Finding Growth At Value Prices

By Aaron Levitt | June 12, 2013 AAA

Given just how far the broad stock market indexes like the SPDR S&P 500 (ARCA:SPY) have swooned over the last few years, many investors are concerned about putting new money to work into equities. Quite bluntly, there is a general fear about overpaying for stocks. Unlike during the dark days of 2009- when almost all stocks were at super bargain levels- today it's becoming much harder to determine what makes a good buy versus a poor one. Price to earnings (P/E) ratios for a broad range of sectors and industries are now trading above historical averages.

That’s a big issue considering that bonds and cash are paying virtually next to nothing. Luckily, investors do have an investment style that attempts to bridge the gap between finding value and growth.

SEE: Stock Picking Strategies Tutorial: Introduction

Growth At A Reasonable Price
Investors looking for both value may want to get to know GARP and no, we aren’t talking about the John Irving novel. GARP or growth at a reasonable price investing was first popularized by famed Fidelity Magellan Fund (FMAGX) portfolio manager Peter Lynch. The investing style essentially blends both growth/value metrics. GARP followers will screen for companies that are showing consistent earnings growth above broad market levels- the main tenet of growth investing. Then they will exclude stocks that trade for very high valuations- value investing. Lynch credited the investing with helping him achieve, his 29% average annual return (AAR) over a 13-year stretch- from 1977-1990- and gain the title of the world's best fund manager.

While not as rigid as some forms of investing, GARP followers usually point to one metric in their quest to find stocks. The price to growth ratio or PEG is a measure of a company's P/E ratio and its expected earnings growth rate over the next few years. For GARP investors, a lower PEG is better and traditionalists would seek out stocks that have a PEG of 1 or less. A PEG of 1 shows that P/E ratios are in line with expected earnings growth. By focusing on firms with a lower score, investors are able to uncover stocks that are trading at reasonable prices relative to their projected earnings growth.

Traditionally, GARP stocks, such as water heater manufacturer AO Smith Corp. (NYSE:AOS) aren't particularly exciting, but represent growing, cash flow heavy businesses. If the markets continue their recent bout of up & down or float sideways for a while, GARP could be a superstar strategy for investors.

SEE: How To Choose The Best Stock Valuation Method

Creating A GARP Portfolio
Since the closure of Russell’s GARP ETF at the end of 2012, investors looking to implement a growth at a reasonable strategy for their portfolios have had to run their own screens and research. The new Barron's 400 ETF (ARCA:BFOR) hopes to eliminate that. The fund uses a series of screens- including growth, value, profitability, and cash flow metrics- to pick the constituents for the index. That causes the Barron’s 400 to essentially be a GARP portfolio. Holdings include AZZ incorporated (NYSE:AZZ) and LeapFrog Enterprises (NYSE:LF). Over the last five years, the Barron’s index has managed to produce an annualized total return of 7.7%. That compares to just a 5.5% gain for the S&P 500 and a 6.6% gain for the Dow Jones Industrial Average.

For investors wanting to go the Do It Yourself approach, running a simple stock screen with low PEG and P/E ratios can be the starting point for further research.

One such firm that meets the GARP criteria could be heavy machinery superstar Caterpillar (NYSE:CAT). The marker of dump trucks, back-loaders and farm equipment has fallen on hard times lately as China’s economy begins to slow. However, the firm is still minting cash and seeing explosive growth elsewhere in the emerging world. CAT shares currently trade for a P/E of 7.24 and PEG of only 0.87. Likewise, smaller rivals Oshkosh Corporation (NYSE:OSK) and Manitowoc (NYSE:MTW) feature low P/E’s and even lower PEGs.

SEE: Economic Indicators That Do-It-Yourself Investors Should Know

The Bottom Line
With the markets continuing to move in an upwards manner, finding bargain is becoming harder and harder to do. In an attempt to bridge growth and value style investing, growth at a reasonable price or GARP may be just what a portfolio needs. Stocks like oil refiner Marathon Petroleum (NYSE:MPC) -with its PEG of 0.74- along with the proceeding picks are good examples of how to add GARP to a portfolio.

At the time of writing, Aaron Levitt did not own shares in any of the companies or funds mentioned in this article.

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