Stock investing strategies
GARP investing was popularized by legendary Fidelity manager Peter Lynch. Growth at Reasonable Price (GARP) is a combination of both growth and value investing. While a growth strategy is more focused on a company’s earnings growth and value investing seeks companies having their prices below their intrinsic value, growth at reasonable price as a strategy, hunts for stocks that have both a growth potential and are also trading at a reasonable price. A typical GARP investor seeks to invest in companies that have had a positive performance over the past few years, and also have positive projections for the upcoming years.
What Is an Ideal GARP Stock?
In fact, the ideal GARP style stock would be one with above average growth potential in earnings and revenue for the future, greater than its peers in its industry group, but would also happen to be trading at a value or lower price than its fundamental analysis valuation target.
A GARP investor would buy stocks that are priced lower (but not as low as possible) than their fundamental analysis target but that also have good future prospects of growth in cash flow, revenue, earnings per share and so on. In other words, a GARP investor tries to find stocks that will rise in value for two specific reasons:
- Stock is priced under valuation target: One, if a stock is priced under its fundamental analysis valuation target, then over time, the stock should rise to that consensus target of what it is intrinsically worth, or its intrinsic value.
- Stock has above average earnings potential: Second, if the stock has above average potential for earnings or revenue growth in the future, then the price of the stock should rise as the company grows in value, makes more sales, and increases its revenue and earnings per share in the future.
PEG and ROE ratio- The benchmarks for a GARP investor.
A solid benchmark to spot a GARP stock is PEG ratio or price/earnings growth 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.
Another ratio that’s relevant for a GARP investor is the Return on Equity percentage. Finding companies that have a consistently high ROE generally shows that you are dealing with good management and a strong business.
GARP is all about finding rapidly growing companies that are available for low PE multiples. If an investor gets it right, this strategy could yield multi baggers in due course of time because of two factors. One, the growth of the company and its per share earnings would increase over a period. Two, because it shows sustained growth over many years, its price to earnings ratio would get re-rated.
- A GARP investor will have a hybrid investment style that allows for some of the principles of a value investor and some of the principles of a growth investor-Truly the best of both worlds.
- In value investing, one might miss a potentially good quality stock trading at reasonable valuations; one is more likely to spot the opportunity under the GARP style of investing.
- Owing to the strategy employed by GARP, an investor is more likely to see his returns to be more stable than those of either a pure growth or value investor.
- In a bull trend, it is the growth investor who will stand to benefit the most, followed by GARP and value investor.
- In a bear run, the growth stocks will see big falls in their value than the GARP or value stocks.
- Thus irrespective of the market movements, the GARP investor would strike the golden mean. His investments would yield reasonable returns
GARP is a balanced approach to investing. It tends to combine the positives of value and growth strategies. A GARP investor wants a stock that’s not priced too high or too low, but one that is slightly priced lower that perhaps it should be and that also has good prospects for future growth– but not so much that the stock is overpriced or the future projections are too high.
In a nut shell….
Growth investors, invest in companies that exhibit signs of above-average growth. They don’t mind if the share price is expensive in comparison to its actual value. ‘Signs of above-average Growth’ is what growth investors try to spot. These signs gets revealed when you study the fundamentals. This is the exact opposite of ‘value investing’ approach. In a nutshell, the difference between ‘value’ investing and ‘growth’ investing lies in the methodology adopted by the investors. While the value investor looks for undervalued shares, the growth investor looks for shares with higher growth potential.
What exactly is ‘growth’?
Benjamin Graham defined a growth share as a share in a company “that has done better than average in the past, and is expected to do so in the future.” Any company whose business generates significant positive cash flows or earnings, which increase at significantly faster rates than the overall economy, can be categorized under ‘growth’. A growth company tends to have very profitable reinvestment opportunities for its own retained earnings. Thus, it typically pays little to no dividends to stockholders, opting instead to plow most or all of its profits back into its expanding business. Software companies are examples of growth oriented companies.
What’s the concept all about?
Investors who follow this strategy look for companies that exhibit huge growth in terms of revenues and profits. Typically, this set of investors looks for those in sunrise sectors (those in the early stages of growth) hoping to find the next Microsoft. A growth investor may look into the past year’s data to recognize the past growth rates and based on his studies about the industry’s potential and company’s prospects; try to estimate the future growth of the company. Investors look to spot a company that grows at minimum 15% annually. If a stock cannot realistically double in five years, it’s probably not a growth stock. That’s the general consensus. This may seem like an overly high, unrealistic standard, but remember that with a growth rate of 10%, a stock’s price would double in seven years. So the rate growth investors are seeking is 15% per annum, which yields a doubling in price in five years.
What does a Growth Investor look for in a stock?
Low dividend yields, high price-to-earnings ratio or high sales-to-market capitalisation ratio or a mix of all. For identifying stocks with high potential, growth investors look at key variables such as rate of growth in per share earnings over the last five-10 years, expected growth in earnings over the next five years or so, operating and net profit margins and business efficiency. A growth investor would target a company that’s growing at 15%-40% year on.
On a macro level, factors such as the stage in business cycle in which the industry operates, its relative attractiveness, and the positioning of the company in the competition matrix form part of the investment analysis. They then look at the current price and determine if it reflects the growth potential of the company’s business.
Growth – the risky strategy.
As growth investing often involves taking exposure to companies that trade at high valuation levels, the downside risk is relatively high. Sometimes, owing to their unproven business models, these companies could be sensitive to changes in market movements and business cycles.
Is a sky rocketing share a growth share?
Not necessasarily. Share prices can move up due to various reasons including fraudulent practices. High price is never a criteria for spoting a growth share. What matters is the rate of growth in the past years and the future prospects of the industry in which the company is in.
What are the sources to find Growth shares?
The best method is to do your own research. Most growth stocks can be spotted in the small cap and mid cap indexes. It is the growth rate that finally makes them large caps. Try to spot new companies that come up with innovative ideas – for example in medical Pharma industry. Watch companies that have grown from small cap to mid caps. Watch companies that breach all time high levels. Investigate why the prices sky rocketed. You may also validate shares of Industries that are currently facing market overreaction to a piece of news affecting the industry in the short term and try to spot one.
Is this approach popular?
Yes. If warren buffet is popular for his value investing strategies, Peter lynch is one of the greatest growth investors. Both he strategies are being used by investors according to market conditions worldwide.
What are the Pros and cons of Growth investing?
- Pros:The biggest advantage of this approach is Potential for incredible returns in a short period of time
- Cons:On the negative side, these shares carry the potential for huge losses.
- Market downturns hit growth stocks far harder than value stocks.
- Failure to relate the stock price to the company value leads to purchasing overvalued stocks
- Hot stock tips, rumors, hype, and market hysteria are not reliable sources of information to act upon
Which is better? Value or growth?
Both has its pros and cons as mentioned in our lessons. In value investing, the investor has to ensure correct stock valuation as well as the right time of entry – both being equally vital as he would not like to get too early into a stock.
In growth investing, it is essential for the investor to identify businesses that face little threat of erosion so that earnings growth of those companies is not impacted. Growth investors are generally in for short time frame compared to value investors. In general, value stocks tend to hold up better during stock market downturns.
An investor having a high-risk appetite is more likely to choose a growth strategy. While a defensive investor would choose to take the value investing route.
In a nut shell….
In ‘Value’ investing approach, Investment decisions are made based on the basis of valuation of a share. That is, the ‘Actual value’ of the share is found out by certain calculations and the figure you get is compared with the current market trading price. If the particular share is undervalued it signals a good investing opportunity and if the share in question is overvalued, it is better to stay off from investing in that share. Whenever a share is undervalued by the market, analysts call them ‘value shares’. This is the strategy of investing is followed by masters such as warren buffet. Value investing is discussed in detail in a separate chapter.
Where did value investing come from?
Value investing was started by a man named Benjamin Graham. (1894 -1976). He was Warren Buffet’s mentor and author of some great investing books. He is considered to be the father of Value Investing.
What’s the concept all about?
Investors that follow this strategy believe that there are two values to a stock. The current market price (which is influenced by market forces and investor sentiments) and the ‘actual’ or ‘fair price’ (called intrinsic value). Value Investors actively look out for shares of companies that they believe have been undervalued by the market – that is the current market price below the intrinsic value.
But why should a company’s share price be less or more than what it is really worth?
The answer is – The market overreacts to good and bad news, causing sharp movements in prices that do not correspond with fundamentals of the company. This results in stock price movements that do not correspond with the company’s long-term fundamentals. The result is an opportunity for Value Investors to profit by buying when the share price is low.
What does a Value Investor look for in a stock?
The Value Investor looks for stocks with strong fundamentals – including earnings, dividends, book value, and cash flow – that are selling at a bargain price, given their quality. The Value Investor seeks companies that seem to be incorrectly valued (i.e. undervalued) by the market and therefore has the potential to increase in share price when the market corrects its error in valuation.
Value investors collect certain Financial and Non-financial datas about the company, and by using those data, they derive at a conclusion as to whether the share price is undervalued or not. Typically, they look at stocks with high dividend yields, high book value or low price-to-earnings multiple or a mixture of all three. It basically fundamental analysis.
Value – the defensive strategy.
Value investors focus on the inherent strengths/weaknesses of individual companies and as such market gyrations and macro-level changes do not matter to them. The ‘margin of safety’ approach ensures that the downside risk to investment is limited. However, value investing should be applied with caution. Everything that appears cheap may not be a good bargain.
Is a low priced share a value share?
Value Investing doesn’t mean just buying shares in a company where the price is declining. It’s important to distinguish the difference between a value company and a company that simply has a declining price. A sudden drop in the share price of the company does not mean that the share is selling at a bargain. The drop in price could be a result of the market responding to a fundamental problem in the company.
What are the sources to find value shares?
The best method is to do your own research. Those who do not have time may try to locate them from the indexes or from 52 week lows list. You may also validate shares of Industries that have recently fallen on hard times, or are currently facing market overreaction to a piece of news affecting the industry in the short term and try to spot one.
When can I find value shares?
Anytime. You have to keep analysing selected companies one by one. But it’s hard to find value bargains in a bullish market. Value investors go on an investing spree when the markets are down. They stay away from the market when everyone’s in and they enter the market when everyone’s washed out.
Why is this approach not used by everyone?
Only very long term investors can use the value investing approach. The reasons are –
- The length of time that may be required to find a target
- Once invested, an investor should probably hold for years to come. This means that an investor needs to have enough capital to not be forced to sell a holding for other reasons
- An investor who follows and operates this method needs to have considerable patience. Waiting on the sidelines for a long time (probably many years) or holding on to an investment for a long time (sometimes a decade!) before proving your skill is not an easy trait to display
- Value investment is a method of analysis that is very logical and rational and therefore rather seductive to potential investors. But the extreme dedication required to actually practice it makes it a method that is only really used by professionals.
Are value stocks the best way to ensure capital preservation in equities?
By their very nature as deeply discounted “on sale” securities, value stocks are safer than most other equities. If you pick the wrong stock, you don’t lose as much as other investors because the stock is already scraping bottom.
At times, the fall in a stock’s price may be on account of impending events such as a change in industry dynamics that are not captured in its current financials. Investors who buy such a stock thinking it to be a value pick may end up with a dud.
What are the Pros and cons of value investing?
- Pros: Less risky approach.
- “Hot” stock tips, hype, and mass hysteria do not affect the decisions of a value investor.
- Produces steady, consistent gains that regularly outperform the Market Index
- Cons: On the negative side, the potential returns for value investing are smaller than those of growth investing
Technical investing is the exact opposite of fundamental investing. The word ‘technical’ is used because, this school of stock analysis believes that all the fundamental factors that affect a company would be reflected in the share price at any point of time. The price movement is purely technical and has nothing to do with the fundamentals of the company. If this assumption hold true, then there is no need to analyse the stocks fundamentally. So, what remains to be analysed is the demand and supply levels of the stock. For this, a technical analyst has something called ‘price charts’ in which the daily price movement of the stock along with the volume is recorded. This school believes that emotions, reactions, and psychology of individuals regarding economic events and news influence the demand and supply of stocks and in turn, it is that demand and supply forces that keep the market ticking.
- Category: Stock investing strategies
- Point Blank
- Financial Discipline for all.
- Investing Basics
- Shares & Stock Markets
- Introduction to Financial Statements
- Financial ratios.
- Stock investing strategies
- Technical Analysis I
- Technical analysis II
- Before Picking up stocks..
- Choosing a Broker and opening Demat Accounts
- Make your debut !!
- More ... from stock markets.
- Valuation of shares
- Futures and Options - The basics.
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