How to hunt for GARP stocks like an investment legend

In our recent review of the strategy styles that paid off in the first half of 2015, it was Growth investing that led the pack. In particular, it was those strategies that appeal to both growth hunters and value investors that proved to be some of the strongest performers. ‘Growth at a reasonable price’, or GARP investing, is a hallmark of some of the world’s best known finance legends - and it’s finding a sweet spot in the current market conditions.

Investors like Peter Lynch, Thomas Rowe Price Jr., Jim Slater and Jason Zweig forged their reputations by hunting down high growth companies without overpaying for them. While their favoured ratios and metrics differ slightly, the thrust of the strategies is the same.

Rapid and persistent earnings growth

Chief among the rules is a track record of earnings growth. In his book One Up on Wall Street, Peter Lynch, the ex-Fidelity fund manager, is emphatic about the importance of earnings. “If you can follow only one bit of data, follow the earnings... I subscribe to the crusty notion that sooner or later earnings make or break an investment in equities.”

Earnings growth was also a central tenet of an approach used by the late American investor, Thomas Rowe Price Jr. Back in the 1930s he earned a reputation as the ‘father of growth investing’ with a strategy that looked for a long-term rising trend in earnings per share (EPS). Stockopedia’s modelling of that strategy - which looks for above-average compound earnings growth over three and five years - has generated a 15.2% return during the last six months.

For the late US money manager Martin Zweig, EPS growth was also crucial. Our modelling of his approach is more specific than Rowe Price. It looks for firms that achieve compound earnings growth of greater than 15% over three years. It’s a strategy that has returned 12.3% in the UK this year - and an impressive 21% in Europe.

Growth at a reasonable price

Beyond earnings growth, GARP investors typically look for companies with below-average valuations. Often, that means using the price-to-earnings (PE) ratio as a yardstick for cheapness. Two growth investors that took that further were Peter Lynch and Jim Slater. They applied differing versions of something called the PEG - or price-earnings to growth rate - to measure the relationship between value and growth.

The aim of the PEG is to buy growth at an acceptable price. Traditionally the PEG divides the trailing PE ratio and by the forecast EPS growth rate. Slater put his own twist on the calculation by using the the forecast PE instead. In each case a PEG of less than 1 suggests that a company is growing EPS faster than its price-to-earnings ratio. As a result it can be a pointer to growth stocks that aren’t on the sorts of nosebleed PE multiples that can be susceptible to dramatic falls if investor confidence is shaken.

In his book The Zulu Principle, Slater explained: “Finding shares like these will ensure that you have the maximum chance of capital appreciation, and will at the same time provide you with an important safety factor.”

Stockopedia’s tracking of the Slater screen has returned 9.7% over the past six month. But the Lynch strategy - which has demanding rules and therefore fewer stocks - has underperformed the market and suffered through 2014, too.

Screening for GARP shares

To get an idea of the sorts of small-cap companies currently showing strong growth characteristics, we set up a screen using the GrowthRank. This scores and ranks companies using five individual measures, including historical and forecast earnings and sales growth. Each company needed a rolling PEG of less than 1x, together with positive relative price strength over the past year.  

Don’t forget, you can dive into the Growth Rank using the StockRank portal. Just select Growth Rank from the drop-down menu and simply add you own sectors and size rules.

These rules produce a varied mix of stocks, with airline leasing company Avation achieving the highest GrowthRank, at 99 (out of 100). It’s followed by fast growing London-focused housebuilder Telford Homes and telematics business Trakm8 Holdings (Paul Scott reviewed Trakm8’s recent final results here). Other telecoms and technology businesses on the list include Telit Communications, Iomart, and Sepura.

Also qualifying with a high GrowthRank and low PEG is Tasty, which runs a fast growing chain of restaurants under the DimT, Wildood and Wildwood Kitchen brands. The strongest price performer over the last year is electronics manufacturer, Solid State. Meanwhile, stocks including online marketing firm XL Media and support services company Restore, have been (and may continue to be) holdings of Mark Slater - the son of Jim Slater who runs the highly regarded MFM Slater Growth Fund.

Go-go growth - but watch the risks

While some of the world’s most highly regarded investors have made a name for themselves by netting spectacular returns from growth stocks, it can be a risky approach. Strong sales and earnings growth that becomes excessive can end up killing small companies that overstretch themselves. And while the PEG can be a line of protection against overpaying for growth, frothy prices can still leave investors exposed to sharp falls if the growth stalls. But there’s no doubting it’s an exciting strategy that targets what can be the most dynamic companies in the market. As always, in depth research is vital.

You can find out more about the StockRanks here. If you aren’t yet a site member get started at Stockopedia here.