Lifting The Lid On The Best Performing Guru-inspired Strategy Over Five Years

25th May '18 by Ben Hobson

15 comments 10494 reads

When it comes to investing in growth stocks, there are two types of investor. There are those relaxed about paying high prices for the promise of rapid growth. And there are those who hate the idea of overpaying and take valuation seriously.

Over the past three years, Fever-Tree Drinks has been an excellent example of what it means to pay a high price for growth. The high-end mixer and soft drinks business floated at the end of 2014. But its shares have never looked cheap against standard valuation ratios. With a current PE ratio of 73, it’s got the kind of rating that would have value investors choking on their G&Ts.

Yet you won’t hear too many complaints from investors who actually bought Fever-Tree stock over the past couple of years. Fever-Tree has been a consistent over-achiever, smashing analyst growth forecasts at almost every turn. Its share price has soared as a result - paying off superbly for the growth investors prepared to bet that Fever-Tree could (and can) keep delivering.

There are similar examples with varying degrees of extreme prices. Over the past five years stocks like ASOS, Just Eat, JD Sports and Domino’s Pizza have all, at times, offered the promise of future growth but demanded a high price for it.

Sadly, however, stunning success stories like Fever-Tree don’t come around very often. When they do, the powerful momentum that builds in their share prices can deliver stunning returns. But that momentum also means they are prone to sudden drawdowns if (and when) the growth story slows down. This happened at ASOS and JD Sports, and it’s precisely why many growth investors take valuation so seriously.

Growth at a better price

Growth at a reasonable price (GARP) investing was made famous by a fund manager called Peter Lynch. He produced stunning returns while running the Magellan fund for Fidelity Investments (he later wrote the book One Up on Wall Street). In the years that followed, the late Jim Slater introduced a similar growth approach to the British investing masses in his book, The Zulu Principle.

In essence, GARP strategies look to balance a track record of earnings growth with a moderate valuation in stocks that are usually good quality and may already have caught the attention of the market.

At Stockopedia, a screen that models these factors…

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Nick Ray

25th May '18

Curious thing is that if you turn off the two P/E-related rules you will also pick up stocks like Games Workshop (LON:GAW) Burford Capital (LON:BUR) Advanced Medical Solutions (LON:AMS) NMC Health (LON:NMC) and Rentokil Initial (LON:RTO) which are also excellent performers. The latter three also seem to have excellent stable long-term behaviour too.

I am increasingly finding that the valuation-based ratios (the P/ ones) have very little selective power. Although it is obvious that value must be taken into account somehow, I find that adding more than one kind of Quality-based ratio works better than adding a Valuation-based ratio.

I'm not sure why this is but I have a suspicion that markets these days are very efficient. So value-based mispricing is relatively rare or short-lived. As a consequence valuation-based selection will only find short term mispricings (or maybe hunting for mispricing is harder than simple screening can do), whereas Quality-based selection finds stocks with longer legs, especially if at least one rule is based on a 3y or 5y outlook.

PhilHofGrowYourDough

I am increasingly finding that the valuation-based ratios (the P/ ones) have very little selective power. Although it is obvious that value must be taken into account somehow, I find that adding more than one kind of Quality-based ratio works better than adding a Valuation-based ratio.

It's PEGR for me!

iwright7

26th May '18

Coincidentally earlier this week I was looking at the impressive Stocko 5Y GARP graph https://www.stockopedia.com/sc... and thinking that I should re-read Smarter Stock Picking, listed as the reference; which incidentally is one of the few books recommended by fellow GARP investor Robbie Burns/The Naked Trader https://www.stockopedia.com/sc...

I have looked at the GARP chapter again this morning and it reiterates your point about the difficultly in finding Value mispricing and thus the appeal of Quality/Growth/Moats. Indeed the author cites Buffett and Munger:

....His partner Charlie Munger reminded him that simply bottom fishing was proving an increasingly difficult exercise as the amount of money he managed exponentially grew in size. Both Munger and Buffett concluded that there just weren’t enough sufficiently cheap shares for the vast amount of money under their management. Better, Munger suggested to Buffett, to switch their mutual attention to finding solid, decent, quality companies with great businesses where earnings were steadily rising.

Another Munger gem (who at 94, claims he is a better investor now than he was at 50), from this year’s Berkshire meeting; “...You have to keep learning … what you formerly knew is never enough.” How True. Ian

https://www.intelligentinvesto...

Mechanical Bull

Mark Minervini pretty much ignore the P/E ratio, at least when he is buying. He argues that if want to buy a stock that really moves, you want to buy a Ferrari and they do not come cheap. However, he will monitor the P/E ratio after buying. If the ratio moves up too quickly, then this is a sign that the valuation is becoming over extended and acts as a flag to exit the position.

AnonymousUser252054

'the gold mining business Griffin Mining'

Just to note that Griffin Mining (LON:GFM) is predominantly a zinc miner.

Andrew L

29th May '18

PEGR? You mean P/E to Growth Ratio? So you would search by PEG? However, how do you determine if growth is long-term in nature? Growth could just be a temporary earnings rebound. What about quality do you look at that?

I think valuation like P/E doesn't work as you are comparing apples with oranges. A homebuilder on a P/E of 6 is very different to say Domino's Pizza. One is cyclical and the other has secular growth.

The trouble with P/E is that last year's or this year's earnings are not necessarily and indication of the long-term earnings. For a cyclical company this is very much the case. Last year's earnings also do not highlight risk or quality.

It is probably best to screen for other things and then add a valuation overlay. Looking at the GARP screen above and some issues are potentially evident. Screening for cheap companies tends to throw up low quality sectors/companies.

Plus 500 - A number of questions on the quality of this company. They are riding the bitcoin boom at the moment but how long will that last?
CMC - A similar business. The leader in this area is IG Group.
Griffin Mining, Ferrexpo - Clearly cyclical businesses.
Persimmon - one of the highest quality home builders. But also a cyclical sector.

Without having a long look it is clear that the GARP screen in this instance may have thrown up "cheap for a reason" stocks. Even if these stocks do ok long-term it is clear that many of them don't offer secular growth. They offer cyclical upswing type growth, which is much less valuable.

Cyclical upswing or low quality growth stocks offer great returns until the point that they don't. So in my view, you have to be very careful about investing in them. These are not exactly by and forget stocks in the main. An issue with GARP in my view is that it will tend to drag up low quality sectors and cyclical growth stocks. The higher quality secular growth stocks will be too expensive to fall into the screen.

What you really want is not necessarily GARP but price relative to long-term potential. Recent earnings growth can be an indication of long-term potential but this isn't necessarily the case. Some companies can produce earnings momentum for a few years and then competition takes hold and they have issues. Or they may be cyclical in nature.

The most valuable companies have secular growth such as Unilever (emerging markets). These will never appear cheap and the top-line growth and earnings growth is modest. However, the growth is also consistent and long-term. This is very valuable. By contrast will Plus 500 be doing well in 15 years? It is hard to say. Many of its growth drivers appear to be transitory in nature (bitcoin etc). However, I haven't looked closely and online gaming is a growth area.

I mean risk adjusted P/E to Growth Ratio. See ... https://www.stockopedia.com/co...

However, how do you determine if growth is long-term in nature?

I don't. I look for stocks exhibiting growth in FY 1 & FY 2 estimates, normally > 3% over last 3m ideally 5% over last 3m. A low risk adjusted PEG (PEGR in screener). Remember I'm a farmer rather than a stock picker. I invest in a cluster of stocks exhibiting the same characteristics knowing some will fail but most will succeed. I don't need to worry about some not working out.

Growth could just be a temporary earnings rebound.

Indeed.

What about quality do you look at that?

All of my stocks are high quality. My strategy is high QM. I've never been quite able to engage with a VM strategy, but each to their own.

Here's my 3% screen

TheWatchmaker

Hi Phil,
Thanks for sharing that screen - Looks useful, I'll butcher it to suit my preferences/biases.

I have also transitioned to using QM approach after realizing that I don't have the patience or skill-set to be very successful using a Value based approach - too many traps that I don't see soon enough.
The Hill and Smith Holdings from your screen fits many of my conditions - high Quality and Momentum Scores, and upward earnings revisions - but I think it needs double figure growth to justify a higher valuation, and without that I won't invest.
I often use the Guru Screens to highlight new investment ideas - GARP / CANSLIM / 52wk High Momentum - all these screens prove good hunting grounds for my investment style.
Cheers
Geoff

robinleggate

31st May '18

I am concerned that dividends are excluded in your comparisons of investing styles. " (where the portfolio is rebalanced quarterly and costs and dividends are excluded)".
A share like Persimmon, with a yield of 7.9%, will actually have performed much better than one like Ashtead, with a yield of only 1.6%.
So a screen that picks out high yielders will automatically seem inferior to one with very low dividends but higher share price growth, though the two screens may have produced the same result.

MattSellwood1982

Ummm….the Price Momentum screen is currently showing a 630% performance over 5 years. Is that right?

GrahamF

The point is well made, we must not ignore dividends.

With regard to the two stocks you mention, Thomson Reuters total return data as at 1 May 2018 is as follows

Persimmon

1 year. 28%
2. 52
3. 88

Ashtead

1 year. 27%
2. 132
3. 90

So not much to choose between the two over 3 years, but in other cases the high yield share may have done better.

Rusty2

1st Jun '18

Yes fair point, I think dividends should be included in the guru screens, does not make sense with certainly the income screens. Re Persimmon (LON:PSN) they did not pay a dividend for a number of years, if there is a downturn in the housing market then that could happen again.

Growth at a Reasonable Price screen is best performing guru screen in the UK but in Europe the Tiny Titans is better, 380% over 5 years, Canslim is 300% and Growth at a Reasonable Price is only 176%.

Brigra

Given how consistently successful Tiny Titans has been in UK and Europe, I was surprised to see it languishing in last place (yes 66th out of 66!) in Asia at -7.6% annualised.
GARP currently comes in at 12th, with a healthier 33.4% pa since inception.

Brian

Lifting the lid on the best performing guru-inspired strategy over five years

Growth at a better price

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Ben Hobson

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