GARP Strategy: Explained [Growth At A Reasonable Price]

In our complex world of stock investing, finding a strategy that balances growth with valuation can be challenging. One approach that has gained significant traction among savvy investors is GARP, which stands for Growth at a Reasonable Price. This investment strategy merges the best elements of both growth and value investing. It aims to identify stocks with strong growth potential while ensuring they are not overpriced.In this article, we’ll learn how to create a custom filter in the Stock Engine’s Big Screener to filter GARP Stocks. You can also save this custom GAPR stocks filter in Big Screener so that you can access it easily the next time you log in to the Stock Engine (jump here to learn how to make custom GARP filter).GARP investing is rooted in the philosophy of Peter Lynch. GARP is a combination of growth investing and value investing.Pure growth investing: It focuses solely on growth rates regardless of their price.Value investing: It targets undervalued stocks based on financial metrics. Read more about value investors.GARP investing: It seeks a middle ground. It aims to capitalize on growth opportunities without overpaying for them. This way it optimizes returns while managing risk.Let’s explore the fundamentals of GARP investing and learn how we can apply this strategy to make better decisions.Topics1. What is GARP Investing?GARP, or Growth at a Reasonable Price, is an investment strategy designed to balance growth with sensible valuation. The core concept of GARP is to identify companies that exhibit strong growth but are trading at reasonable prices.1.1 What GARP Stands ForThe term “GARP” highlights the strategy’s dual focus: achieving growth while paying a reasonable price.Pure growth investors may overlook valuation in their quest for high returns. Similarly, value investors may miss out on high-growth opportunities as their focus is on valuations. But GARP investors seek a middle path. They look for stocks that offer a favorable balance between growth prospects and valuation.1.2 Key Principles of GARP InvestingThe key principles of GARP investing include:Growth Potential: Investing in companies with solid historical and projected growth rates. Read about stocks with sustainable growth.Valuation Discipline: Ensuring that the stock price reflects a reasonable valuation relative to its growth potential, often measured using metrics like P/E ratio and PEG ratio.Sustainable Growth: Focusing on businesses with a sustainable competitive advantage and strong fundamentals.[Read here to learn how to apply these rules in a stock screener]The concept of GARP investing was said to be popularized by Peter Lynch. Lynch’s philosophy emphasized investing in companies with robust growth prospects while maintaining a disciplined approach to valuation. He believed in the long-term potential of companies that demonstrated consistent earnings growth and strong market positions.The GARP strategy allows investors to capture growth opportunities without overpaying. It is a pragmatic approach to building a resilient investment portfolio.2. How to Identify Stocks with Growth PotentialIdentifying stocks with growth potential requires a keen understanding of certain financial metrics. One of the most telling indicators is the company’s historical growth rates. Consistent growth in revenue, profits, and earnings per share (EPS) are the two main indicators. Their growth over several years signals a company’s ability to expand its business effectively. However, past performance alone isn’t enough. It’s important to evaluate whether the company can sustain this growth.2.1 Historical Growth RatesAnalyzing historical growth rates is a critical step in identifying stocks with strong growth potential. It involves examining the CAGR of key financial metrics like revenue, profit margins, EPS, and free cash flow. CAGR gives a clear picture of how these metrics have expanded over time.A steady increase in revenue, for instance, indicates that the company’s products or services are in demand. Similarly, improving profit margins over the years suggest that the company has a pricing power.However, focusing solely on growth during prosperous periods can be misleading.It’s equally important to assess how a company has performed during economic downturns or industry-specific challenges. Companies that continue to show growth, or at least maintain stability, during tough times, are often those with strong competitive advantages. Such companies generally have unique products, strong brand loyalty, and prudent management. These are the companies that can weather the storm and emerge even stronger in times to come.By examining how a company has managed to sustain or even grow in tough times, we investors can gauge the strength of its underlying business fundamentals.2.2 Industry Trends and Market ConditionsUnderstanding industry trends and market conditions is crucial for identifying stocks with strong growth potential. A company’s growth prospects are closely tied to the health and trajectory of the industry in which it operates. Analyzing these trends helps investors anticipate future opportunities. The purpose is to select companies that are likely to thrive in the future.Industry Growth Drivers: Certain industries naturally have stronger growth drivers than others. For example, technology and healthcare are sectors that have shown consistent demand growth due to their essential nature and constant innovation. In technology, the rapid pace of digital transformation, the expansion of cloud computing, and the increasing importance of cybersecurity create a fertile ground for growth. Similarly, in healthcare, aging populations, advancements in medical research, and the rising demand for healthcare services ensure steady growth.Impact of Macroeconomic Conditions: It’s also essential to consider how broader economic conditions influence industry performance. For instance, interest rate trends, inflation, and government policies can have a significant impact on sectors like real estate, banking, and manufacturing. During periods of economic expansion, cyclical industries such as consumer discretionary and industrials often perform well. Conversely, in a downturn, defensive sectors like utilities and consumer staples may offer better protection due to their stable demand.Emerging Trends and Innovations: Companies that are innovation leaders or are strategically positioned to capitalize on emerging trends and hence offer superior growth potential. For instance, the shift towards renewable energy presents significant opportunities for companies in the clean energy sector. Similarly, the rise of e-commerce and digital payments has revolutionized the retail and financial industries, creating new leaders and transforming traditional business models.Competitive Positioning within the Industry: A company’s position within its industry is another critical factor. Market leaders who command significant market share or possess a strong brand often have the resources and influence to set industry standards and capture emerging opportunities. These companies are more likely to benefit from industry growth and can often sustain their competitive advantage over time.Case Study: HDFC Bank and Other Prominent ExamplesHDFC Bank is a standout example when discussing growth potential in the Indian market. Over the past two decades, the bank has consistently delivered impressive financial performance, making it a preferred choice for long-term investors. What sets HDFC Bank apart is its ability to maintain a strong growth trajectory while navigating various economic cycles.One of the key factors behind HDFC Bank’s growth is its relentless focus on expanding its customer base. The bank has not only increased its number of branches and ATMs but also embraced digital banking early on. This innovation in digital services has allowed HDFC Bank to cater to a broader audience.Another crucial aspect of HDFC Bank’s success is its strong credit profile. The bank has managed to maintain low NPAs despite aggressive growth. This discipline in lending practices has helped HDFC Bank build a reputation for financial stability, which attracts both retail and institutional investors.Other companies like Asian Paints and Bajaj Finance have also demonstrated remarkable growth over the years.Asian Paints has capitalized on its market leadership and brand strength to expand its product offerings and reach new markets. The company’s ability to innovate in product development and marketing strategies has kept it ahead of competitors, ensuring steady growth.Bajaj Finance, on the other hand, has shown resilience by diversifying its financial products and expanding its customer base across urban and rural markets. Its strategic expansion and focus on customer-centric services have allowed it to achieve consistent growth, even in challenging market conditions.3. Building A GARP Strategy Stock ScreenerGARP is a blend of both growth and value investing. It aims to find stocks that are undervalued but also have strong growth potential. The main idea is to balance the risk of overpaying for high-growth stocks. It is done by focusing on those stocks with a reasonable price relative to their growth prospects.3.1 Key Elements of GARP Strategy:Growth Metrics:Earnings Growth Rate: Look for companies with a consistent and sustainable profit growth rate, typically around 15-20%.Revenue Growth: Strong and consistent revenue growth is a good indicator of a company’s ability to expand.Valuation Metrics:Price-to-Earnings (P/E) Ratio: While growth investors may accept high P/E ratios, GARP investors prefer them to be lower, typically below 20, depending on the industry.PEG Ratio (Price/Earnings to Growth Ratio): The PEG ratio is crucial in GARP investing. It compares the P/E ratio with the expected earnings growth rate. A PEG ratio of around 1.2 or lower is often considered ideal.Quality Metrics:Return on Equity (RoE): A higher RoE indicates efficient use of equity capital. Look for companies with RoE consistently above 15%.Return on Invested Capital (RoIC): This metric helps gauge how well a company is using its capital to generate returns. A higher RoIC often indicates a strong competitive advantage.Financial Health:Debt-to-Equity Ratio: Lower debt levels reduce financial risk. A D/E ratio below 0.5 is generally preferred.3.2 Creating a Stock Screener for GARP Strategy:To create a stock screener theme based on GARP, you can use a combination of the following criteria:Earnings Growth Rate (EPS Growth): Set a filter for companies with a 5-year EPS growth rate of 15-25%.Price-to-Earnings Ratio (P/E Ratio): Filter for stocks with a P/E ratio below 20.PEG Ratio: Set the PEG ratio filter at less than or equal to 1.2.Return on Equity (RoE): Include companies with a RoE of 15% or higher.Return on Invested Capital (RoIC): Include stocks with a RoIC of 10% or higher.Debt-to-Equity Ratio: Filter for companies with a debt-to-Equity ratio of less than 0.5.Market Cap: Depending on your focus, you can include a filter for small-cap, mid-cap, or large-cap stocks (I generally avoid this filter lineitem to identify GARP stocks).Example:If you set up a screener with the following values:5-Year EPS Growth: ≥ 15%P/E Ratio: Below 20PEG Ratio: ≤ 1.2RoE: ≥ 15%RoIC: ≥ 10%Debt-to-Equity: < 0.5This screener will help us you identify stocks that are not only growing but are also available at a reasonable price. It aligns with the GARP strategy.It is an approach that allows us to filter companies with solid fundamentals and growth potential. But we are also making sure that we are not overpaying for the growth. It’s a balanced way to capture the best of both value and growth investing strategies.3.3 Where to apply these filters?You can apply the above filters to screen stocks that satisfy these criteria. However, the issue is that there are hardly any Indian stock screeners who can do such a detailed screening. Our Stock Engine can do this task for you. Navigate to the new updated Big Screener and apply the above screening parameters.ConclusionThe GARP strategy transcends the traditional boundaries of growth and value investing. It embraces the notion that investing is not just about numbers but about understanding the stories behind those numbers.GARP encourages investors to look beyond surface-level metrics. It urges us (stock investors) to seek companies with strong fundamentals, sound management, and sustainable growth trajectories. This strategy is particularly relevant in today’s dynamic markets. These days, our adaptability and forward-thinking are crucial to generating alpha from our stock portfolio. Read about alpha and beta of investment portfolios.By focusing on reasonably priced growth, GARP investing aims for substantial returns and aligns with a philosophy of prudent, long-term wealth creation.It’s about recognizing that true value lies in the intersection of potential and caution. This way it can offer a roadmap for investors who wish to grow their wealth without succumbing to the risks of speculation or the pitfalls of undervaluation.Have a happy investing.Suggested Reading: