- Company A is trading at a P/E of 20, and its profits are expected to grow by 30% per year. Divide 20 by 30, and you get a PEG ratio of 0.7.
- Company B is trading at a P/E of 10, but its earnings growth is expected to be around 8% over the next few years. Which gives us a PEG ratio of 1.3.
Company A, despite a higher P/E ratio, has a lower PEG ratio, which makes it more attractive for a GARP investor. This lower PEG ratio indicates that the company’s future earnings growth is less likely to be impacted by its current valuation.
When Peter Lynch practiced GARP investing, he searched for businesses with PEG ratio of less than 1 to be attractive. According to Lynch, being below this threshold meant that the company’s growth is not yet fully taken into account in its current valuation.
There is no miraculous solution
As with any financial parameter, the PEG ratio is not free from default and there are risks.
First, although attractive, copying the decision threshold of Peter Lynch must be put in context. He invested at a time when the economy and financial markets were significantly different from today. Much like the intrinsic value formula of Benjamin Graham, so you must not forget today’s low interest rates. In doing so, modern GARP investors consider a stock to be attractive if its PEG is less than 2. If it’s lower than 1, you could be looking at a very good deal.
But be careful! Only using the PEG ratio to make investment decisions would be simplistic. An undervalued company with high future growth prospects may seem tempting. But as with any investment, understand what you are investing in. A value trap quickly arises, especially when it comes to using growth projections! Especially because you should take growth estimates for what it’s worth. Past performance is no guarantee of future results.
A bunch of tools for GARP investors
You can of course do calculations by hand, but it’s also possible to go through screeners. Here are some:
- Reuters Stock Screener dedicated to GARP Investing
- Yahoo Finances Screener (click on “Add another filter” and check “Price / Earnings to Growth (P/E/G)” in the “Valuation Metric” section)
- Finviz Screener (US only, click on an industry for details, and sort by increasing PEG)
Another option is the S&P 500 GARP Index, focusing on companies showing constant fundamental growth at a reasonable (and financially strong) valuation. It is replicated by the Invesco S&P 500 GARP ETF. Also note the Barron’s 400 ETF, based on an equally weighted smart beta index, whose methodology is clearly based on GARP.
Time to conclude
In his letter to Berkshire Hathaway shareholders in 1992, Warren Buffett wrote:
In our opinion, the two approaches are joined at the hip: growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive. In addition, we think the very term ‘value investing’ is redundant. What is ‘investing’ if it is not the act of seeking value at least sufficient to justify the amount paid?
With GARP mindset, you should now be able to find stocks sitting at the junction of growth and value styles : undervalued growing stocks. In doing so, you won’t have to choose between one or the other! You can then invest in companies with growth potential, for a reasonable price; it’s the best of both worlds.
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Raphaël is the founder of Investiforum.fr, a financial website for French-speaking private investors. This article was originally issued on Investiforum, the financial website for French-speaking private investors. Read the original article (in French).
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