Month 9 running our Growth At A Reasonable Price Strategy sees our portfolio of stocks rising by 3.1% in May.
The strategy is now showing 8.4% YTD returns and has shrugged off the effects of the correction at the start of the year.
We analyse what’s happened in the last months 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 on look to create a portfolio with the perfect blend of value and growth stocks.
In the summer of last year, we published How To Return 29% A Year From This Successful GARP Strategy. The article 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.
How The Strategy Works
The strategy was built and tested using the InvestorsEdge.net platform – you can find more risk and strategy performance information on the model, together with the actual strategy definition details, by clicking here.
Each month we rebalance our portfolio using the following rules – we begin by 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 we then rank using the following factors:
Price to Book Value
Price to Free Cash Flow
We then buy the top 10 stocks in our ranked universe of securities, dropping existing positions unless they continue to rank in the top 10.
Our 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.
How Has The Strategy Performed Since Then?
Backtested results are a good starting point to identify robust and high-flying strategies, but they can be misleading as they often don’t produce matching results in the real world. We have been tracking and investing our own cash into this strategy since September 2018 with promising results – you can see how we have performed here.
The equity curve chart shows our strategy weathering the recent pause for breath in the markets by dropping in February and March but powering back in April and May:
Total Return (9 months)
Win Rate (Closed)
Our strategy sold 8 out of its 10 positions at the start of June. 5 of these positions were in the red, leading to our win rate reducing from 60% to 50%. We expect this to increase to the backtested average of 65% over the next few months.
The big winner in our portfolio of stocks is Mercer International with a 15% gain over the month. Again, looking at the backtests we performed when designing the strategy this is typical – losing trades have been cancelled out by the smaller winning trades, with the larger winners carrying the profits for the portfolio.
Why The Strategy Has Worked
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 4th June 2018, the strategy held the following positions:
Williams-Sonoma Inc (WSM)
BG Staffing Inc (BGSF)
Tower International (TOWR)
Park-Ohio Holdings (PKOH)
Magic Software Enterprises (MGIC)
CONSOL Coal Resources (CCR)
Hyster-Yale Materials Handling (HY)
Wheaton Precious Metals Corp (WPM)
Abercrombie & Fitch (ANF)
Positions Closed On 4th June 2018
The strategy sold eight positions to make way for the newcomers:
Tilly’s Inc (TLYS)
Hi-Crush Partners (HCLP)
Star Group (SGU)
Toll Brothers (TOL)
American Eagle Outfitters
Just Energy Group (JE)
Marvell Technology (MRVL)
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 25% in the nine 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.