In the world of investing, numerous strategies have emerged, each with its own unique approach and philosophy. One such strategy that has gained popularity over the years is GARP (Growth at a Reasonable Price) investing.
Being inspired by the legendary investor Peter Lynch’s investment philosophy, GARP investing combines the best of both growth and value investing. Its aim is to identify companies with strong growth potential at a reasonable valuation.
In this article, we will delve into the principles and techniques behind GARP investing and provide practical insights for investors looking to unlock its potential.
Let’s read more about GARP investing.
#1. Understanding GARP Investing
Definition of GARP
GARP investing can be defined as an investment approach that seeks to identify companies with robust growth prospects while considering their valuation.
It strikes a balance between growth investing, which focuses on companies with high growth rates, and value investing, which emphasizes undervalued stocks.
GARP investors aim to identify companies that have the potential for sustainable growth and are trading at reasonable prices.
The Philosophy Behind GARP
To understand the philosophy behind GARP investing, we turn to Peter Lynch, the renowned investor and former manager of Fidelity Magellan Fund.
Lynch believed in the long-term growth potential of select companies. He emphasized the importance of investing in companies with solid fundamentals. By solid fundamentals, Lynch includes factors like consistent earnings growth, increasing sales figures, and significant market potential.
By focusing on companies with such qualities, Lynch aimed to capitalize on their growth trajectory while maintaining a disciplined approach to valuation.
#2: Identifying Stocks With Growth Potential
Evaluating the Growth Potential
Assessing a company’s growth potential is a crucial aspect of GARP investing. Historical and projected growth rates are key indicators to consider.
Examining a company’s past performance can provide insights into its ability to generate consistent growth. Additionally, analyzing industry trends and market conditions can help identify sectors with potential for sustained growth.
For example, in the Indian stock market, one such company that demonstrated strong growth potential in recent years is HDFC Bank. With consistent growth in its earnings and an expanding customer base, the bank established itself as a leading player in the Indian banking sector.
Going forward in the year 2023, Indian industries that come under the bigger umbrella of the manufacturing sector look promising. Quality companies operating in the industries like defense, electronic manufacturing, healthcare, renewable energy, logistics, agriculture, etc can see robust growth.
Key Factors in Assessing Growth
Several factors play a role in evaluating a company’s growth potential. GARP investors consider a company’s competitive advantage, market share, and product differentiation.
A strong competitive position can allow a company to capture market opportunities and maintain its growth trajectory.
Taking an Indian stock as an example, Asian Paints has showcased remarkable growth. It has a dominant market position, strong brand recognition, consistent product innovation, and a large distribution network. This has enabled the company to capture market share and achieve sustained growth in the Indian paint industry.
Example (Growth Potential Scrutiny)
For investors like us, the way to forecast future earnings growth rates is to look into the past. We can look at their PAT and EPS numbers in unison.
Note the last 10 years’ PAT and EPS numbers of the company. Plot a line chart for both of them to get a visual trend.
To quantify the trend. We can also calculate the last 10-Yr, 7-Yr, 5-Yr, and 3-Yr growth rates, for both PAT and EPS. The Growth rate (CAGR) formula to be used for calculation is shown below.
Now, compare the PAT and EPS growth numbers.
Digging into the PAT and EPS Growth Rates
Compare the PAT and EPS growth rates. If they are growing at the same pace in all years, it is an ideal growth story.
Explanation (difference in PAT and EPS growth rates)
For some stocks, the PAT growth rate will be higher than EPS growth. It is a situation that will happen only if the company has raised funds by issuing more shares. The number of shares outstanding for such companies grows with time. This in turn reduces the EPS numbers. As an investor, we want outstanding shares to remain constant or better reduce in numbers (shares buyback).
EPS = PAT / NO OF SHARES
If PAT is growing at a negative rate, then EPS will also show a negative growth rate. Companies showing such characteristics are avoidable.
Note: You can see in the above table, our example stock’s PAT has grown at a slow pace in the last 10 years. But its EPS numbers are either negative or below PAT growth rates. For me, this is a company that is not falling in the investor-friendly range. Though there can be other factors that can fall in its favor. Only a deeper analysis will confirm it.
I use a weighted average method to forecast future earnings growth. Here is the formula:
Growth Rate = 15% * EPSG3Y + 20% * EPSG5Y + 30% * EPSG7Y + 35% * EPSG10Y
If we have a formula, why it is required to establish a trend? The trend of PAT and EPS will highlight the cause of positive or negative growth rates.
- If a positive growth rate is because of growing PAT and shares buy-back it is the most suitable scenario.
- A combination of growing PAT and constant or negligible shares-outstanding growth is also good.
- If PAT is growing but EPS is not growing, it is a case of too much share liquidation. I personally consider this occurrence as a negative indicator, highlighting non-investor-friendly management. Why? Because shares issuance is in the control of the top management. If shares are issued so rampantly that it is causing negative EPS growth, it is not serving the shareholder’s value.
#3: Assessing Stock Valuation
Understanding Valuation Metrics
Valuation metrics are crucial in GARP investing as they help determine if a company’s stock is reasonably priced. Commonly used valuation metrics include the price-to-earnings (P/E) ratio, price/earnings-to-growth (PEG) ratio, and price/sales ratio.
These metrics provide insights into a company’s valuation relative to its earnings or sales figures.
- P/E Ratio: The P/E ratio is a valuation metric used to assess the relative price of a company’s stock compared to its earnings. It is calculated by dividing the current market price per share by the earnings per share (EPS). A high P/E ratio suggests that investors are willing to pay more for each unit of earnings, indicating a potentially overvalued stock. The high PE of quality companies also indicates that the stock is in high demand.
- PEG Ratio: The PEG ratio takes into account a company’s growth rate alongside its P/E ratio. It provides a measure of a stock’s valuation relative to its earnings growth. A PEG ratio below One (1) is generally considered favorable, indicating that the stock may be undervalued relative to its growth prospects.
- P/S Ratio: The P/S ratio is a valuation metric that compares a company’s market capitalization to its total sales revenue. It is calculated by dividing the market price per share by the sales per share. The P/S ratio can help assess a company’s valuation compared to its sales performance. A lower P/S ratio may suggest a potentially undervalued stock, while a higher ratio may indicate an overvalued stock.
Balancing Growth and Price
In GARP investing, finding a “reasonable price” is essential. Peter Lynch emphasized that a reasonable price should take into account a company’s growth prospects and industry norms.
A stock can be considered overvalued if its growth potential does not justify its current price, and conversely, undervalued if its growth potential exceeds market expectations.
An example of this kind is Infosys. The company experienced significant growth during the 2010s, driven by its strong positioning in the IT sector. However, there were instances when the stock became overvalued. It prompted GARP investors to exercise caution and assess whether the price reflected the company’s growth potential.
Example (Price Valuation Scrutiny)
Once the future growth rate is established, the stock’s price analysis is comparatively simpler. We can consider only the PE ratio (Price To Earning Ratio) as the qualifying metric.
PE = Price / EPS
- The Price will be the current stock price.
- EPS will be the trailing twelve-month EPS (EPS-TTM).
What we can do more is to analyze the PE number a bit deeper. How? By establishing the PE trend and estimating a forward PE (PE of the future).
For that, we will have to calculate the PE of the last 5 or 10 years. Note the price and EPS data for a 10-Yr time period (as shown below):
Once these two data are available, calculate the PE ratio of the 10 years as tabulated above. Once the calculation is done, we can plot a line chart and establish a trend.
- The ideal case will be to see a rising PE. Here we will use a forward PE greater than the current PE (PE-TTM)
- In case of a falling trend, we will use a PE that is lower than the current PE (PE-TTM).
The above two steps have established the ‘future earning growth rate’ and ‘Forward PE’. Now, we are ready to confirm if the stock is showing the characteristics of “growth at a reasonable price (GARP)?” How to do it? By calculating the GARP multiple.
PEG Ratio (Let’s call it GARP Multiple)
The lower is the GARP multiple (PEG ratio) the better. If the PEG ratio is below one, the stock’s price is said to be at par with its growth rate. If the PEG ratio is below one, the stock can be said to be undervalued. There is a difference between low PE stocks and GARP stocks. The stocks showing a low GARP multiple may have a high PE ratio, but their PEG will be close to one or below.
#4: Implementing the 8GARP Strategy
Building a GARP Portfolio
Diversification is crucial when constructing a GARP portfolio. By selecting growth stocks from various sectors and industries, investors can mitigate risks associated with individual companies or sectors. GARP investors aim to identify stocks with a combination of solid growth potential and reasonable valuations.
An illustrative example of a GARP portfolio in the Indian context might include companies like HDFC Bank, Asian Paints, and Infosys, which exhibited strong growth potential while maintaining reasonable valuations during certain periods.
Logical Steps To Implement GARP Strategy
Implementing the GARP (Growth at a Reasonable Price) investing strategy involves a series of logical steps that can help investors effectively apply this approach to their portfolio. Here is a breakdown of the process:
Step 1: Define Investment Objectives
Clearly articulate your investment objectives, taking into consideration factors such as risk tolerance, investment horizon, and financial goals. This will provide a foundation for selecting suitable stocks within the GARP framework.
Step 2: Research and Identify Potential Stocks
Conduct thorough research to identify companies with strong growth potential in the Indian market. Look for businesses that demonstrate consistent earnings growth, increasing sales figures, and a solid market position. Consider factors such as industry trends, competitive advantage, and product differentiation. Our Stock Engine can be a tool that can help in stock research.
Step 3: Evaluate Valuation Metrics
Assess valuation metrics such as the price-to-earnings (P/E) ratio, price/earnings to growth (PEG) ratio, and price/sales (P/S) ratio to determine if a stock is reasonably priced. Compare these metrics to historical data, industry averages, and peer companies to gain insights into a stock’s valuation relative to its growth potential.
Step 4: Analyze Management Quality
Evaluate the quality of a company’s management team and their ability to execute growth strategies. Look for experienced and visionary leaders who have a track record of delivering results. Assess their strategic decisions, capital allocation, and ability to adapt to changing market dynamics.
Step 5: Construct a Diversified Portfolio
Build a diversified portfolio of GARP stocks from different sectors and industries. Diversification helps mitigate risks associated with individual stocks or sectors. Allocate funds across companies with varying market capitalizations and growth prospects to balance potential returns and risks.
Step 6: Monitor and Review
Continuously monitor the performance of your GARP portfolio. Stay updated with company-specific news, industry developments, and macroeconomic factors that may impact the growth potential and valuation of your holdings. Regularly review your portfolio’s performance against your investment objectives and make adjustments as needed.
Step 7: Practice Patience and Discipline
GARP investing requires patience and discipline. Avoid making impulsive investment decisions based on short-term market fluctuations. Stick to your investment strategy and give your chosen stocks sufficient time to realize their growth potential. Maintain a long-term perspective and resist the temptation to make frequent changes to your portfolio.
GARP investing offers a powerful approach to identifying investment opportunities that combine growth potential with reasonable valuations.
Peter Lynch’s principles and techniques provide valuable insights for investors looking to embrace this strategy.
By understanding and implementing the principles of GARP investing, investors can aim to uncover hidden gems in the market.
However, it is crucial to conduct thorough research, before buying a potential GARP stock. Generally speaking, GARP stocks trade at a high P/E multiples. Buying at such high PE multiples can be justified only by the stock’s future growth potential. One shall do thorough research on the future growth potential of the stock while practicing GAPR investing.
GARP investing, when executed diligently, can be a valuable tool in an investor’s arsenal, offering the potential for long-term success.
Have a happy investing.