Month 11 running our Growth At A Reasonable Price Strategy sees our portfolio of stocks rising in value by 2.85% in June.
The strategy is now showing 36% YTD returns and has largely ignored the ups and downs of the market this year.
We analyse what’s happened in the last month and why our strategy has remained so resilient.
Growth at a Reasonable Price, or GARP, is an investing style popularized by Peter Lynch, the legendary Fidelity manager. A GARP strategy looks to buy companies that show consistent earnings growth combined with a low relative price. These types of strategies look to create a portfolio with the perfect blend of value and growth stocks.
In the summer of last year I published some research (How To Return 29% A Year From This Successful GARP Strategy) that examined traditional factors used to identify companies exhibiting strong growth at low prices to see what worked and what didn’t, and came up with a mechanical trading strategy that looked extremely promising.
July Performance (Month 11)
You can see the full results and statistics for the model by clicking here, but in summary the model had another good month and now sports an equity curve that looks like this:.
Our strategy sold 4 out of its 10 positions at the start of August (MERC, BGSF and TOWR, KMT), locking in 40% profits for both Mercers and BG Staffing and small wins with Tower Intl and Kennametal.
In their place comes four stocks come Synnex Corp (SNX), Taylor Morrison (TMHC) , Williams-Sonoma (WSM) and Hyster-Yale (HY). The rest of the positions are slightly underwater and since we are now in the traditionally quiet month of August I’m not expecting huge changes in the value of our portfolio in the next few weeks.
Total Return (10 months)
Win Rate (Closed)
How the Strategy Works
Each month I rebalance my portfolio using the following rules – starteing with defining a universe of stocks that have:
Market capitalizations greater than $150m and share price greater than $2.
A PEG ratio less than 0.9.
An average EPS growth rate greater than 10% for the past 8 quarters.
Net Current Asset Value of greater than $-750m.
Gross Income greater than Gross Income from the last quarter.
On 1st January (our last rebalance point), this would have returned 76 stocks, which are then ranked using the following factors:
Price to Book Value
Price to Free Cash Flow
I then buy the top 10 stocks in our ranked universe of securities, dropping existing positions unless they continue to rank in the top 10.
The original backtests displayed compounded average returns of 29% a year since 2000 with remarkably low volatility for a strategy that invests primarily in small and mid cap companies.
Why The Strategy Has Worked
Why does the market favour this strategy? Why haven’t others spotted the opportunity and started to trade it?
Our strategy has worked so well because it does exactly what it says in the title – seeks growth at a reasonable price. The GARP strategy looks to identify companies that have a recent history of growing both its top line income and bottom line earnings that are still undervalued according to their current price compared to book value, cashflows and historical growth.
Because the stocks that the strategy picks have shown growth in fundamentals but not yet in price (we specify a PEG ratio of less than 0.9), we select stocks which have a high chance of popping higher in the short term. Coupled with the fact that the strategy also tends to only hold stocks 1-3 months, this enables us to take profits on successful positions quickly and drop losing positions before they can do too much damage to our returns
As of 2nd August 2018, the strategy held the following positions:
Synnex Corp (SNX)
Taylor Morrision (TMHC)
Hyster Yale (HY)
CONSOL Coal Resources (CCR)
PulteGroup Inc (PHM)
Toll Brothers Inc (TOL)
Park-Ohio Holdings (PKOH)
Magic Software Enterprises (MGIC)
Positions Closed On 1st August 2018
The strategy sold four positions to make way for the newcomers:
Mercers Intl (MERC)
BG Staffing (BGSF)
Tower Intl (TOWR)
A key risk that we always examine with mechanical investing strategies is that the data phenomenon that we are exploiting will simply stop working. To combat this, we look to see if a strategy intuitively makes sense – our model invests in companies with high historical and estimated EPS growth, high yields and assets and that are cheap relative to their book value and free cash flows, and that are showing improving gross income figures. To us, these are all logical and understandable factors as to why our system works and should continue to be profitable.
The average company our strategy invests in has a market capitalization of $250m-$2.5bn, leading to potential problems exiting positions at the lower end of our range in a market downturn. Risk appetite is an individual thing – for us the enhanced returns that come from focusing on smaller companies more than compensate the liquidity risk we take on. If this is a concern, operating the strategy with a higher market cap threshold would have resulted in smaller but still substantial historical profits.
Our Growth at a Reasonable Price strategy has held up as US stocks headed lower, and then raced ahead of its benchmark as the market bounced back. The value of our holdings have grown by 33% in the eleven months since we published our idea and we feel that the strategy has demonstrated a good level of resilience during the recent market turbulence.
We have invested in this strategy with our own funds, and will continue to do so as this strategy shows no sign of running out of steam.