The World According to GARP
Courtesy of Matt Sauer, MWSWNB Investments:
- GARP is not a free lunch.
- Yesterday's growth is not always a prelude to tomorrow's growth.
- P/E Ratios are not mean reverting.
Although the desired outcome of equity investments is defined by the scorecard, there are also definitions of the process. Value and Growth are the long-held descriptions in the industry while over time adjectives such as deep and aggressive have added punch to the nomenclature.
Investors usually have a reason why they prescribe (or succumb?) to a philosophy on how to beat the market. Their first job, a book read, a class in school all are potential catalysts for the inevitable line drawn in the sand regarding philosophical alignment.
Value investing usually incorporates the philosophy of reversion to the mean suggesting that today’s beaten down stocks will be revalued upwards as the market evaluates their intrinsic value. The other style is comprised of growth stocks which are often viewed as tickets to investor’s nirvana; the next Microsoft, Apple or Starbucks.
Market cycles create a dynamic tension with these two styles as they drift in and out of favor with investor preferences and economic forecasts of GDP growth, interest rates, oil prices as well as recent performance of the style.
Many traditional investment counselors and concentrated mutual fund managers have adopted the style that is known as GARP or Growth at a Reasonable Price. A desire to own “good businesses” but not be labeled as a reckless buyer of growth securities, this name is intended to act as a safe harbor for managers trying to demonstrate common sense to their client base. The marketing message is always the same: our portfolio has better businesses than the market with less risk which is defined in this case as leverage. The universal distinction of the GARP portfolio is that it has lower leverage, higher growth and a p/e multiple that is lower than the recent past where it was unsuitable for this group of prudent investors.
The pitch that investing in today’s superior businesses will guarantee tomorrow’s outperformance is simply a false assumption. The marketing pitch from the GARP manager is always the same: we have always wanted to buy this stock, but it has always been too expensive. They never mention the investor on the other side of the trade declaring they have always wanted to sell this stock after a long run of outperformance. Buying yesterday’s performance has its pitfalls.
We will investigate GARP investing from two angles; academic theory and statistical practice:
Significant amounts of research have been produced to investigate the observation that high beta stocks underperform the market. In this context it is assumed that high beta is due to the growth characteristics and not leverage or other factors. (The writer acknowledges that many stocks have low betas in their growth period because they do not exhibit much cyclicality because of consistent market share gains or an end market that is developing and rapidly growing.) The growth stocks of yesterday are the GARP stocks of today.
The market reduces current P/E multiples on stocks due to a changing view of the future. Management changes, supplier constraints or general economic malaise are all examples of why multiples become lower at any given time. Relative multiples are the benchmark for GARP investors and there is no siren song like that of a long-term outperforming growth stock that has suddenly become “cheap” on a relative basis. We have heard investors describe a list of stocks that they want to own at the right price. This is an assault on all academic research but more than that it is an equal assault on common sense. The prospects of businesses change consistently with the inputs of the Porter model, due to the effect of capitalism. Suppliers, customers, competitors and suppliers are the hallmark of the Porter model and while they change constantly the big new force known as disruption looms large as well. The economics of a business do not provide the S&P 500 with a static pool where the cohorts can be evaluated in a vacuum. To paraphrase Jerry Seinfeld- “its dynamic and its spectacular”. Yesterdays wish list is tomorrows neglected stock.
The slope of the CAPM line is consistently too flat and an explanation has been the constraints on investors due to the lack of borrowing capability as a conduit to increasing risk, the theory suggests that high beta stocks are bid up by risk hungry investors.
In the case that these stocks underperform the market in a bull market there is a tendency to believe that the stocks are relatively cheap. This comparison can be magnified by the P/E cycle of cyclical stocks. As these equities approach peak earnings their P/E multiple contracts and they look relatively expensive (albeit faster growing) than the traditional GARP stocks.
GARP stocks are the fallout of the outcome of investors paying too much for growth too late in the growth curve. As the expectations of growth slow due to competition, market saturation or increased costs the multiple of earnings paid by the market starts to fade. It is not yesterday’s growth at a discount but simply today’s growth discounted.
When a GARP stock is bought by a value investor looking to buy “quality” there is often an investment thesis that includes a higher exit multiple than the purchase price. Ignoring the fact that this exercise almost always justifies the purchase price, there is a reason to reconsider the thesis. The Price/Earnings Ratio does not exhibit normally distributed values because it does not go to negative territory thus it is a lognormal distribution without a mean.
If the P/E multiple is not mean reverting than what exactly is it? Well the lognormal distribution places it in the domain of the Pareto distribution or the often used 80-20 rule. As we have previously discussed the performance of the S&P 500 is winner take all as 20% of the companies make up all of the value creation over time. The thesis should not involve whether the multiple is going to revert to the mean but the probability that this particular stock is part of the 20% that will create value. This changes the discussion from the outcome (the P/E multiple) to the inputs (value creating assets). Isn’t that where we should have been all along?
--Matt Sauer, MWSWNB Investments. Originally published here.