Growth Investing with a Value Twist

Growth and value investing intersect with an approach called growth-at-a-reasonable price investing (GARP).

Growth-At-A-Reasonable Price Stock Investing

Value investing is a strategy that involves buying stocks that are cheap relative to their intrinsic value or some other fundamental measure, such as earnings, revenue, cash-flow or book value. Growth investing is an approach that seeks out companies that are growing their sales and earnings and have strong growth prospects in the future. Value and growth investing intersect in a growth-at-a-reasonable price investing method, also known as GARP. This investment strategy combines tenets of both growth and value investing into one approach. Oftentimes, growth-like companies command a higher valuation as investors place more value on these types of companies because of their potential to deliver profit in the future. The opportunity is to identify those growth stocks trading at a reasonable valuation relative to their growth rates now and in the future.

Some of the best investors in history, such as Fidelity’s Peter Lynch, were GARP style investors who were able to find stocks that may have appeared expensive on the surface but were cheap because they delivered on their growth and grew into their valuations.

The PEG Ratio, Peter Lynch’s Favorite Investing Metric

Peter Lynch, the former Fidelity Fund manager with one of the best track records in mutual fund history, popularized the GARP style of investing when he was at the helm of the Magellan fund. Lynch would often look for growth companies benefiting from a market trend. Oftentimes, these stocks looked expensive when being looked at from a standard valuation multiple such as the price-to-earnings ratio, but ended up being cheap relative to their growth.

To better analyze growth companies, Lynch used the PEG ratio, which is the price-to-earnings ratio divided by the firm’s growth rate. This was one of Lynch’s favorite stock investing criteria; here's how it works:

Assume we are comparing two different stocks, and both have a price-to-earnings ratio of 30. On the surface, they may look the same but now let’s look at the growth rates. Let's say Company A is growing earnings at 40% while Company B is growing earnings at 15%. Company A has a PEG (price-to-earnings to growth rate) of 0.75 (30 divided by 40 equals 0.75) while Company B has a PEG of 2.0 (30 divided by 15 equals 2).

The lower the PEG, the more attractive the company is relative to its growth rate. For Lynch, a PEG of 1 or less was considered very good.

Lynch even went a step further, and for those companies that paid a dividend and were considered slow growers, he would adjust the PEG since dividend yields are an important driver of the total return of slower-growing companies. In these cases, the dividend yield is added to the growth rate in the denominator to get the yield-adjusted PEG ratio.

Still, like anything in investing, the PEG ratio is not the end-all and be-all of all valuation and growth measures. And as Lynch espoused in his books and articles, the PEG is best used along with other fundamental investment criteria and is only part of the equation in finding winning stocks.

Other Considerations for GARP Investors

Going beyond the PEG, there are other value and growth qualities investors can analyze to determine if a stock looks attractive from a growth-at-a-reasonable price standpoint.

The first question is around growth and if sales and earnings growth will continue in the future. While very difficult to predict, there are several factors one can look at. If the firm is reinvesting in its business through research and development, advertising or capital expenditures that is a good sign in that the company believes those investments will produce a positive return on investment, ultimately translating into growth. In addition, the variability of sales and earnings is also important for growth companies. For example, a company with 20% earnings growth over the past three years would be more attractive than a company with the same 20% average growth, but with less consistency.   

When looking for value, investors also need to be mindful. If the valuation is too low and a company’s stock performance is also very poor, it might signal permanent impairment of the business, even if there are signs of temporary growth. Companies that are generating earnings but not positive cash flow would be another red flag. Lastly, if future earnings are very disconnected from current earnings, it could indicate signs that past growth can’t at all be reflected in the analysis. An example of this might be an oil company that has grown earnings 15% a year over the past five years, but when the price of oil falls from $80 barrel to $40 a barrel, those past earnings are not a good indication of the future. This type of company may look attractive through the lens of a GARP-like strategy, but that would be a misidentification of a strong value and growth stock opportunity.

Value and growth investing can sometimes be at odds with each other, but GARP investing is a way to bring some value orientation to a growth investing approach, which may help avoid overvalued growth companies.

Finding Growth-At-A-Reasonable (GARP) Price Stocks in Today’s Market

Investing in GARP companies offers investors a sensible way to benefit from growth while helping ensure they are not paying too high a multiple for that growth. Over time, stock multiples, valuations, investor expectations and a company’s ability to deliver on those expectations are major drivers of long-term returns.

The stocks below are the top scoring stocks in today’s market using a GARP-based model largely inspired by the investing method outlined by Peter Lynch in his public writings. The PEG ratio, which we discussed on the previous card, is the most important criteria (i.e. the lower the PEG the better). Companies are categorized by their earnings growth rate (fast growth, slow growth or stalwart), and from there, a series of fundamental tests, including analyzing the debt/equity ratio, earnings per share growth rate, inventory/sales ratio and free cash flow, are performed to ensure the company stacks up fundamentally.

See the Top Scoring GARP Stocks in Today’s Market

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