How does the GARP investment concept blend both the growth and value investing styles?

New Delhi: Both growth and value investors are eager to buy companies that can outperform the market in this market. Growth and value styles manifest themselves at different times. Value stocks, for example, have made a resurgence in the previous two years.

The Growth at Reasonable Price (GARP) investment strategy combines both growth and value.

Quality matters

Good quality enterprises with strong structural foundations can be invested in. A good quality firm is one that has attained a minimum revenue scale, has gone through at least one downcycle and emerged stronger, has consistent cash flows, and has a greater Return on Capital Employed (ROCE) over the last decade or so.

The second factor has been to always own companies that are market leaders in their respective fields. We have seen over time that market leaders frequently come back stronger and with a larger market share following a slump, but smaller players usually disappear. While a company’s track record (quality) is required, it is not sufficient to be included in the portfolio. We want to be satisfied with the following:

• The company's ability to increase sales and profits during the next three to five years.
• The company's ability to do so without relying on extra external capital on a regular basis.
• The management’s track record in capital allocation and treating minority shareholders equitably.

A GARP-centric portfolio should provide higher risk-adjusted returns over time since it does not overpay for growth while also participating in the growth of the investee companies.

The GARP philosophy may produce higher long-term returns by combining the finest characteristics of both value and growth investing. We have filters in place as part of the investment process to include a stock in the investment universe (high Return on Capital Employed, or RoCE, low debt, positive operating cashflows, stronger governance, and so on). Many of these techniques would help us prevent major blunders, improving performance.

The returns on a stock are typically composed of two components:

• The company’s ability to generate future earnings growth.
• The stock is reasonably valued, which suggests that a PE re-rating is possible.

We constantly choose firms with the potential to more than quadruple earnings per share (EPS) in four to five years. This is easier said than done, as predicting earnings over a five-year period is difficult. The portfolio construction process includes a structure that increases the likelihood of this happening. Positive cashflows, low-leveraged balance sheets, and no major corporate governance difficulties in the past include risk management.

Price/Earnings-to-Growth Ratio

The PEG Ratio is an illustration of the GARP concept that we use in our thinking. The technique employs PEG valuation, which divides P/E by the expected earnings growth over the following three years. This ensures that every firm, whether strong structural or cyclical, passes through a common denominator framework, hence reducing the “Affect Bias”.

Markets tend to oscillate between extremes of optimism and pessimism, with growth at any cost and the advent of excessive value consciousness. The GARP strategy assists in avoiding extreme overpricing as well as value traps.