As advocated in the value investing strategy, some people enjoy the idea of getting a stock for a bargain price. Others like investing in companies with large growth potential and pursue growth stocks in their portfolio. But for those people who like the ideas presented in both strategies, but, find some of the stock picking criteria too severe, then the GARP stock investing strategy might be appropriate.
GARP (Growth at Reasonable Price) is literally a hybrid stock investment strategy that emphasizes picking investments slightly undervalued, but still expected to have solid earnings growth in the coming years.
What is GARP?
Growth at a reasonable price (GARP) is an investment strategy that combines tenets of both growth and value investing by finding companies that show consistent earnings growth but don’t sell at overly high valuations. The main goal is to avoid the extremes of either growth or value investing; this typically leads GARP investors to growth-oriented stocks with relatively low price/earnings (P/E) multiples in normal market conditions.
GARP investing was popularized by legendary Fidelity manager Peter Lynch. While the style may not have rigid boundaries for including or excluding stocks, a fundamental metric that serves as a solid benchmark is the price/earnings growth (PEG) ratio.
The PEG shows the ratio between a company’s P/E ratio (valuation) and its expected earnings growth rate over the next several years. A GARP investor would seek out stocks that have a PEG of 1 or less, which shows that P/E ratios are in line with expected earnings growth. This helps to uncover stocks that are trading at reasonable prices.
In a bear market or other slump in stocks, one could expect the returns of GARP investors to be higher than those of pure growth investors but fall short to strict value investors who generally purchase shares at P/Es under broad market multiples.
How does GARP work?
The basic formula for finding GARP is the price/earnings growth ratio (PEG). The ratio divides a company’s current P/E ratio by the earnings growth rate and is designed to measure the balance between growth and valuation.PEG optimal PEG ratio is one or less.
For example, let’s say Company ABC is trading at $70 per share, and its earnings per share (EPS)forecasted to grow at +20% for the year.
ABC’s P/E ratio is ($70/$7 = 10), and its PEG ratio is (10/20 = 0.5).
The PEG is less than one and makes ABC a good candidate for GARP.
Does GARP matter?
GARP seeks to avoid the disadvantages or drawbacks possible with pure growth and pure value stocks. Growth stocks can form a bubble by rising highly and crashing very fast while value stocks can go nowhere. By finding the GARP middle ground, investors seek to enjoy rising prices without being vulnerable to a price crash.
That said, GARP stocks can underperform growth stocks in a growth market and underperform value stocks in a value market. However, GARP can outperform in mixed markets and over the longer term.
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