What does GARP mean?

If you think pure growth investing is too risky but strict value investing is too boring, then GARP might be the investment strategy for you.

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What is the meaning of GARP?

Short for 'growth at a reasonable price', GARP is an investment strategy that tries to find the middle ground between growth and value investing. Investors who follow this strategy look for companies that display consistent, above-average earnings growth – but aren't already overvalued by the market.

GARP was popularised by legendary investor Peter Lynch, the former manager of Fidelity Investment's Magellan Fund. During the 13 years Lynch managed the fund, it returned an average of 29% each year.

The GARP strategy seeks to avoid the perceived pitfalls of both growth and value investing. For growth investors, the danger is that they will buy into a company's growth story without adequately considering its valuation – unconsciously contributing to share price 'bubbles' that can quickly burst, leading to substantial corrections.

On the other hand, value investors can spend lots of time researching and stock-picking for only small gains. Value investing often requires lots of analysis and frequent trading, and many investors may feel like the measly returns they earn don't justify the amount of time they put into executing the strategy.

This is where GARP comes in.

How does this investment strategy work?

Before diving into GARP, it's worth having a quick refresher on growth and value investing. We'll need a good understanding of both before fully explaining GARP.

Growth investing

Growth investors look for companies that have the potential to grow much faster than the rest of the market. By their very nature, these are usually junior or emerging companies that have yet to prove they can generate long-term profits.

This makes growth investing a high-risk, high-reward investment strategy. Only some of the stocks growth investors buy will succeed in the long-term, but the ones that do should deliver high returns to shareholders.

Value investing

Value investing is quite a contrast to growth investing. Investors who follow this strategy focus on companies with solid underlying fundamentals but that the market briefly undervalues. This means value investors usually invest in larger companies — including blue chips – with proven track records that have suffered a recent fall in share price.

A one-off bad result, negative press, or other short-term events may have caused the share price drop. As long as nothing about the company's underlying financials has significantly changed, value investors would see this as a buying opportunity. They would reason that the company's share price will shortly recover once whatever bad news is out there blows over, and they will be able to lock in a profit as a result.

Because value investing mainly focuses on more established companies, it is a lower risk than growth investing. However, this also means it is likely to be a lower return than growth investing, as these companies don't offer the same explosive potential of growth stocks.

Value investing also relies on an investor's ability to successfully 'time the market' by buying stocks when prices are low and selling them when prices recover. And while this sounds great in theory, it can be tough to do consistently in practice. It requires significant time and market knowledge on the part of the investor with no guarantees of success.

So, what about GARP?

GARP is a combination of growth and value investing. Just like a growth investor, a GARP investor will look for stocks that have the potential to grow quickly, but they will also make sure that these shares still offer good value.

For example, you might find a company that is growing its earnings hand over fist – but if it's a popular stock amongst investors, its share price may already be very high relative to its fundamentals. A growth investor might still buy the stock, but a GARP investor would likely ignore it, despite the company's growth potential.

This is because part of a successful GARP strategy is looking for bargains. This usually means GARP investors will select growth stocks with lower price-to-earnings multiples than their peers.

Price-to-earnings multiples

We calculate a company's price-to-earnings (P/E) ratio by dividing its share price by its annual earnings per share. This tells investors how much they are paying for a dollar of the company's earnings.

Fundamentally, the P/E ratio is a way of working out how expensive a company's shares are. It doesn't mean much on its own, but the P/E ratio can be useful for comparing stocks, especially those in similar industries.

For example, you might have a stock currently trading at $10 per share, with annual earnings per share of $2. Analysts would say this stock trades at a multiple of five times earnings because its share price is five times its earnings per share.

Popular growth stocks will often have higher P/E ratios because investors will bid up their share prices even though their earnings per share is low (or may even be negative). But this is because investors are buying these stocks based on their expectations of future earnings potential, which justifies the high prices they're paying now.

GARP investors steer away from companies with excessively high valuations, which means they are drawn to stocks with lower P/E ratios. This means they are cheaper than their peers, and GARP investors love a bargain.

P/E to growth ratio

Although there aren't many firm rules about how GARP investors select their stocks, one commonly used financial metric is the P/E to growth (PEG) ratio. This measures a stock's P/E ratio relative to its expected earnings growth rate over a given timeframe.

For example, let's say that a company trading at five times earnings was expected to grow its profits by 10% each year for the next five years. To calculate the stock's PEG ratio, we divide the P/E ratio by the projected growth rate, which would be 5/10 or 0.5.

A good rule of thumb for GARP investors is that a stock with a PEG ratio of less than one is undervalued, while a stock with a PEG ratio above one is overvalued. In our case, the company with a PEG ratio of 0.5 is undervalued by the market – meaning that an investor who picked up this stock is paying a relatively low price for that degree of earnings growth.

Examples of GARP share investments

GARP investing can be subjective, as there are no firm rules regarding stock-picking. Because it combines elements from growth investing, a GARP strategy often hinges on an investor's expectations about a company's future earnings potential. And where one investor might see a great opportunity, another might simply see a flash in the pan.

Some ASX contenders for GARP investments might include stocks like CSL Limited (ASX: CSL), NextDC Ltd (ASX: NXT) or Xero Limited (ASX: XRO). These are all companies with high growth potential but are also now established firms in their fields with solid fundamentals and significant revenues, and each has a sizeable market cap.

But if you want to take the hard work out of GARP investing, you can also buy units in an exchange-traded fund (ETF) which follows a GARP strategy. For example, the VanEck Global Healthcare Leaders ETF (ASX: HLTH) invests in global healthcare companies with the best GARP attributes.

An ETF is similar to a mutual fund but trades on the stock exchange just like ordinary shares. Investing in a fund like this means you can adopt a GARP strategy without having to do all the research and analysis yourself.

How to identify stocks to buy using GARP

As previously discussed, the PEG ratio is an excellent metric for identifying GARP stocks. This is because it tells investors the stock's value relative to its growth prospects. The lower the PEG ratio, the better the value. And these are precisely the types of shares a GARP investor is hunting for.

However, it's important to remember that the PEG ratio can be very subjective. It relies on expectations about a company's future earnings – and different analysts may have different opinions about its earnings potential. This can result in one stock having many different PEG ratios, depending on the analyst and the growth assumptions used in their modelling.

But there are no firm rules about how to go about implementing a GARP strategy, and investors can use other metrics to assess a company's stock. Investors will often use different metrics as 'screeners' to exclude certain shares from their list of potential investments. It will be screened out if the stock doesn't meet a certain threshold (for example, it has a PEG ratio greater than one).

Some GARP investors might use other profitability measures as screeners, like a company's net profit margin or its return on invested capital (ROIC). Others might prefer to use debt-to-capital ratios to ensure they only invest in companies with strong balance sheets.

Whatever the method, the overall goal is to buy good quality, growth-oriented stocks that offer the best value for money. Ideally, GARP balances the risk aversion of value investing with the growth-at-all-costs mindset of growth investing. By following this strategy, you can build a growing portfolio tailored to your risk appetite.

Benefits of investing in ASX GARP stocks

Some of the benefits of GARP investing are listed below.

Best of both worlds. Because GARP investing combines elements of both growth and value investing, it gives investors a chance to experience the benefits of each. You may be more risk averse than your average growth investor but still want more upside than pure value investing. Adopting a GARP mindset allows you to blend these two strategies to create a portfolio that meets your goals.

Tailored to your risk profile. GARP investing has no rigid rules, which means you can adjust it to suit your risk profile. If you are more risk-averse, lean towards growth-oriented large caps. On the other hand, if you're happy to take on more risk for greater potential reward, go a little heavier on the more speculative growth stocks.

Ultimately, the idea is to strike the right balance between growth and value that helps you best meet your investing goals and risk appetite.

What are the disadvantages?

As with any investment strategy, there are some disadvantages you need to be aware of.

Lower returning than growth. Although a GARP strategy aims to be higher returning than a strict value investing strategy, it may not deliver the same returns as a pure growth strategy. This is because a GARP strategy is lower risk than growth investing, so you give up some possible upside in exchange for safety.

It is subjective. Although GARP's flexibility can be a benefit, it also means there is no set group of GARP stocks. The most commonly used financial metric for GARP investors – the PEG ratio – is a subjective calculation that includes expectations of future earnings growth, which can differ amongst investors and analysts.

These competing viewpoints can sometimes make GARP investing harder to implement for everyday investors, as you might need to devote a lot of time to reading, researching, and coming up with your independent view of a stock's valuation.

Is the GARP strategy a good investment tool?

Adopting a GARP mindset when building your stock portfolio is a great idea. GARP allows you to combine the best bits of growth and value investing to create a portfolio of good quality stocks with great long-term growth potential that aren't as high risk as growth shares. This is because – like value investing – a GARP strategy also factors in the company's underlying performance and its relative cheapness.

However, it's important to remember that GARP investing also has limitations. GARP can be a lower return than growth investing and time-consuming for everyday investors to implement, like value investing. If GARP investing sounds appealing to you, but you don't have the spare time to research stocks and calculate ratios, a quick, easy and cheap alternative is to invest in ETFs.

Funds like the VanEck Global Healthcare Leaders Fund use GARP principles in their investment strategy, which means you can be a GARP investor without having to do any hard work.

This article contains general educational content only and does not take into account your personal financial situation. Before investing, your individual circumstances should be considered, and you may need to seek independent financial advice.

To the best of our knowledge, all information in this article is accurate as of time of posting. In our educational articles, a 'top share' is always defined by the largest market cap at the time of last update. On this page, neither the author nor The Motley Fool have chosen a 'top share' by personal opinion.

As always, remember that when investing, the value of your investment may rise or fall, and your capital is at risk.

Motley Fool contributor Rhys Brock has positions in Nextdc. The Motley Fool Australia's parent company Motley Fool Holdings Inc. has positions in and has recommended CSL and Xero. The Motley Fool Australia has positions in and has recommended Xero. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.