The market is characterised by both growth and value investors looking to buy companies that can outperform the market. Growth and value styles play out during different time periods. For instance, value stocks have made a comeback in the last two years.
Growth At Reasonable Price (GARP) is an investment philosophy which blends both – growth and value.
One can invest in structurally strong companies that are termed as good quality companies. A good quality company is a company that has reached a minimum scale in terms of revenue, has gone through at least one downcycle and emerged as a stronger company, has a consistency in cash flows and higher Return on Capital Employed over the last 10 years.
The second aspect has been to always own companies which are market leaders in a particular domain. We have over a period of time seen that market leaders generally tend to come back stronger with higher market share after a downturn as weaker players usually vanish in the downturn. While a good track record (quality) of a company is a necessary condition, it is not sufficient to be included in the portfolio. We seek to satisfy ourselves about the following:
(a) The ability of the company to grow its sales and profits over the next 3-5 years
(b) The ability of the company to do this without consistently resorting to additional external funding
(c) The track record of the management in capital allocation, and in treating minority shareholders fairly
A GARP-centric portfolio in the long term should offer superior risk-adjusted returns through its very nature of not overpaying for growth, at the same time participating in growth of the investee companies.
By combining the best attributes of both value and growth investing, GARP philosophy could yield superior long-term returns. As part of the investment process, we have filters for including a stock in the investment universe (High Return on Capital Employed, or RoCE, low leverage, positive operating cashflows, better governance) etc. Many of these measures would help us avoid big mistakes, thereby contributing to performance.
The returns made in a stock generally consist of two components:
· The ability of the company to deliver earnings growth in the future
· The stock is reasonably valued, which gives the chance of a PE re-rating
We consistently focus on companies that can grow their earnings faster with a potential to double Earnings Per Share (EPS) in 4-5 years. This is easier said than done, as predictability of earnings over a 5 year period is reasonably challenging. The portfolio construction process entails a framework, where the probability of this happening is more likely. Risk management comprises of positive cashflows, low leveraged balance sheets (Net debt: Equity < 2) and no major corporate governance issues in the past.
Price/Earnings to Growth
One example of GARP philosophy which we incorporate in our thought process is the PEG Ratio. The valuation followed in the strategy is PEG, where P/E is divided by the predicted earnings growth over the next 3 years. This ensures that, every business, whether strong structural businesses or cyclical commodities, moves through a common denominator framework and inevitably reduces the Affect Bias.
Markets tend to swing between excesses of both optimism and pessimism – wherein we see growth at any price and emergence of excessive value consciousness as well. GARP helps avoid extreme overpricing as well as avoiding value traps.
Surjitt Singh Arora is Portfolio Manager - PMS, PGIM India MF.