The New World According to GARP

Growth at a Reasonable Price or GARP investing began a long time ago. One of the early spotlight managers was Peter Lynch. He was an innovator and leader as he sought out growth companies that were fairly priced. Sounds like a simple plan, but good growth companies that are not already expensive can be hard to find in any market condition.

First, the attributes of GARP investing are typically firms with low PEG (price to earnings to growth) ratios and in many cases are undiscovered. Once discovered their multiples can perhaps be worth their growth potential to many investors, but not to GARP investors. We prefer to find the growing companies that are assigned a multiple based closer to today’s earnings, rather than a high PEG based on future expected growth.

Additionally, in the case of our investment process specifically, quality measures such as low debt for its industry, strong balance sheets and good operating margins are required before we screen for low PEG. Screening to create a custom universe of these firms is a great way to narrow the overall universe of stocks to further research and is an easy project most years. Add screens such as market cap minimums and maximum, liquidity and a few of your own and you are on your way. The usual down fall is finding too many seemingly qualified firms. Screener beware; do not get caught up in refining your screens to diminishing returns. Find some basics to provide you with a good solid list of stocks to research. From there, do your own thinking and choose a good selection of stocks.

Fast forward to 2009 and the task become impossible, well improbable. I state this because the vast majority of firms experienced negative earnings and revenue growth through much of 2008 and the beginning of 2009. If one is screening for one and three years net income growth in Q109 or Q209 they narrowed their universe to a very small list of companies. Few of these firms are likely to be considered real growth candidates.

The issue is that most firms were forced to retrench in this 12 to 18 month time period. Growth stopped almost universally and many firms contracted, some quite a bit. So what is a growth investor to do, and what is a GARP investor to do?

We understand, by studying history, that after a market meltdown there may be a market melt up. This year was met by an unprecedented melt up. Many prudent investors had trouble keeping up with the market as so many quality companies did not benefit from the markets meteoric rise.

Our investment team decided before the market turned around that we would redraw the lines of measurement to create our own new GARP definition. We gave every firm a free pass until 1Q09 earnings. We then shortened the timeframe from one or three year to quarterly/prior year max, with the caveat that sometimes what we would consider growth was really earnings that are less negative than a quarter ago. We also added in quality metrics for instant wheat / chaff separation. We then categorized companies in three stages of the new GARP definition:

• Stabilizing businesses; less negative earnings than last quarter.
• Stabilized business; about to break even or make a small profit. This usually signals a right sized business and more consistent revenue.
• Growing once again; albeit from the new base we have established.

One of our holdings Intel Corporation (NasdaqGS: INTC) reported better than expected earnings this week and its stock benefited the entire market. Its revenues and earnings numbers are still down from last year, but using the new yard stick we can own a company that is growing and indeed, management announced they predict a real return to growth.

It is not just tech companies that can fit this new set of conditions. Although these firms have yet to report this quarter Cummins Inc. (NYSE: CMI), BB & T Corp. (NYSE: BBT) and even Apple Inc. (NasdaqGS: AAPL) all have exhibited these new GARP qualities. Although these may not be undiscovered they still, for a variety of reasons, earlier this year made investors nervous. Each one of these firms had to press that GARP reset button to gain our consideration.

The investment strategy for success remains constant; the tactics for getting there evolves with the times. Over the next few years portfolio managers will revert back to their roots and much of 2008 / 2009 will be forgotten. I hope this generation and the up and coming investment professionals will remember all of the lessons of how we got into this down market, and the way to reestablish wealth for clients. Those who do not study history are destined to repeat it.

Disclosure: Mr. Corn is Chief Investment Officer – Equities of Beacon Trust Company. Through various equity strategies under his supervision he is currently long INTC, CMI, BBT and AAPL.