GARP Investing

What is Growth at a Reasonable Price (GARP)?

Growth at a reasonable price (GARP) is an equity investment approach that combines features from both growth and value investing. The main philosophy of GARP investing is to seek companies that exhibit strong earnings growth potential while at the same time avoiding those that are overpriced. In order to identify the stocks that are trading at a low price relative to their growth potential, investors would typically use metrics such as the Price/Earnings to Growth (PEG) ratio. The strategy aims to strike a balance between the high potential returns that growth companies offer and the lower price (and in most case risk as measured by market volatility) of value stocks.

What is a GARP Strategy?

The Growth at a Reasonable Price strategy was popularised by the prominent fund manager Peter Lynch, who was at the helm of the Fidelity Magellan Fund in the 1980s. Blending strong growth prospects and reasonable valuations proved to be very efficient and he managed to deliver and average return of 29.2% per annum during his tenure, nearly doubling the S&P 500’s 15.8% over the same period (NASDAQ).

To better understand the philosophy of GARP investing, investors need to be familiar with the fundamentals of both growth and value investing. Below are some of the key essentials for both.

Growth Investors

This strategy aims at identifying stocks that are expected to grow at an above-market rate. Such companies usually reinvest earnings to fuel further expansion rather than paying distributing dividends to the shareholders. Growth investors purely focus on capital appreciation, betting on the firm’s future ability to generate profits instead of current share price. This typically is a higher risk approach as such firms’ share price can be volatile, but in return offer higher potential upside.

Value Investors

On the other hand, value investors focus on opportunities that the market has underappreciated due to temporary issues such as missing earnings targets or change in leadership. To identify those companies, investors use metrics such as the Price-to-Earnings (P/E) or Price-to-Book (P/B) ratios. Buying value stocks that are trading below their intrinsic (or fair) value creates profit opportunities in the case of a company turnaround. However, cheap companies often allude investors by paying above-market income to investors which also create a risk of a so called “value gaps” (referring to companies with bleak future that may never improve and return to their historic price levels).

So, blending these two styles together leaves investors with a balanced portfolio showing both opportunistic and defensive features. This approach is also more independent of the different economic cycles and while for example it may not keep up with aggressive growth peers during a phase of economic expansion, it would also not underperform to the same degree as them during a market decline.

What is the Formula for Uncovering GARP Stocks?

Among the most popular filters that GARP investors use to screen the stock market is the Price/Earnings to Growth (PEG) ratio. It divides the company’s valuation (as per its P/E ratio) by its expected earnings growth over the next year (or more).

To put this into practice, let’s say a company is currently trading at $20 per share. It expects to earn $2 per share this year, which is 10% more than the previous year. Its PEG ratio would be 1 (10/10=1).

What is a Good Price to Growth Ratio?

Typically, a GARP investor would consider a PEG ratio of 1 (which shows that P/E ratio is in line with the expected earnings growth) or less to be attractive. Research published by the CFA Institute found that on average, 38% of all stocks exhibit a PEG ratio below 1, which leaves plenty of opportunities for stock selection. The below chart shows how that number has evolved over time – clearly, during periods of market stress that number goes up due market sell offs and reduction in valuation multiples.

From a sector perspective, consumer discretionary has been one of the areas that feature quite a few companies that fit the GARP criteria. The sector consists of businesses offering non-essential consumer goods or services, for example high end clothing. In this space, GARP investors would focus on fast-growing companies in niche markets that have sustainable competitive advantages that can lead to higher returns on capital. Other popular segments for GARP investors include energy and information technology. Although the latter is typically perceived as a pure growth area, overreaction to corporate events could lower valuations and present buying opportunities.

For more guidance on sectors and performance, investors may use the S&P 500 GARP index, which seeks to track companies with consistent fundamental growth, reasonable valuation, solid financials and strong earnings power. Below is the most recent sector breakdown as of August 2024.

An Example of a Top GARP Stock

JD.com is a good example of a top GARP stock. The company is a leading supply chain-based technology and service provider. It offers an exceptional retail platform that seeks to enable consumers to buy anything anywhere. To boost innovation and productivity, the firm has opened its technology to third party brands and other sectors as part of its Retail as a Service offering.

The company has a PEG ratio of 0.58 and a P/E ratio of 9.81(Stock Analysis), both below the peer group average, while at the same time has shown a consistent historical long-term growth rate at above 60%.

Access the free download for GARP stock examples.

How to Use the GARP Strategy?

There are a few ways that investors can implement and use the GARP approach.

1. Self-select companies and build a GARP portfolio – this is the most difficult approach as it requires strong knowledge of the markets and different companies, along with the use of specific software. It also requires significant time resource.
2. Use a professional manager – this is a way more popular approach with both individual investors and asset allocators (i.e. professional investors that focus on asset allocation and outsource security selection to third parties). It allows for a team of expert investors to select GARP-like stocks and look after the ongoing monitoring and management of the portfolio. Generally, there are two possible routes to invest:
   1. Active funds – these are products run by portfolio managers and all investment decisions are at their discretion.
   2. An example is the JPMorgan U.S. GARP Equity Fund
   3. Passive funds – strategies that aim to closely track a market index, based on specific investment methodology and where no personal investment views are expressed
   4. Such fund is the Invesco S&P 500 GARP ETF

Conclusion

GARP is a popular approach to stock picking which essentially favours growth companies but also applies a valuation rigour. By blending both styles together, investors may achieve better risk-adjusted returns over the long-term. As this is a hybrid solution, investors would experience a combination of returns, unlike for example value investors, who are expected to outperform only when markets are falling.

Additional Resources

Price to Book Ratio

Growth Investing

Thematic Investing