06) Stock Picking Strategies: GARP Investing

by · October 16, 2010

If you’re comfortable with value investing and growth investing, then perhaps the world of GARP investing is right for you. GARP is simply: Growth At a Reasonable Price.

GARP

GARP method looks for companies that are somewhat undervalued but has a solid growth potential at the same time.

Even though GARP uses a hybrid technique from both value and growth investing, it uses a set of criterion that help investors identify potential stocks to buy.  Some critics say that GARP-ers are on the fence when it comes to picking stocks or that their portfolio is a mixture of companies that have value and growth.  This is not true because investors who use GARP identify stocks that have neither growth nor value but have a combination of both.

Who Uses GARP?

Peter Lynch, who is perhaps better known as the world’s best fund manager uses GARP.  He wrote “One Up on Wall Street” and “Learn to Earn”.

The Hybrid Characteristics

GARP investors are concerned about the growth prospects of a company.  They like positive projections for the future.  But unlike their pure growth investing cousins, GARP investors don’t like overly high projections.  They see anything above the 25-50% range as high risk.  They prefer the lower, yet safer 10-20% growth rates.  However, like growth investors, they pay close attention to ROE. A high ROE in relation to industry levels means the company is solid.

Because of the different criteria investors have when using GARP, preferences and picking style is usually customized to suit the investor.  Because investors need to exercise subjectivity when using GARP, investors must rely on their own personal interpretation of a company and use their own judgment.

P/E ratio is often used to pick good companies.  While growth investors look for companies with high P/E ratio, GARP-ers see this as too risky.  They will usually settle for companies within the 15-25 range. Although, this is again subject to an investor’s personal tastes.

Aside from preferring low P/E ratio, they also like companies with low price-to-book ratio.  They prefer P/B to below industry averages.  The idea is that GARP-ers are usually more concerned about present valuations.

The Numbers

What numbers do GARP investors look for in a company?

The PEG Ratio

This is the most important measure to a GARP investor.  Preferably, it should be no higher than one and closest to 0.5.  PEG gauges the balance between a stock’s growth potential and value.

Example, Company X has a P/E = 19 with earnings growth at 30%.  Which means that Company X has a PEG of 0.63 (19/30=0.63).  Good by GARP standards.

Company Y on the other hand has P/E = 11 and growth at 20%.  Its PEG is at .55.  Although it has slower growth compared to Company X, Company Y currently has a better trading price.  Meaning, even though Company X has higher growth potential, it is also overpriced.  GARP demands that a company should have solid growth, but also states that said growth should be valued at a reasonable price.

GARP at Work

Because GARP-ers use a combination of value and growth, the returns an investor experiences are very different from those who use purely value or growth investing.  Example, during a bull market, a growth strategy would be more favorable and returns for the investor would be unbeatable.  During the dotcom boom, neither investor could compete but if the market did turn, a GARP-er would be less likely to be out of pocket.  GARP investors do better in a bearish market because it uses both value and growth strategies.

Conclusion

Mastering both strategies is a must if you want to become a GARP investor.  A novice venturing into GARP world would find himself buying mediocre stocks instead of good GARP companies.  However, many expert GARP-ers have proven that taking the time to master both techniques pays off handsomely in the end.

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