Stock Picking Strategy: GARP Investing
What Is a GARP Strategy?
Most investors are familiar with “value investing,” which is investing in companies that are undervalued based on their fundamentals. Also common is “growth investing” where one invests in companies that are growing at a higher rate when compared to the markets. When both of these investing methods are used together it is known as growth at a reasonable price (GARP) investing.
GARP stocks are almost always in a booming sector of the economy and could mean higher returns if you stick to the requirements.
The GARP strategy focuses on companies considered undervalued. using a company’s price-to-earnings (P/E) ratio and earnings growth outlook. There are also a few other factors that come into play before an investment is made.
Below is more information regarding on how to use this stock picking strategy for your own investment portfolio, as well as its benefits over value and growth investing.
The GARP Approach to Investing
Step 1: Determine which stocks or sectors you are looking to invest into.
Step 2: Look at the P/E ratio of the above stocks. The focus should be on those with a lower P/E ratio when compared to their industry peers and the overall market index.
The assumption is that the stock will be trading in line or a higher ratio after factoring in the growth earnings outlook.
Step 3: Go over the company’s reported earnings for the past 12 months, paying attention to the current earnings trend(s) and growth rate. These are relevant because if the trend for earnings is negative, then GARP investing would not work and you would have to start again from step 1.
Then look at the 12-month earnings outlook from analysts. Typically, the goal is finding a company that has earnings growth of 10% to 20%.
Step 4: Combine steps 2 and 3 to determine the PEG ratio. In addition to its use for the GARP strategy, this ratio also determines if a stock is overvalued or undervalued.
The GARP strategy requires the price/earnings-to-growth (PEG) ratio, which is calculated using the following equation:
PEG = price/earnings ÷ growth of earnings
The price/earnings part of the equation is determined by taking the current trading price of the stock and dividing it by the annual earnings of the company on a per share basis.
The bottom part of the equation, the earnings growth, is based on the expectations of analysts that follow the company and sector very closely.
By using the PEG ratio, you can tell if a stock would be undervalued or overvalued and if the growth of earnings is satisfactory. A ratio of 1.0 means the stock is fairly valued, while greater than 1.0 means it is overvalued and below 1.0 indicates it is undervalued.
An undervalued stock would be a positional investment for a GARP investor. The ideal range for such investors is between 0.8 and 1.0.
Step 5: Calculate or look up the price-to-book ratio. Also used by value investors, this is more of an accounting ratio and is adjusted on a quarterly basis. The formula for this ratio is as follows:
Price-to-book = current share ÷ the book value of the shares (historic value)
Below is the formula for the book value of shares:
Book value per share = book value (total assets – total liabilities) ÷ outstanding shares
The ideal metric of the price-to-book ratio would be under 1.0. This would mean that the current share price is selling less the liquidation value of the company.
Step 6: Find the return of equity (ROE) of the potential investment. The ROE represents the net income return divided by shareholders’ equity. The range desired by GARP investors is between 10% and 20%. Growth investors make use of this metric as well.
Step 7: Once you have a list of undervalued stocks, spend some more time determining if the investment is right for you. Take a look at past shareholder rewards (dividend payments, share repurchases, etc.) and other positive catalysts to decide if you’re ultimately comfortable with the investment.
How to Calculate the PEG Ratio
Below is details on how to calculate the PEG ratio:
|Stock||PEG Ratio||Price-to-Earnings Ratio||Expected Earnings Growth||Valuation|
PEG = Price/Earnings ÷ Growth of Earnings
= 20 ÷ 10= 2.00
This stock is overvalued because the growth rate does not outpace the P/E ratio of the stock. As a GARP investor, stock A would be ignored.
PEG = Price/Earnings ÷ Growth of Earnings
= 18 ÷ 18 = 1.00
Stock B would be considered as fairly valued, though a GARP-using investor would still hold off until the PEG ratio fell below 1.0. This would require a pullback in the stock.
PEG = Price/Earnings ÷ Growth of Earnings
= 12 ÷ 16 = 0.80
As a GARP investor there would be an investment considered in stock C because based on the PEG ratio, the stock is undervalued.
Benefits of Using the GARP Strategy Over Value Investing
Value investing is a strategy that sees a person invest in companies that are undervalued when compared to industry peers and the overall market. Potential reasons for the stock trading at a cheap valuation include the sector falling out of favor, no growth within the stock, and other preferred investment opportunities in the marketplace.
Value investing means going against the market, a strategy that requires patience; it could take some time for other investors to realize that the stock is undervalued. But if the stock doesn’t make a move for years, it means your investment could be considered “dead money,” meaning the stock return remains flat over a long period of time.
When it comes to GARP investing, the focus is still on purchasing an undervalued stock, as with value investing. The main difference is that the GARP-using investor will also look at companies that have earnings growth to look forward to. Also, the investment should be working for a GARP investor in a shorter period of time than a value investor.
Benefits of Using the GARP Strategy Over Growth Investing
Growth investing is a strategy that ignores the valuation and only looks at how much the company can grow. This could result in a lot of risk as an investor because if the good news keeps being reported by the company then the stock price should increase. This could mean that the valuation of the stock continues to climb. If there is bad news that is reported it could result in the price declining until the valuation makes more sense from the point of view of an investor.
By using the GARP investing strategy it does lower the overall risk and volatility because an investment will only be made if the stock is undervalued. The growth from the company, when using the GARP investing strategy could be as high or higher when looking at stocks that would be considered growth stocks.
In a bear market the GARP investing strategy will outperform a growth investing strategy; which adds to the preservative of capital of the investment.
Advantages of Using the GARP Investing Strategy
Using this strategy will avoid making decisions based on emotion, strengthening financial discipline, as only undervalued stocks would be considered.
The GARP strategy is great if you have a list of stocks in different sectors and of various market cap sizes. This is because the same formula will be applied to the stocks that you are considering owning, saving time.
A great aspect of using this strategy is that the investment opportunities would only be companies that are currently in favor. For instance, if the technology sector is one that many investors and analysts are looking at for bullish reasons, then the PEG ratio should lead you to it.
But what if a sector is bearish? For example, let’s say energy stocks were very undervalued and the oil price outlook was very negative. In this case, use of the PEG ratio would make it clear to stay away and preserve your overall capital.
Drawbacks of Using the GARP Investing Strategy
An important aspect of using the GARP strategy is based on growth expectations of analysts. An analyst’s job is to focus on a specific sector and the companies within it. However, when determining those companies’ outlook, they are not always right. An analyst’s growth outlook could be much higher than what is actually seen from the company, leading to an investment decision not turning out as planned.
Also, when making an investment, you must be willing to accept the stock’s daily movement. The GARP strategy completely ignores daily volatility, even though a stock could end up being one that is not suited to your investment profile.
The GARP strategy focuses on companies that are performing well in the current market conditions, potentially leading to investors trading more frequently. This could result in more trading commissions and taxes on the capital gains generated.
Also read: Stock Picking Strategy: Dogs of the Dow
Final Thoughts About the GARP Investing Strategy
The GARP investing strategy is appealing because it combines both growth and value investing into one strategy. As an investor, I would recommend that once you conclude that a stock is undervalued, take a little more time to understand if the stock would be right for your portfolio.
Also, determine if the company meets all your criteria. Does it pay a dividend, should you want to receive one? Are you comfortable owning a stock in that particular sector? Are you okay with the size of that particular market?
If you really want to use the GARP strategy and do not want to take the time to research stocks, there are always opportunities to invest in exchange-traded funds that will implement this strategy. These don’t require much time, aside from a few minutes reading the necessary paperwork.
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