Wednesday, September 7th, 2011
a reasonable price

One investing approach is summed up in four letters:  GARP (growth at a reasonable price).  That description is widely used — and when used it’s assumed that we’re all talking about the same thing.  For this next chapter of a series on investment styles,the research puzzle | This index will be updated as further postings are completed. we’ll examine some ways in which that might not be the case.

But first, a question:  Does one go looking for a GARP manager?  When you read about searches for managers by institutional investors, you don’t see ones for “a GARP manager,” but rather for attributes related to market capitalization and definitions of growth/core/value.  If GARP is an overarching philosophy that works, shouldn’t we be seeking out those that can do it well?  (That’s a question that can apply to other strategies that don’t fit the standard manager grid.  Are they incorporated as we stumble upon them or is there a better way to build around them?)

GARP is one of those styles that spills across boundaries.  It’s billed as a way to combine the strengths of growth investing with those of value investing, with that phrase “a reasonable price” providing the hope that the manager won’t fall in love with growth because she’s watching out how much she pays for it.  I’ve also seen the phrase applied in other ways, such as in “momentum at a reasonable price,” which is an interesting concept to consider, although MARP sounds funny to me.

There are a couple of ways to differentiate GARP managers in addition to the capitalization bands in which they play.  First is that notion of “reasonable price.”  What does it really mean in practice?  Specifically, how does Manager A define it versus Managers B and C?  And how do those definitions shape the security selection process and the sell discipline?  What are the bounds of reasonableness?  How do they adjust in different market valuation regimes?  A careful examination of buys and sells and portfolio attribution should reveal critical differences among managers.

Most people equate GARP with the PEG ratio, so it’s at this point that I direct you to one of my most popular postings of the past, which talked about how “unpegged” the slavish use of that valuation measure has become.the research puzzle | This piece looks at the history of the PEG ratio and issues with how it’s applied.

That posting highlighted the sloppy growth rates used throughout the business that make PEG ratios and other growth-based metrics suspect.  So, the critical skill for GARP managers is not really the “reasonable price” that found its way into today’s title, but the ability to assess growth.  Without that, you have “extrapolation at a reasonable price.”  (Yes, EARP.)

Therefore, due diligence on GARP managers can focus mostly on their processes for analyzing and predicting growth, and it takes relatively few questions to determine whether a manager is doing anything remotely interesting or unique in the estimation of growth rates.  As with many other factors in investing, it’s not so much the precise level of anticipated growth that matters, but the rate of change and, especially, signs of reversal of past trends in growth rates.  Working off of consensus forecasts of growth is unlikely to lead to much if any analytical advantage.

Whether you are looking for a GARP manager or applying the principles of that approach yourself, the search for reasonableness should begin with growth, not price.  While careful valuation is important, if you get the growth wrong with regularity, nothing else will matter.