GARP Investing: Golden or Garbage?
Value vs. Growth
With their thousands of employees, suites of products, international reach, and legendary histories, General Electric (GE) and Amazon are true corporate empires. Of course, GE’s fortunes have lately been in decline while Amazon’s are ascendant. But the stocks of these two companies stand for more than just the old versus the new; they also represent a face-off between two investment styles: Value and Growth.
Most investors are inclined toward Value, a preference backed by ample academic research. But these days, picking GE, which trades at a significantly cheaper valuation than Amazon, would be challenging for most investors. The company has structural issues that are reflected in a declining share price and a slew of negative news stories, all of which would give one pause when considering the stock. Amazon has no such dilemmas and is decimating entire industries, secure in its status as the most valuable company on the planet.
Some investors have sought to bridge the Value–Growth divide through a hybrid strategy, opting for the growth at a reasonable price (GARP) approach popularized by Fidelity manager Peter Lynch. But if Value creates positive excess returns, as the research demonstrates, then Growth does largely the opposite, which would seem to cast doubt on GARP’s underlying logic. So how do GARP strategies perform in the US stock market?
Definitions of GARP stocks can vary but are generally based on the price/earnings (P/E) to growth ratio (PEG), which divides the P/E ratio by the growth rate. In our analysis, we derive the PEG from the P/E ratio from the last 12 months of earnings and the three-year growth rate of earnings. Stocks that exhibit a PEG ratio below 1 are classified as GARP stocks. We focus on all US stocks with market capitalizations greater than $1 billion. Indices are rebalanced monthly, each transaction incurs costs of 10 basis points (bps), and stocks are weighted by their market cap.
Analyzing GARP Stocks
GARP stocks are selected by a combination of earnings growth and valuation. The idea is to identify those that sit somewhere between GE-like Value traps — cheap stocks with a bleak future — and overhyped and overvalued Growth stocks reminiscent of Amazon. Accordingly, we find that the earnings growth of GARP stocks is significantly above that of the market.
Three-Year Earnings Growth: GARP Stocks vs. All Stocks
Not only do GARP stocks show higher earnings growth than the market, but they also have lower valuations. The analysis shows median rather than average P/E multiples, which explains why the benchmark P/E multiples of all stocks are less extreme at certain periods — for example, during the tech bubble in 2000 — than in similar capital market research.
Valuation (PE Multiples): GARP Stocks vs. All Stocks
Does the stock market provide a sufficient number of companies that are growing earnings while trading at reasonable valuations? We find that, on average, 38% of all stocks exhibit a PEG ratio below 1, which is more than enough for security selection.
Stocks in the US Stock Market with PEG below 1
Broken down by sector, GARP stocks compose a relatively diversified universe. Some sectors, like financials and consumer discretionary, contribute more stocks relative to the benchmark of all stocks, while telecoms, utilities, and real estate contribute less. The latter three are asset heavy, exhibit only low earnings growth, and tend to trade at high P/E multiples given their bond-like features, so their PEG multiples rarely fall below 1.
GARP Stocks: Breakdown by Sector
GARP Stocks vs. the Stock Market
Investor interest in Value and Growth is driven by a desire to outperform the market. GARP stocks have indeed outperformed substantially since 1989. But that can be explained in part by simply excluding stocks with negative earnings. The PEG ratio calculation requires stocks to have positive earnings. When negative earnings stocks are filtered out, then the GARP stock outperformance declines substantially.
GARP Stocks vs. the US Stock Market
GARP — More Like Value or Growth?
Since GARP combines Value and Growth investing, we can benchmark GARP stocks to their Value and Growth counterparts. Here we define Value as a combination of price-to-book and P/E multiples and Growth as a combination of the three-year sales and earnings growth.
According to the analysis, a GARP approach seems to extract the best of both investment styles. Between 1989 and 2001, GARP and Growth outperformed Value, especially during the tech bubble between 1999 and 2001. However, when the tech bubble imploded and Growth started to underperform Value significantly, GARP stocks behaved more like Value stocks.
GARP vs. Growth and Value Stocks
This data demonstrates that GARP was an effective strategy since 1989, though how effective depends on the time frame. If we rebase the portfolios in 2000, then a pure Value portfolio would have worked better. Rebase the portfolios in 2010, and the market would have generated the highest annual returns, especially if negative earnings stocks are excluded.
GARP Performance across Different Time Periods
Fusing Value and Growth has an intuitive appeal but is somewhat at odds with academic research.
Our results suggest a GARP approach can generate enviable results, although how enviable depends on the observation period.
Perhaps the strategy’s key benefit is forcing investors to adopt a systematic framework so they can allocate to exciting growth stories — the rising Amazons — albeit only when they are trading at reasonable valuations.
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9 thoughts on “GARP Investing: Golden or Garbage?”
Thanks for the insight.
Pour ma part, j’aime le smart beta alternatif de valeur et rendement pour facteurs sur le marché français.
Depuis 14jan2019 je fais 16%.
Thank you for the interesting research. One question I would pose in response is what the definition of value investing is?
Value investing to me is about buying something at a price that is attractive relative to your view of value, which may be based on future earnings (sustainable or growing), underlying assets or scarcity / strategic value. So is GE great value? I haven’t done the work but with talk of negative cashflow in a mature business, I expect the question is wide open. But buying a business that has a strong position from which to grow earnings rapidly at a price that leaves scope for multiple expansion as well – that sounds like more convincing value to me.
Thank you for the article Nic. Very interesting indeed. A couple of questions.
– Same as Pretty above, how do you define value stocks?
– For the returns on the different strategies, how is this calculated. Is it from a buy/hold stand point or would you buy at a low PEG and then sell it off at a higher valuation.
– Why would valuations on growth stocks tend to be lower than the rest of the universe of stocks? Which is surprising to me. All the growth stocks in my radar have very high valuations.
if a stock has low growth rate but the investor expect its growth to be long term, its p/e can be high. competitive advantage will make format the expectations of the investors. if the investors think that the competitive advantage of a stock is hard to destroy, the investor will ready to pay high p/e for a low growth stock. Microsoft will have high p/e because investor think that its competitive positioning is hard for its competitor to overcome.
what is the research in the article ?. I think all about stock is not numbers, but about competition.
For those who are interested in what value investing is, I suggest you all to refresh on Graham’s Security Analysis and Intelligent Investor. True value investing is an exercise to combine market multiples, balance sheet strength, cashflow analysis and your due diligence on where you think the company will be given the ongoing changes in its operating environment. As far as I remember, Value started with buying companies that below their liquidating value (trading below net working cap), and the rule had relaxed somewhat over time. To me, value is how much the company is worth, assuming there is no growth (aka PVGO = 0) and how predictable the cashflow is because the quality/predictability is then back into the discount rate. So higher the quality, lower the discount rate, and so higher the price multiples.
GARP seems to do well when capital is abundant and cheap , and many companies can pursue whatever strategies they want to maintain the growth targets. These activities aren’t all value additive, and you can see the goodwill in many corporate balance sheets ballooning. Then once the volatility returns, you are killed by earnings and multiple contractions. From personal experience, GARP works only when you manage the portfolio actively, and by actively, I don’t mean trade, you just havet o stay on top of all things that affect your “g” when you lean heavily into the PVGO, and the list is long.
Thank you for the article. As Warren Buffett said: “In our opinion, the two approaches (value and growth) are joined at the hip: Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive.”
I have one question. Is it reasonable to assume a PEG ratio of 1x for the market as historic mean or median? Like PE 15x for the S&P 500? Thanks
thank you, very interesting article
could you shed some more light on how you select the portfolio?
your GARP seems like value names filtered by growth… the garp etf which has done very well seems to be more growth filtered by value.
it is 2019 as i write this ………. i believe some of the huge tech names are good GARP stocks these days. FB? GOOG? AAPL? but not sure of your parameters i.e. does the p/e have to reasonable independent of growth?
Thoughtful and useful content