Monday, June 23, 2008


GARP (Growth At a Reasonable Price) investing is an offshoot of the growth investing principles propounded by Philip Fisher and T Rowe Price. It involves identifying rapidly growing companies that are available for low PE multiples. If an investor gets it right, this strategy could yield multi baggers in due course of time because of two factors. One, the growth of the company and its per share earnings would increase over a period. Two, because it shows sustained growth over many years, its price to earnings ratio would get rerated.

One of the leading practitioners of this investment style, Peter Lynch, often looked at businesses which manufactured products that he liked and used. An aspect of his investment style involved going to shopping malls with his family to check out the brands that were doing the best sales. Then he would research the companies that owned these brands and come up with options for investment.

An important aspect of GARP investing is the PEG ratio. This is the ratio of the PE multiple of the company to its average growth rate in EPS over a period of 3-5 years. For small companies that are growing rapidly, a PEG of 1 is considered suitable for investment in the Indian context. Here rapid growth rates are seen in a variety of businesses and an investor can find many companies quoting at PEG of 1 and below. Are all these companies good buys on the basis of GARP? To determine that, an investor needs to look at the sustainability of that growth. For example a company growing at 25 % per annum for the past three years and quoting at a PE ratio of 15 may be a buying candidate if an investor can satisfy himself that the business can sustain growth rates of at least 15% if not 25 % over the next few years.

How does an investor ascertain that? Therein lies the art element in investing. He looks at the business prospects of the industry in which the company is operating, the brands it owns, how well its products are doing in the markets, its loyalty among buyers, service track record, capacity additions it has planned and the quality of its management.

A risk in employing GARP investing is that high growth and low PE businesses are available mostly in the small and midcap space. By nature these companies do not have the staying power to overcome prolonged adverse market cycles. This risk can be mitigated to an extent by selecting companies which have been around for some length of time and have demonstrated their ability to weather difficult conditions. Large cap companies can be considered buying opportunities at a PEG of 1.25.

Let's try and apply this methodology to the BSE Sensex. The Sensex is expected to deliver earnings of 970 for FY 08-09. In the past the Sensex earnings have been growing at 25 % per annum. Since a slowdown is expected due to inflation, crude prices and other factors, let us assume that the Sensex will grow at 15 % in future. Since India is among the top five markets in terms of market cap in Asia, it is analogous to a large cap company. Therefore, it deserves a PEG of 1.25.

Price/Earnings/Growth = 1.25

Price (Sensex) = 1.25 x Growth x Earnings
= 1.25 x 15 x 970
= 18180
So, when various analysts say that India at a PE of 17 is expensive compared to other emerging countries, they fail to take the growth rates into account. PEG normalises the PE ratios by adjusting for growth.
Brazil's GDP growth rates for the past 6 years are given below:
2003 1 %
2004 -0.2 %
2005 5.1 %
2006 2.3 %
2007 3.7 %
2008 4.5 %
Average GDP growth over 6 years = 2.73 %
The PE ratio of Bovespa was 16.8 as on 31.05.08.
Brazil being a commodity driven economy, these growth rates are in an era of high commodity prices. Even in such conditions adverse to it India has clocked a GDP growth of 8 % over 6 years. What would happen if commodity prices were to correct, as is widely expected? Therein lies the genesis of my arguments that long term investors should buy Indian stocks at present levels.


Uma said...

That's a well-researched argument in favour of Indian stock valuations. But as they say, we're both 'preaching to the converted'. Only value investors will listen to each other at this point of time. Others will find their own reasons to stay away from markets or take part in the carnage.
I've realized one thing, Mahendra.
Even if you aren't afraid to invest now, DO, DO capitalize on the fear of others. Don't jumo in too soon.

Uma said...

jumo = jump sorry for typo

Mahendra Naik said...

Point well made Uma & thanks for the suggestion. I am only investing a part of my cash and that too adding in small lots. With every fall I'll try to add more. In case of a sharp bounce back I plan to cash in & if it does'nt bounce back, well I've got a good stock in my portfolio.

Uma said...

mahendra, it's hard now to even visualize how we stayed up so long after the P-note unwinding. It's only now we're starting to realize how little liquidity there is.

But I've noticed another thing...Speculators follow investors...not the other way around. Long before the bull run that took Nifty to 6000, around 3 years ago money started pouring into Indian markets from overseas....that's when the foundation of the bull run was laid. I stil can't much cash these operators have, how much they must have lost...Mahendra, it's a foregone conclusion that it was the concerted action of a few operators that was keeping Nifty around 6000. What else could have driven our markets into a free-fall so suddenly huh? What was the trigger? There was no external trigger.

Another thing that I've been wondering about is that, while valuations matter, we must also take into account the speculator activity.

Why do we have a fertilizer company such as Nagarfert at PE over 80, when TataSteel keeps crashing, with its PE around 4??

The price of just Reliance is kept at this level to serve as a sort of benchmark...but where's the rest of Nifty? Years behind, in terms of valuations (but not in terms of profitability.)

India is selling at a throw-away price. And the biggest trigger was the P-note unwinding. You know something Mahendra, Indians found India AFTER the smart fund managers overseas found us. That's what I mean by speculators follow investors.

Where are domestic investors now? What are they waiting for? Truth is, they were never there, nor are they waiting to come back.

Look at the companies they keep asking about on the biz channels. Typical speculative counters.

Mahendra Naik said...

You're dead right, Uma. That's a great summation on how Indians in particular and investors in general behave. I think, most of the times it pays to be a contrarian. JUst look at someoneone shorting at 20,000 or buying infy at 1350 or innumerable such examples. I know you don't get the exact bottom or top, but in general you know the trend and as a strategy go against the trend. I read an interesting book where the author describes an investor who converted $ 2000 in $ 1 Mil by following a simple strategy of buying the Dow when the dvd yield on the Dow went to over 6% and sold his entire holding when it went below 3 %. Of course it took him 30 years to do so but still awesome results.


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