What are we looking for?
Reasonably valued, predictable, growth stocks in the U.S. markets.
The screen
The term GARP (growth at a reasonable price) has long been known to investors who search for companies that show growth in earnings but remain reasonably valued. This investment style is often associated with one of the investing greats, Peter Lynch, who managed the Fidelity Magellan Fund from 1977 to 1990, during which time he drastically outperformed the market.
This week, I use Morningstar CPMS to create a GARP-like strategy for the U.S. market, focusing on large-cap names with predictable earnings. One of the more notable measures in this type of strategy is the PEG ratio, which measures a company's price-earnings ratio against the projected growth rate of earnings. The lower the PEG ratio, the better value investors are getting per unit of growth. The strategy ranks stocks based on the following characteristics:
- Forward PEG ratio;
- Trailing P/E ratio;
- Price to book;
- Trailing reinvestment rate;
- Earnings variability (measures the historical volatility of a company’s reported earnings, lower percentage preferred);
- Quarterly earnings momentum (latest four quarters of earnings compared against the same number, one quarter ago);
- Price change over the last nine months.
Qualifying companies have a market cap greater than $6-billion (U.S.). Companies with a limited partnership structure were also excluded.
More about Morningstar
Morningstar Inc. provides independent investment research in North America, Europe, Australia and Asia. Its research tool, Morningstar CPMS, provides quantitative North American equity research and portfolio analysis to institutional clients and financial advisers. CPMS data cover more than 95 per cent of the investable North American stock market. With more than 110 equity and credit analysts, Morningstar has one of the largest independent institutional equity research teams in the world.
What we found
I used CPMS to back-test this strategy from December, 1993, to April, 2015. During this process, 10 stocks were purchased and equally weighted with a maximum of three stocks per sector. Stocks would be sold if they fell outside the top 25 per cent of the ranked universe, or if quarterly earnings momentum dropped below minus 5 per cent. Over this period the resulting strategy produced an annualized total return of 14.7 per cent while the S&P 500 total return index returned 9.4 per cent. Although the strategy only held 10 stocks at a given point in time, today 20 stocks qualify to be purchased into the strategy.
As always, investors are advised to conduct their own independent research before purchasing stocks shown.
Ian Tam, CFA, is a relationship manager for CPMS at Morningstar Research Inc.