GARP INVESTING – BLENDING TWOSOME IS AWESOME

Equities – The best over Long-term 

Here is the table of post-tax returns (CAGR)* as on Jan 2015 of various asset classes:

 *Compounded Annual Growth Rate:

Source: Economic Times & Morgan Stanley

Equities had consistently outperformed all other asset classes over long-term. But some of us become averse of stock market, may be because of past bitter experiences and keep saying “Stock market is a casino and it is a gambler’s paradise,” without analysing our mistakes AND failed strategies.

In fact, the real time to make money in stocks is the time that gives us nightmares. If we analyse “what went wrong,” realise and start learning from our mistakes, the stock market is no longer a casino.

Did Warren Buffet ever make an investment mistake?

Of course, he did. All legendary investors, including Mr. Buffet continue to make mistakes, but they won’t make the same mistake again.

It is his Growth At a Reasonable Price(GARP) investing strategy that made Buffet a legendary-investor, not the “quality time” spent in watching “experts’ views” and day-trading.  Our goal is to achieve financial freedom quickly, not becoming “next Warren Buffet”, at least for my sake.

It is a strategy that borrows its tenets from both growth investing and value investing. So, GARP = Growth + Value

Benjamin Graham authored the idea of value investing. Graham’s model of value investing is to invest in a company if it is trading below its intrinsic value. Intrinsic value can be calculated by various methods, including the Discounted Cash Flow Analysis.

Typically, value stocks have:

•         ƒ         Low Price – Earnings Ratio

•                       Low Price-to-Book Value

•         ƒ         High Dividend Yield

•         ƒ         High Dividend Pay-out Ratio

•         ƒ         Strong Cash flows

•         ƒ         Strong Balance Sheet with little/no debt

•         ƒ         Most importantly, UNDERVALUED (Trading less than its Intrinsic Value)

Companies, which belong to upstream Oil & Gas Industry like ONGC, OIL India & GAIL fits the bill in Indian parlance.

Price Chart of Oil India over 5 year period

If we look at the price chart of Oil India, it traded in a very narrow range and more stable compared to the roller coaster ride in the broader stock market.

Value investing strategy is more suitable for risk-averse investors, who forgoes high return and satisfied with low return, stable dividend income with capital protection.

Beware of Value Traps

Some stocks appears to be cheap because of trading at low P/BV, P/E ratios, but it is not so. Those who are investing with the hope of earning good returns may fall in the trap and stock will keep on going downwards.

Some characteristics of value trap are: technological obsolescence, high debt, over aggressive, inefficient management, corporate governance and cooking account

Price Chart of MTNL from 2000 onwards

A cash rich company till late 2000’s, today it has more than Rs. 15,000 crores in debt. Although, it may have significant land bank which was not reflected to their true worth in the books, the stock price fell from Rs. 390 in 2000 to Rs. 15. MTNL’s twin brother BSNL is not listed in the stock exchanges.

Growth Investing

Growth investors do the reverse of what value investors do. While value investors are concerned more with the company’s value as on today, growth investors look at the company’s future potential. Common Characteristics of Growth Stocks include:

•         ƒ         High Price – Earnings Ratio (some stocks may quote at P/E of more than 100)

•         ƒ         High Price-to-Book Value

•         ƒ         Very Less/No Dividend

•         ƒ         Aggressive Strategies

•         ƒ         New Technology/Sunrise Sectors

•         ƒ         Niche Product/Brand value

•         ƒ         Exponential Revenue Growth

•         ƒ         Mostly belong to Mid-Cap/Small-Cap Category

•         ƒ         Often Overvalued

So many stocks fits the bill of growth stocks like Just Dial, Facebook (listed in NASDAQ), Page Industries, Jubliant Foodworks, Sun Pharma, Dish TV, Bharti Airtel (from 2002 to 2008).

Let us look at the chart of the biggest wealth creator of the last decade “Bharti Airtel” from the date of listing in stock exchanges

From IPO price of Rs. 22.50 (adjusted for stock-split) in February 2002, it skyrocketed to Rs. 574.50 in October 2007 i.e. a 26-bagger* in less than 6 years. From the days of mobile phones being used by multi-millionaires in late 1990’s to dual-sim lifestyle, mobile tele-density transformed our lives and Airtel being the No.1 mobile operator in our country benefited the most from it. Now, it is trading less than the all-time high, because of its loss-making African operations (acquired from Zain).

Growth investing is most suitable for risk taking investors, who afford to lose substantial part of their capital in search of high returns. They are interested in capital gains and ten-baggers*, not dividends.

GARP Investing – Blending Twosome is Awesome

Growth At a Reasonable Price – An investing strategy that combines the tenets of both value investing and growth investing.

Like growth investors, GARP investors also consider the future potential of the Company, but they avoid stocks, which are quoting at extreme valuations like high P/E, high P/BV, start-up companies, etc., The benchmark ratio for GARPers is PEG Ratio*.

*Price-Earnings/Growth Ratio = P/E Ratio / Expected Growth Rate.

A GARP investor seeks out for stocks which are trading at PEG Ratio of less than 1 (i.e. Expected Growth Rate of the Company is more than its Price-Earnings Ratio). Most of the time, GARP investors track the same stocks that Growth investors are tracking, but they wish to buy them at a significant discount to the prices that growth investors are paying. In short,

GARP investors wish to “BUY A GROWTH STOCK AT VALUE INVESTOR’S PRICE”.

But this type of situations arises either in bear markets like the 2008 sub-prime crisis, when Sensex itself was trading at 10 P/E Ratio (i.e the Yield from basket of stocks constituting Sensex is 10%) or negative news, which may drag down the share price (like the recent Maggi Event costing Nestle.

Let us look at the price chart of Tata Consultancy Services from 2008 lows to today

On 27^th Oct 2008, it has touched a low of Rs. 209/- (price adjusted for Bonus issued on June 2009) and it was trading below Rs. 250/- till April 2009. Had we invested a significant corpus at that time, when TCS was trading at 8 to 10 times P/E Ratio with EPS of Rs. 26.82/- (adjusted for bonus), by now we would have achieved our goal (financial freedom). The investment would have delivered more than 1000% return in just 6 years (that too excluding dividends).

Our buying price determines our returns. So, wait patiently and swing the bat (BUY) only when it is a bad ball (BEAR MARKET/CORRECTION) and dispatch it to the stands for 115m six (MAGNIFYING RETURNS).