What Is GARP Investing, And Is It For Me?

by: John Bay, CFA

Summary

GARP investing and value investing hybrid strategy.

How to execute a GARP strategy successfully.

Departure from traditional value to mitigate style-risk.

If you’ve found your way to this article, you probably already know what value investing is: a famous type of investment strategy started by Benjamin Graham, and followed closely now by disciples such as Warren Buffett, Seth Klarman, and Mohnish Pabrai. GARP investing is not so dissimilar to value investing, and I would argue that it is actually just a special case of value investing.

Specifically, value investing seeks to invest in “cheap” securities that are selling for below their intrinsic value. Price is what you pay, value is what you get, as Buffett famously says. That value is captured as the market realizes that a certain security should actually be trading higher, and starts to bid up the price toward its intrinsic value.

GARP investing does require that the same adage holds, that securities revert toward their intrinsic values. However, the main differentiator is that GARP stocks do not have to be “cheap” by historical, or sectoral standards. In other words, value investing pre-supposes that a good proxy for cheapness is by measure of statistical variation of a stock (whether by P/E, P/FCF, or P/B) about its historical mean, or about the current valuation of a sector of the economy. GARP investing does not make such a pre-supposition, and instead the investor assumes that such historical precedent may not be accurate going forward at all. This is how companies such as Amazon (NASDAQ:AMZN) and Facebook (NASDAQ:FB) continuously boast price-to-earnings multiples that are many times larger than that of the average S&P 500 company. Investors in these companies do not believe that their multiples need to be tethered to their own past, or to their sector in any predictable way. In essence, it would be foolish for any investor in Amazon to trick themselves into thinking this way – such thinking would also pre-suppose that Amazon or Facebook will never enter another line of business, say, for instance, groceries for Amazon and online dating for Facebook. Unfortunately for investors, reality is not static, and nobody has a crystal ball. GARP investing assumes that there are select investment opportunities in which the growth of a special company will continue to endure longer than the general investing public thinks it will. Essentially, a GARP stock is a naked call option on the uncertain, but optimistic future. Based on past patterns of management behavior, successful GARP portfolio company managers display, through their financial performance, a consistent initiative to make this call option increasingly valuable.

This might be ringing some alarm bells to readers. If you feel worried why anybody would invest in high-multiple companies, consider the fact that bankrupt companies typically ride the roller coaster down a P/E multiple before going to zero. In essence, the GARP investor is buying a stock that is enjoying record-high sentiment, and betting that the sentiment will keep going higher. In some cases, this sentiment is warranted, and in others, it is not.

There are certain key indicators that make specific glamour stocks more likely than others to work out as successful trades, or long-term investments. To point some out, they are 1) revenue growth 2) profit and operating margins 3) free cash flow 4) debt to equity ratio, and, finally, importantly 5) the resiliency of all the above. How these statistics change over time can tell you most of what you need to know about a successful future investment. Then, one must make a subjective judgment about whether the business models underlying these statistics are sound, and defensible (in other words, does it have a moat?)

For all of you income investors, be warned, this portfolio does not have a strict income mandate. There is a dividend rate attached with the portfolio, but this is purely by happenstance. I do not believe that dividends are the primary driver of outperformance over time (that is not to say that successful dividend investors don’t exist). I believe that truly great companies have exceptional reinvestment opportunities, and invest capital at a rate that far exceeds their cost of capital.

Finally, it’s important to keep in mind the portfolio context. Only a portion of the stocks I invest in are GARP companies. The other companies are traditional value investments. Therefore, within the broader context of a portfolio, the multiple is slightly below the S&P 500’s multiple. Also, since the strategy is a hybrid strategy, some of the money (roughly 40%) is invested passively in low-cost ETFs. These anchors help ensure that a period of drastic underperformance never occurs, and also helps to ensure there are no trading costs on this portion of the portfolio.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.