Growth at a Reasonable Price: Does it Make Sense for Value Investors?

Growth at a reasonable price

GARP, or growth at a reasonable price, is an investment strategy that seeks to combine the tactics of value and growth investing into one coherent strategy that an investor can use to select individual stocks.

Value investing is the process of investing in stocks that are trading at a discount relative to their intrinsic value. Growth investing is a style of investing where the focus lies squarely on identifying companies with above-average earnings growth.

Growth investing can be a complicated philosophy to adhere to long-term. A successful growth investor hopes that the companies they invest in continue to produce significant earnings growth. Otherwise, they will not realize a stable return. Unfortunately, there is little empirical evidence that strategies which rely on buying stocks with strong historical earnings growth tend to generate excess returns.

There are a few reasons why this is the case.

Markets tend to over price growth

The P/E ratio, price-to-earnings, is a means of understanding growth expectations. Investors expect companies with low P/E ratios to grow at lower rates than companies with high P/E ratios.

Research has shown that on average, low P/E stocks beat high P/E stocks. The excess return on low P/E stocks in the US is about 7-11%. Further research shows that the growth of total firm assets is also inversely correlated with total firm stock returns (Cooper, Gulen, and Schill 2009). Over a forty year period, it was found that low growth companies returned 20% more than high growth businesses.

See also: book value of a company

Investor exuberance is the problem here, as optimistic investors bid up the prices of high P/E companies, leading to overvaluation. If you pay too much, then you’ll make less money no matter how good the company is.

Mean reversion

Earnings growth shows the tendency to mean-revert. That means high earnings growth tends to fall and weak earnings growth tends to increase over time. In a paper by Debondt and Thaler (1989), the authors discovered that the stocks in the lowest price-to-book quintile they examined grew earnings faster than stocks in the highest quintile. Mean reversion suggests that the growth rates of all firms in the stock market tend to move towards the average.

Despite this evidence, there are still occasions when growth investing outperforms compared to a value-based approach. Growth investing tends to do well when earnings growth in the overall market is low, while value investing does better when earnings growth is high. In a high growth environment, it may be investors chasing after high-growth companies find that these businesses have simply reached the ceiling on growth and mean reversion takes over.

Another time when growth investing outperforms is when the yield curve is flat or downward sloping. In other words, at times when the difference between the yields on short-term and long-term bonds is small or negative, a growth investing approach is a better bet than a value-investing approach.

Enter GARP

A lot of growth investors would argue that their central strategy is not to buy high P/E stocks, rather they always include some element of value in their dealings. In other words, most growth investors are practicing some form of growth at a reasonable price, buying stocks with high historical earnings growth where the business is also undervalued for whatever reason.

To find such businesses, growth at a reasonable price investors implement a number of strategies.

PE less than growth

One of the simplest GARP strategies is to purchase shares in companies that trade at a P/E ratio less than their expected growth rate. So if a company like John Deere (NYSE: DE) has a PE of 23 and an expected growth rate of 9%, then it is overvalued.

PEG ratios

The PEG ratio is another approach to finding undervalued growth companies. An investor calculates the ratio of the PE multiple to expected growth rather than the difference.

If John Deere has a PE of 23 and an expected growth rate of 9%, then the PEG ratio is 2.55 (23/9). The rule of thumb is that an investor should invest if the =PEG ratio is less than 1, but this is similar to investing when “PE less than growth”, the only time the PEG ratio would be below 1 is when the PE multiple is lower than the growth rate. Instead, investors should invest in companies with the lowest PEG ratios relative to other businesses, even if they are greater than 1. The lower the PEG ratio, the cheaper the company is considered to be.

In his value investing book, Investment Philosophies, Aswath Damodaran examined how low PEG strategies fared versus high PEG strategies. He found that on average, investment in cheaper companies as defined by the PEG returned 3% more than the high PEG ratio stock portfolio.

There are some issues with the above approaches. Firstly, the PEG ratio does not take into account any uncertainty about the expected growth rate. It is possible for an investor to be fooled into investing in risky companies because of this, given that the market prices risky stocks “at a discount”.

Therefore a risky stock may slip through a PEG screener, prompting the analyst to think that the stock is an undervalued company, but is priced correctly for its inherent risk profile. The other issue lies with interest rates. When interest rates are high, it suddenly becomes easier to find undervalued growth stocks.

To succeed at investing using a GARP method, investors will have to account for and adapt to the weaknesses inherent in GARP strategies. For these investors valuation rests on growth, so it is imperative that prospective GARPers work to refine their estimates of expected growth constantly.

Growth at a reasonable price becomes fashionable every once in a while when classical value stocks are hard to find. Most of these times, it is better to stay consistent with your own strategy rather than trying to incorporate a growth investing mindset.